European investors often have a very strong domestic bias in their equity portfolios, allocating investment elsewhere to global mandates. While many global managers see the US market as a whole expensive and are accordingly underweight, this overall view is heavily influenced by the top 250 stocks which account for 70% of market capitalisation. But as Andrew Chapman from the John Lewis Partnership pension fund declares, “finding a manager who can outperform US large cap is impossible”.
However, the small and mid cap sectors of the US market are still a larger market than any other equity market outside the US, and it is here that potential for outperformance lies. With 6,500 or so stocks in the US marketplace, it is not surprising that many stocks have either no coverage at all or only one analyst. The issue for European investors is how to incorporate US portfolios within their overall asset allocation.
If there are no asset allocation skills available in-house, it can make sense to award global mandates to managers and leave them to make the allocations to the US. Chapman’s non-UK portfolio is generally underweight the US, but the reason he also hired a solo US small cap manager is that the US small and mid cap market “is huge and there are inefficiencies which global managers cannot find”. However, relative valuations of small and mid caps after almost seven years of outperforming large cap stocks, are looking strained which suggests that while seeking specialist managers may be justified, having excess weightings may not be.
The mid cap universe is generally seen as the size range between $2bn (e1.68 bn) or so and $10bn corresponding to between 70-90% of the US market by capitalisation, while small cap is generally regarded as the next 5%, essentially between $1.8bn and $900m, while micro cap is the last 5%, where few managers focus.
The small and micro cap universe overlaps in size with private equity investments and as Neil Wagner from BlackRock explains: “Clearly, this is having a big impact on the market. We have had a number of companies acquired by private equity firms. There has been a pick up in M&A recently and private equity firms have had a big hand. Private equity returns in the near term have been good, partly because of cheap financing and companies in public markets are clearly going to benefit by being acquired.” He adds: “We would never buy a stock though, in the hope of it being acquired, but some have been and this process will continue.”
The Russell set of indices is used widely with core, value and growth variations of the Russell 2,000 small cap while the Russell 2,500 includes mid caps as well. In a less liquid market with a large number of stocks, it is sensible to treat indices as a measure of comparative performance rather than a minimum risk portfolio.
Style indices add another dimension to performance measurement of value and growth managers, but need to be treated with care. As Brian Berghuis who runs T Rowe Price’s mid cap growth fund points out: “We have a couple of benchmarks, we use the S&P mid cap index, which was the only mid cap index around when we started. The drawback to it is that it is not strictly a growth index, so it has utilities and financials as components at much greater weights than we would have. We also use the Russell mid-cap growth index as a benchmark. That tends to be much more aggressive than what we do. So we are not particularly benchmark centric.”
The idea of separating out small cap managers for dedicated mandates does appear to have some academic evidence to back it up. What is now known widely as the small cap effect was first analysed by Rolf Banz at the University of Chicago in 1981 and, based on stock returns from the New York Stock Exchange from 1926-1975. He found that small companies have higher expected returns than large companies and behave in a different manner.
This led to the founding of Dimensional Fund Advisors (DFA) as a way of seeking to exploit this anomaly. The above figure from DFA looks at the annualised returns of the total universe of US listed stocks grouped in 10 size bands over the period 1926-2004 (using data from the Center for Research in Security Prices that is free of survivorship bias). This shows a clear and consistent increase of annual return with decreasing market capitalisation. What it does not show however, is the volatility of different segments and Berghuis argues the case for mid cap which “prior to 1990 was not even a category”, by explaining that their own analysis of the data showed that “small caps outperform mid caps and mid caps outperform large caps over long periods of time. However, what we also found was that while the performance of mid caps was closer to the higher performance of small caps than large caps, the volatility of mid caps as a proxy for risk, was closer to large caps than the higher volatilities seen in small caps.”
DFA also base their own investment approach around the fact that historical data shows small cap value to have greatly outperformed small cap growth over the same period. The reasons for this may be as much to do with sector selection as size, since small cap value has a higher weighting in finance while the three largest growth sectors are technology, healthcare and consumer.
As Greg McCrickard who runs T Rowe Price’s small cap growth fund declares: “We think this small cap cycle is really long in the tooth, if we get to April 2006 you will have had seven full calendar years of the cycle working for you. They don’t look cheap to us on a valuation basis. Early this year our small cap growth portfolio hit levels of valuation it had not seen in more than 20 years,” going on to add that “Steve Leuthold of the Leuthold group calculates that ‘small caps are at an 8-10% valuation premium to large caps and the last time they were at a 10% premium was 20 years ago in 1983’.”
In the mid cap area, Berghuis sees the situation as less clear: “Mid caps do tend to trade closer to small caps over time than to large caps. So if the small cap cycle were over, mid caps would underperform in all likelihood compared to large caps. On the other hand, the magnitude of the up cycle has been smaller than average and the conditions that we typically see towards the end of a cycle, don’t seem to be prevalent at this point. Valuations in the mid cap arena are comparable to large cap and that’s reasonable given the higher growth prospects in the mid cap sector. I haven’t really seen the speculative fervour that you would expect to see in the small or mid cap sectors towards the end of the cycle.”
McCrickard says T Rowe Price “thinks there is more of an opportunity in larger caps, especially large cap growth. On an 18-24 month view large cap growth might be a better place to look over the next couple of years”. While “if there is going to be a last rally in small caps it’s going to come from the small cap growth side because that is the area which has underperformed relative to small cap value”. He adds: “Overall I think there is probably a transition across the market from value to growth and small to large.”
Unlike the more internationally oriented large caps, the prospects for the small and mid caps are heavily weighted to what happens in the domestic US economy. BlackRock’s Neil Wagner sees two possible scenarios. “One good, one not so good. Can the Fed engineer a soft landing? Drive rates higher without engineering a recession? If so 2006 could look a lot like 1995, which was a very good year for small caps. The other scenario is that the Fed goes too far, in which case 2006 will be disappointing for the equity market in general and for small caps in particular. The market is clearly worried about the latter scenario.”
In 2003 the small cap rally was broad based, but then the Fed raised rates and started its tightening cycle. Since the tightening started, the Russell 2000 has gone on to hit an all time high but it has been driven by fewer and fewer stocks. I think this indicates that there is less and less overall confidence in the economy.”
Increasing globalisation across most industrial sectors does raise some opportunities though in private equity, as Stephan Breban of City Capital Partners points out: “Small averagely run businesses could become big and better placed with just a buy and hold strategy and the starting point is more likely to be a small US company as they will have the larger initial size off which to build.”
Despite the issues of valuation, DFA’s Philip Nash has found that while “some of our clients who have been with us for the last four years are starting to scale back their investments, on a net basis we are still seeing inflows as there are more new investors coming in”.
The sheer number of companies and the total market cap has spawned a huge variety of different approaches to investment. While some firms have a strong focus on particular styles, eg, Friess Associates as a specialist US small cap growth house, others such as GMO have started out as value, but also introduced growth within the same firm.
T Rowe Price started out as a growth house in 1937 and now offers value, growth and core, run by separate fund managers but utilising a common research platform. More recent entrants such as BlackRock have built up capabilities through incorporating separate teams covering small and mid cap core, and small and mid cap value in addition to having a separate mid cap quantitative process all run autonomously with dedicated research analysts; although information is shared within the firm, and core products are run by a fund manager using ideas generated by the two separate value and growth teams.
Indexation as a process is better suited to liquid markets with a relatively small number of stocks giving the opportunity to achieve full replication at a reasonable cost in terms of trading and market impact. With 4,800 stocks of less than $2bn, and many that are hardly traded at all, indexation is not an attractive option. DFA’s approach is essentially pragmatic, screening the universe for all stocks that satisfy the eligibility requirements giving a current buy list of around 2,700 and essentially buying and holding all stocks with new investment. Turnover is around 10%, and selling principally occurs when a stock moves up out of the size range. The benchmark used is an internal index which gives the target weights of the underlying companies.
At one extreme in active investment are the active quantitative firms such as GMO, AXA Rosenberg and others, who rely totally on data to analyse companies, and typically have portfolios with hundreds of stocks. At the other extreme, operating in essentially the same universe, are private equity firms who may often be running larger portfolios with $10bn or more, but have 15-25 companies in the portfolio with major or majority stakes, a key role in strategy through seats on the board and an active role in locating M&A opportunities.
The issue for any firm in the middle is how to sift through information on 6,000 companies to select stocks and construct portfolios. While the market is large enough to support specialist boutiques focusing on particular niches, the larger players face the issue of supporting products invested across a wide range of size buckets and styles.
One approach is that of T Rowe Price, utilising a large research team organised predominantly on an industry basis providing ideas and inputs to separate fund managers, although Greg McCrickard admits that “there are times when things fall between the cracks, so our team have a couple of generalists to cover that”.
BlackRock in contrast, has dedicated research teams for value and for growth, where according to Wagner “a typical analyst follows 50-100 companies. Typically, an analyst’s coverage universe is pretty consistent over a three- to five-year period. New ideas for our portfolios come from the analysts.” Both firms have a strong focus on stock picking rather than sector allocations.
For BlackRock’s small cap portfolio Wagner is “looking for companies with 10% growth and and market capitalisation of less than $2bn. There are about 800-900 companies in US small cap which satisfy these criteria. We take these companies and distil them down to a 100 stock portfolio, mostly through qualitative research done by the analysts. But quantitative screening using relative valuation metrics, such as P/E and price to sales, is just one element of idea generation.”
McCrickard says T Rowe Price “doesn’t have a rigid, mechanical process. Some 90-95% of ideas come directly from the research analysts. In general they know the types of companies I am looking for, those with reasonably strong cash flows or the prospect of getting there with a pretty attractive valuation. We also use screening, we look for companies generating reasonably high returns on invested capital, firms which are adding value. That will spit out a list of 10, 15, 20 companies and we will go through those to see if anything looks interesting.”
One problem any new investor will face is that of gaining access to the preferred manager, whether in private equity or the listed markets. Many firms have either closed to new business altogether, or have restricted new investment to particular classes of investors or mandates. The limits to capacity are not necessarily “the aggregate assets under management. It was the rate at which money was flowing in,” McCrickard points out.
Turnover also plays a key role, “A typical manager turns over 100% and runs maybe $1.5bn which is definitely what you see out there” while McCrickard running $8bn and turning over 20% is trading the same amount going on to add that: “Îf we were looking to do 100% turnover then it would be hard with this level of money but that is not how we run money.”
With market returns looking less attractive in the future, and seeking excess returns through choosing managers made more difficult by closure to new investment, new investors need to tread warily before overweighting what is undeniably an attractive long-term asset class.