Pas de deux or danse macabre?

Free market economies are often characterised as competitive jungles with efficiencies and performance being driven by the relentless warfare of the marketplace. The US public markets are viewed as critical to ensuring the ongoing dynamism of the US economy, and within that, whilst large caps may make up 70% of the market capitalisation, it is the thousands of small and mid-sized companies that represent the potential giants of tomorrow and which provide fertile hunting grounds for seeking superior investment opportunities.

However, whilst the US small cap market is larger than the whole of the Japanese stock market, most of the stocks are too small for mainstream fund managers to bother with.

For New Star’s Greg Kerr, “a large number of stocks are not on the radar screen and what you have to remember is that because they are small they are not really investible. So, sure, there are zillions of stocks at the market cap level of $100m but they aren’t investible
and even if they doubled it wouldn’t make any difference whatsoever to your portfolio. So that is why big caps are important - they do reflect the aggregate value and indeed from an investible perspective, the big companies are the ones you can invest in more easily.”

Despite the hurdles, the academic evidence of long-term persistent outperformance by small caps is quite strong, which is why small cap specialists such as Philip Nash of Dimensional Fund Advisors (DFA) argue that investors should be overweight small cap. In their own experience of European institutional investors, “in the early part of the cycle, clients were going from a zero to a 10% weighting, which is neutral.

Now, in the last year or two, people have made bigger allocations to, say, 15%. Is that bad timing? Or is it a client saying that I am trying to use my risk budget better, I know that I get a premium for small cap, I don’t know when.”

The mid-market private equity buy-out market, which essentially targets the same size category of stocks around $1bn or less in capitalisation, is also raising record amounts and there is an enthralling ongoing pas de deux between the public and private markets with investors acting as the cheering audience.

Cheap credit and the effects of the Sarbanes-Oxley Act of 2002 is making the dance more frenzied, as many publicly listed small companies consider going private with a large increase in gearing as the cost burden of increased reporting requirements is inevitably more weighty for smaller companies. As Friess Associates’ Gordon Kaiser says, “Sarbanes Oxley is very expensive to comply with and even more expensive if you don’t comply. The lawyers and accountants are really doing well because of it, but we are not so sure that investors have been well served by it, because the cost of compliance is so high relative to the transparency benefits brought.”


The question as to whether US small caps are currently overvalued relative to large is an issue that currently bedevils potential investment into the asset
class. US small cap stocks have had a good run for a number of years and have reached levels that many fund managers believe are overvalued relative to US large caps.

Kerr says: “We try to buy value, value is a function of quality and price. Big cap are often very high quality companies and there is obviously a right price for them. What our work tells us is that those big cap high quality names are actually, relative to history, undervalued compared to mid and small cap names. We have looked at the implied discount rate for big and small caps going back 20 years; you normally expect small caps to demand a higher discount rate because they are riskier stocks, more illiquid etc.

“That historically has been the case
but obviously the spread between those different discount rates changes over time. If you look at a chart of
the spread, not only is the spread the lowest it’s been in 20 years, it is also negative.”

So “why are small cap stocks still outperforming when experts have said they are too expensive and when you are looking at a cyclical downturn in the economy?” asks T Rowe Price’s Darrell Riley.

He goes on to point out that “if you look at the last cyclical downturn in the economy in 2002, small caps had much slower sales growth than large caps. Since 2003 small caps have enjoyed much stronger sales growth than large caps and a lot of this has to do with credit availability.

“Going back to what the
experts say, the common view is that the Fed is raising rates so credit spreads should
widen, credit availability should decline, small caps should underperform. Well that hasn’t happened.
Credit is still available, credit spreads are still very, very tight. Small companies can borrow all the money they want for practically nothing. They can deploy that and they can drive higher top line growth than larger-cap companies. So what is happening is out of sync with traditional thinking.”

Satya Pradhuman, the small cap analyst at Merrill Lynch, is more optimistic about current valuations. He points out in a recent note that larger firms are continuing to look for acquisitions to propel growth, the major elements of the credit cycle remain favourable with easy access to capital for small firms, and a healthy trend in IPOs while private equity flows remain quite strong.

Indeed, he argues, “as the equity markets continue to ease in the form
of increased primary and secondary offerings, the exit environment for private equity firms can only improve. Easier exit strategies in turn make it
easier for such investors to raise new capital and put the new money to work. This fresh infusion of capital should support current trends or make them, hard to believe, even easier. This capital markets circle dance is a symptom of the hunt for growth and an extended small cap cycle.” Some, however, would see it more as a ‘danse macabre’.

Kerr believes that “the private equity transactions we are seeing are not a reflection of bargains but of abnormally low interest rates, which I don’t think is sustainable. That is why when I look at what I think fair values are, there aren’t great compelling bargains. It’s not compelling bargains which are attracting financial companies; it’s the ability to leverage themselves up to the eyeballs with very cheap debt. Regardless of what has been happening with private equity, the only observation I would make is that it would appear to have already been discounted in share prices. My colleagues on the UK side own a lot of UK small caps because they believe private equity is going to buy all their shares off them. But of course in buying these stocks they have driven up the prices, which is why my model is telling me that small caps are expensive relative to large.”

But private equity players are not the only external drivers of performance in the listed US small cap marketplace. Riley makes the point that as well as LBO activity, mergers and acquisitions, hedge fund activity is also driving up valuations of small caps. He says: “If you look at the distribution of hedge fund investments by market capitalisation you see that they are disproportionately weighted in smaller companies. They do not own big companies like Microsoft; they own $1bn to $5bn companies. As hedge funds receive more money they push it into these areas, creating a technical driver behind small cap performance.”


Structure of the small cap market

What is possible only in the US,
because it is a huge and seamless marketplace, is to identify a promising company with a good product and business plan at a very early stage and then stick with it as it expands around the US.

Every major US city seems to have a few good small cap managers with this approach. The capacity of such managers however, is limited to probably not much more than a
couple of billion dollars each without impacting on performance.

With more than 4,000 listed companies in the
small and mid-cap space to consider, with a large fraction being very small and illiquid, it can be a dangerous fallacy to become too fixated on the performance of small cap indices, which may either not be able to fully reflect the universe of opportunities, or else may not reflect what fund managers can realistically achieve. Indeed, arguably many small cap listed companies with illiquid stocks may as well be private since there is little scope for a new investor to gain significant exposure at anything like their indicated stock price.

As Riley points out, “small cap portfolios tend to be more cyclical than large cap portfolios just by their
nature, as they include more domestic companies, so a small cap bet is a cyclical bet. If you believe the US economy is going to slow do you want to own expensive cyclical small caps or less cyclical, more reasonably priced blue chip growth?”

There is also a very pronounced variation between small cap value and small cap growth investing, as the TMT bubble so dramatically illustrated. DFA’s Nash has found that “over the last two years we have witnessed clients being much more aware of style effects in small cap. They have seen that value has a very strong premium over growth in US small cap.”

Certainly the index returns show a very pronounced variation, as Nash goes on to outline: “The size of the
premium is exceptional, with a differential return of 500bp per annum over long periods of small cap value in excess of small cap growth.”

It should be borne in mind however, that using index returns to characterise styles can be misleading as Kaiser explains: “We don’t care about growth versus value labels because those labels are often assigned based upon trailing statistics such as trailing P/Es, trailing earnings. We want to know where our companies are going, not where they have been.”

Investors are also faced with the dilemma that, whatever the past performance figures show, as Riley points out.

“Value is currently more expensive than growth relative to history so you want to be putting your incremental dollar on the growth side. Growth
stocks have been derated over the last six years despite the fact that earnings have been relatively good. Multiples are now back down to where they were in 1993, before the whole run started. That’s a good sign. So growth equities have been suffering through a derating period, which should be behind us now. Next year we should have reasonably good earnings and just a little bit of multiple expansion, if so the returns will be very nice.”

When looking for small cap, the choice is whether you should be taking a decision on beta, the returns possible for the marketplace, or whether there are managers whose performance and style is so uncorrelated to the rest of the marketplace, that it makes sense to invest regardless of index levels if they are seen to be able to offer exceptional returns.

Going for a straight exposure to the market via an index approach is more unsatisfactory than for the large cap marketplace because the illiquidity of small caps means that trading costs become very significant and this makes a purely mechanistic indexation approach very unsatisfactory.

Indeed, Northern Trust Global Investments (NTGI) quote a study showing that funds tracking the Russell 2000 Index lose between 1.30% and 1.84% annually due to expected demand and arbitrage activity around index changes.

More effective are semi-passive approaches, which do not make explicit stock selection decisions, but focus on minimising trading costs.

DFA’s approach for example, focusing on the bottom 10% of the market by capitalisation, does not seek to mimic an external index, but instead, focuses on gaining exposure to the total marketplace at a minimum cost and as a result, has a low turnover with a higher capacity than any active strategy.

Other approaches, such as that of NTGI, use an index such as the Russell 2000 as a benchmark, but access a wider universe and again, control trading costs in an attempt both to generate higher returns and also minimise transactions costs and hence increase capacity.

Active quantitative managers have both the advantage of being able to analyse the whole universe of stocks on a consistent basis, but also the disadvantage that the historical information being analysed probably has less direct relevance to future prospects in the small cap space than it does in large cap as small companies tend to change rapidly.

As Kaiser of Friess Associates, a firm at the opposite extreme in philosophy from a quant house argues “there will always be companies every day who will discover a new product, new technology, or benefit from new government legislation. We want to find those companies and invest in them.

“Our biggest technique is conducting one on one interviews, as a firm we probably conduct over 100 interviews per day with customers, competitors and suppliers of our target companies. We have 30 people who are 100% dedicated to research. We have a contact list with thousands of names of folks we can call who will share their insights on what is going on in specific industries.”

What of the future prospects for US small and mid-cap. When it comes to the effects of Sarbanes-Oxley, Kaiser asks: “Will it change?” He goes on to answer: “We think so. Typically in the US, investor attitudes and legislation is like a big pendulum. It has now swung too far in one direction and will probably swing back in the other.”

As for valuations, New Star’s Kerr says: “Given where prices are today, if you care about valuations rather than newsflow you should be in large caps rather than small caps.”

While T Rowe Price’s Riley puts it more subtly: “Ultimately, if you look at relative valuations it’s hard to put the incremental dollar of investments into the small cap space. On the margin today large cap blue chip growth equities are very cheap and so you want to put the incremental dollar there.”

For those still keen on gaining exposure to US small caps, whether public or private, the key issue any new investor really faces is gaining access to good managers before they close their funds.

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