Still the wild frontier
US small and mid caps remain the crucible of corporate capitalism and opportunity. But Joseph Mariathasan finds that the challenge is in steering through the sheer variety of stocks and managers
The US small cap equity market has represented the cutting edge of capitalism for decades, and with more than 4,000 companies in the small and mid-cap marketplace, the diversity of opportunities is immense. Moreover, as Oscar Vermeulen, managing director of multi-manager Altis Investment Management observes: “Unlike the European marketplace, the US is full of small-cap managers who are able to add value.”
For the most part European institutional investors have ignored this market, despite the fact that, however defined, it is larger than most other all-cap equity markets. “Some of the large Nordic and Dutch investors do allocate mandates to US small and mid-cap strategies,” explains Gordon Hogarth, European managing director of Affiliated Managers Group, which owns a number of specialist US equity boutiques, one of which recently won a $100m small-cap mandate.
But Philipp Schreyer, US manager at Altis, argues that European investors have tended to be very opportunistic in US small caps, with most investing solely in large caps, with perhaps some leeway to invest in mid caps. “Yet what is very attractive about the US small-cap market is that there are many fund managers who have been sticking to their own niche strategy for years, if not decades,” he says.
“These managers are often highly specialised. They can generate alpha through their own niche approaches, but often do not bother with comparisons with the sector classifications of the benchmark indices. Instead, they seek to find gems and hold them for years, even a decade or more.” As a result, the tracking errors can be very dramatic, with sizable short-term underperformance, the best solution to which is perhaps to diversify manager risk between two to three value and two to three growth strategies.
The alpha question is potentially important, as the recent rally might prompt investors to wonder if the beta opportunity has come and gone.
“There is a historical precedent for small caps to outperform in the early stage of a recovery,” says David Wagner, portfolio manager at T Rowe Price. “But that started in March, so it is an open question whether small caps will still outperform over the next year. I am more confident that they will outperform over the next decade.”
One might also assume that small caps are more domestically focused, and therefore less sensitive to global growth. But that is not necessarily so. “Can small-cap US stocks operate in a vacuum?” asks Stephen Knightly, president of Frontier Capital Management. “That may have been true decades ago but is not the case today. Every company operates in the global marketplace and needs to have a global perspective on manufacturing, sourcing, and so on, otherwise they are just roadkill.”
Ron Mushock, portfolio manager at Systematic Financial Management adopts a very bottom-up approach to stock selection, yet he finds that a common factor in recent performance of some of his very domestically focused mid and small caps has been Chinese demand feeding into commodity prices.
The economic outlook is still very uncertain and for Todd Perkins, portfolio manager at Perkins Investment Management, there are significant issues with current valuations: “We have trouble in seeing the type of ‘V-shaped’ recovery that the expectations built up in small-cap valuations are implying,” he says, arguing that there has been little real improvement in economic fundamentals to drive the rally, which he attributes to a weak dollar and a flight to risky assets. However, it could merely reflect a return to reasonable valuations after the avoidance of the doomsday scenario.
David Daglio, portfolio manager at The Boston Company, notes that many companies still trade at a discount to their 20-year average mid-cycle valuations. “Whilst current price/earnings ratios may not look attractive, the earnings figures will look attractive once we go into 2011 and 2012,”he says.
David Wagner, portfolio manager at T Rowe Price, points out that during the 1980s and 1990s small caps dramatically underperformed large caps, before strongly outperforming to sit at a premium in 2006. “Over the last three years valuations have come back to more normal ranges,” he says. “They appear neither expensive nor cheap.”
Small-cap companies still have to rely on surviving and prospering in the raw capitalist jungle without government bail-outs. But small-cap managers do have some significant advantages over large-cap managers. While large companies might have 20 Wall Street analysts following them, most small companies would have a handful at most, and many will have none. But how to tackle the sheer number of companies, many with limited trading volumes? Even replicating an index may itself require costly or market-impacting levels of turnover. Dimensional Fund Advisers (DFA) gets round this by essentially running passive funds without attempting to replicate an external benchmark - instead just purchasing stocks whose market cap falls within the smallest 8% of the total US market universe.
Active managers have the choice of either ignoring the universe completely or using some sort of quantitative screening to filter it down to a core that can be subjected to more fundamental and qualitative analysis. Systematic Financial Management for example, uses a quantitative ranking model that tailors combinations of valuation factors for each sector, combined with an additional model to assess operational trends in areas such as income and profits, earnings expectations and quality, defined by factors such as working capital management and capital deployment, which aims to avoid ‘value traps’.
As well as the use of quantitative techniques, perhaps the other most obvious differentiator among small cap managers is the style bias they choose to adopt. The choice between value and growth is very significant in small cap. Growth managers place less reliance on historical data since, by definition, they are looking for companies that are able to double or even quadruple in size. “Growth investing is often a binary bet on a company,” says Schreyer. “It will either double or go bankrupt. But in the US, there is no stigma in becoming bankrupt.”
By contrast, value managers can utilise historical data with some confidence. But there are also a wide variety of value investing strategies - from the 1,600-plus stock portfolios of DFA’s small-cap value strategy to firms that find their own specialised niches and ignore the benchmarks, except as a target to beat. Third Avenue, for example, is a deep-value investor, but it does not focus on the usual characteristics, like stable earnings, that traditional value managers look for. Instead it is more focused on asset values and the possibilities for the use of those assets, according to co-CIO Curtis Jensen: “The bulk of our investing tends to be in ‘hard asset businesses’. We like industries where supply is constrained, capacity has evaporated and perhaps where there is undue scepticism.” Jensen picks out energy, property and casualty insurance, and some of the smaller US banks.
Small-cap growth companies - the embryonic Microsofts and Googles of this world - may be the lifeblood of regeneration in the US economy, but Altis, as well as the academic evidence, finds that while there is clear proof that many value managers are able to add alpha, the sources of alpha for growth managers are less clear. Bob Marren, managing director and a portfolio manager for Nicholas-Applegate’s US small-cap growth strategies, argues that this might be misleading. “Whilst value indices may outperform growth indices, for active managers it is a different story,” he says. “Value managers tend not to beat the Russell index by the same amount as growth managers do.”
Growth managers such as Frontier Capital Management often have a strong qualitative analysis framework. For Knightly, the approach is built around three questions: Can the company be a good business over the next two to five years? Does it have good earnings potential over that period? Is it priced cheaply? That can rule out entire sectors: “I have no time for any airline apart from Ryanair. None of the others ever made a profit on a sustained basis,” says Knightly.
Clearly, choosing a small-cap manager can be difficult, given the huge diversity of approaches. But as Vermeulen emphasises, unlike the situation in Europe, the US marketplace at least has a huge number of well established and long standing small-cap specialists to consider. The problem is more how best to combine a few of them to deliver the tracking error as well as the outperformance that is being sought.
If small-cap investors are successful their portfolio companies will, of course, grow too large for their universe and have to be replaced by IPOs. Indeed, companies are often removed from small-cap portfolios before they get too large through merger and acquisition activity. While private equity firms might no longer be active players in the small-cap space, in the last eight months or so there has been a pick-up in M&A from strategic buyers. But this has not been matched by a corresponding increase in IPOs, and the few IPOs that have occurred in the last few years have shown dismal performance once the funds were trading, according to Marren.
One factor Marren blames is Sarbanes-Oxley: “A company with a $200m market capitalisation could afford to spend a few hundred thousand dollars on the cost of regulation if they listed,” he says. “But with Sarbanes-Oxley, the cost is now a few million - which could halve their earnings.” However, Wagner is more positive on the outlook for IPOs: “There is still a lot of venture capital that has been successfully invested in areas such as healthcare and technology. As we move through the deleveraging phase for over-leveraged companies, we will start seeing more IPOs in 2010.”
Given the importance of IPOs for the continuing strength of the US economy, it is more likely that Sarbanes-Oxley will be relaxed, rather than a continuing dearth of new companies floated on the marketplace.