Large cap stocks may be set to outperform small caps, but the best active managers will be able to find opportunities whatever the market environment, says Joseph Mariathasan
"Tisn't the season for small caps," declared Steven G DeSanctis, chief small cap strategist for Merrill Lynch, in a recent presentation on the US equity landscape, and most investors in the marketplace would probably agree. Institutional managers such as T. Rowe Price take the view that "the most recent small cap cycle has ended," according to vice-president Darrell Riley. "In our asset allocation portfolios, we have been gradually reducing our weight in small caps since 2004, reaching the maximum point of underweight in early 2007. Our decision was driven by relative valuation and by the more attractive opportunities in the large cap space."
Yet despite this, one of the interesting aspects of small and mid cap investing is the sheer number of companies that are available in the universe that gives rise to an extremely diverse set of opportunities. "We have 4,000-5,000 names in the universe we track," declares Bob Marren a portfolio manager at Nicholas-Applegate, and a few thousand more stocks are probably too illiquid for portfolio managers to bother tracking at all.
Even excluding the large cap stocks, the US small and mid cap market still represents one of the world's largest equity markets in its own right. It is not surprising therefore that the use of quantitative screening processes is pretty much universal. Pure quantitative funds have seen immense success in gathering assets over the past five years or so, although the market dislocation last July and August does raise some fundamental and worrying concerns about the robustness of many quantitative approaches.
Institutional investors have to weigh the opportunities that may lie within such a diverse marketplace, against the comparative valuations of the market averages. Those able to find successful active managers may still find it worthwhile maintaining an exposure, even if it is reduced.
"Relative valuations remain well above their norms and that has typically hurt absolute and relative performance," argues DeSanctis.
"From work we have done, it appears that you cannot make a strong case that either small or large cap is grossly over or under valued relative to the other," says T. Rowe Price's small cap manager Preston Athey.
DeSanctis makes the point that earnings growth has slowed and now favours large caps. "A weaker dollar should compound this problem for the small caps; at 8.9%, we think 2007 earnings growth expectations are a bit lofty in our opinion," he says.
But DeSanctis also points out that small caps tend to perform poorly in the first half of a recession: "Buybacks have been near record levels for the large caps and that helps boost performance. The fall is a seasonally weak period for the small caps thanks to lacklustre fund flows and tax loss selling. When market volatility picks up, small cap performance slows down. When credit spreads widen, the small caps tend to lag behind."
Moreover, De Sanctis sees that a major problem with seeking returns is the inability to locate enough drivers for performance.
Athey says that 2007 is likely to be "the first year since 1998 when large cap stocks handily outperform small caps in the US". He continues: "Historically, a turn in leadership does not end after one year. As a result, I believe that large cap stocks will do somewhat better than small in 2008, and perhaps beyond for some time. Factors arguing for large cap leadership include firstly, an investor flight to quality as the risks of recession grow; secondly a weak dollar clearly benefits reported earnings of large-cap multinationals - Boeing, Caterpillar, IBM and so on - while most small cap companies have a primarily domestic focus."
Within small cap, it is now the turn for growth stocks, and as Marren says, small cap value has outperformed small cap growth in the last seven years. "Most of the small cap outperformance over large cap has been driven by small cap value. So we can see real advantage of small cap growth over value," he continues. "So far in 2007 [to end-November], small cap growth beat value and the S&P500."
Athey adds that 2007 is the first year since 1999 that small growth has clearly outperformed small value. "Small growth stocks look quite attractive on a P/E to growth basis, and traditional growth areas such as technology and healthcare are showing good earnings growth today, and should do OK even in a slow economy," he says. "Traditional value areas such as financials are under real stress - bad loans, unwinding of leverage - while leveraged companies in all industries are at risk in a slowing economy.
"My conclusion is that growth stock momentum will continue for some time until valuations become stretched relative to value stocks, or until we are at a clear turning point in the economy preceding the next up-cycle."
Growth managers such as Janus can combine the overall wind blowing more favourably towards growth with the ability to use bottom up, individual company research to identify the most compelling long term, high quality growth stories trading at an attractive risk/reward profile, according to portfolio manager Will Bales.
"One area in which we are finding compelling individual investment ideas is transportation," he continues. "As rising fuel costs and a potentially negative economic outlook worry the market in general, we believe there are companies in the space whose business models and competitive advantages may help them withstand an economic slowdown and provide the opportunity for longer-term growth. While valuations may look extended given general slowing earnings forecasts, we believe, at current levels, certain companies in the space present an attractive risk/reward profile."
Does this mean value investing has no place? "For a value investor, opportunities are developing in the discredited financials sector, housing stocks, and consumer discretionary," argues Athey. "The key question, is how low can they go before turning around? And, in a number of instances, is the company being considered at risk of bankruptcy? I see risks in the energy sector related to a break in oil prices, and risks in the alternative energy sector related to stretched valuations. I am still bullish about materials, metals and mining in particular, because I see continued demand from India and China outweighing a slowdown in the US"
The sheer size of the small and mid cap universe does mean that it can make sense to structure portfolios into smaller sub-asset classes. Nicholas-Applegate for example, runs a series of strategies across the capitalisation spread with an ultra small strategy with a weighted average market cap of $250m (€170m), micro cap strategy that covers the capitalisation range from $50-700m with a weighted cap of $500m, a small cap strategy covering the range of $50m-$2bn with a weighted market cap of $1.2bn and a small and midcap strategy that extends the cap range to $8bn with a weighted market cap of $3bn.
The impact of quant
The number of companies that need to be covered does make the small and mid cap marketplace very amenable to the use of quantitative screening and fund management techniques.
Numeric's Dan Taylor sees that there are two issues when covering small and mid caps using a quant process.
"Firstly, there is a lot less analyst coverage. Large caps have between 10 and 30 analysts, but for small caps, while some may have between 10 and 20 analysts, others have only one or two," he explains. "So you need to be careful. In the case of earnings revisions, it can be more difficult but their value is more powerful as the market is more inefficient. We have downgraded their importance over the last seven years as the anomaly becomes less significant.
"Secondly, when analysing balance sheets etc, the interpretation can be more difficult. When it comes to IBM, identifying trends is easy as you have comparability of data over time. In a small cap, some can change quickly over time. Imagine IBM doing acquisitions, they distort the balance sheet but the effect is small. But a small cap company of $2bn can buy another company of $1bn, which adds huge distortions to financial statements."
Numeric's response to this issue, as Taylor explains, is the following: "We do what the models tell us generally but we do spend a lot of time focusing on ensuring that the models are doing the right things. For example if a balance sheet balloons, we see what caused it and we may adjust the data to reflect what we think is a better reflection of reality." He adds: "Only some require a little adjustment of the data and around 5-10% of names have data adjusted."
However, the sheer number of quant firms that have developed - all purporting to be able to offer unbiased approaches to identifying mis-priced stocks and many of them running long/short strategies - has created its own market distortions. As Taylor admits: "There is some truth in the statement that there are a lot of quants there and their portfolios can look similar."
This was most evidently seen in July and August 2007 when a large number of US equity-dominated quantitative market neutral funds, marketed as low risk hedge funds designed to have a monthly drawdowns of 1% or less simultaneously experienced drawdowns of 10% or more, reaching levels of 35% in a number of highly publicised cases.
The reasons for this were predominantly due to the fact that the actual alpha they were able to generate was too low to be interesting for investors so that they had to use leverage of anywhere up to six times to produce a marketable return.
As Taylor explains: ‘We have never been enthusiastic about leverage, which is a reaction by some firms to lower opportunities in the marketplace. The valuation spreads had come down and the risk levels had come down. The nominal alpha levels had come down so to generate the 15-20% returns, a fund had to be five, six or seven times leveraged. If you run into a perverse event, leverage can be devastating. A market neutral strategy that is six times leveraged means you lose 60% when an unleveraged strategy losses 10%. That means you are out of the game. A lot of investors were assuming that there was no risk in this."
The period of market volatility was driven in part by the widening of credit spreads causing borrowing costs to go up, and with it the costs of borrowing stocks to go short. As a result, many highly leveraged market neutral quantitative hedge funds found themselves having to deleverage their portfolios requiring them to buy back substantial amounts of short positions.
The problem they appeared to face was not just that a number of quantitative funds were in a similar position, but that many had shorted the same stocks, so that the prices of these were squeezed upwards even though the signals from their models were telling them the stocks were still on the sell list.
The 2007 market dislocations in July and August proved to be a wake-up call for many quant investors. "Focusing on relative value quant strategies has been extraordinarily difficult this year," says Taylor. Clearly it is not a good time to be a quant with a lot of quant strategies having the same positions and strugling.
He adds: "A lot of stocks have been beaten down by technical selling driven by quants. So there is a lot of mispricing and a tremendous amount of opportunities but I don't know about the timing. At some stage a lot of companies will find support from fundamental players stepping in."
Athey admits: "We have had occasion to buy stocks being blasted by quant funds bailing out in a hurry. These opportunities are transitory and require quick reaction, but can be very rewarding when they occur."
Integrating quant and fundamental
The boundary between quant firms and traditional firms is blurring, however. Numeric would regard itself as a pure quant firm, but espouses a philosophy of adjusting (‘arguing') the data when required. Most fundamental research based firms would be using quantitative screening of some sort and what can differentiate the more successful is how well the quantitative analysis is integrated with the qualitative.
Principal Global Investors, for example, argues that its key strength is its ability to marry a quant process with a qualitative through a proprietary global research platform (GRP), according to Ulrika Bergman, a director responsible for business in Benelux and Scandinavia.
"Unusually for a firm that employs quantitative tools, the models are owned, monitored and refined by the portfolio managers and analysts that use them rather than a remote and academic ‘quant resource'," she says.
"This ownership ensures complete ‘buy-in' from our investment staff as well as creating models that benefit from the market knowledge that these professionals possess." While the quant screening identifies companies with improving business fundamentals, rising investor expectations and attractive valuations, the research analysts confirm the sustainability of the trends, they provide an interpretation of the rankings and undertake an assessment of any inherent event risks leaving the portfolio managers to make the buy and sell decisions and risk manage the final portfolio.
The US small and mid cap marketplace is too large a component of the global equity universe to ignore completely, and the sheer number and diversity of companies within it does mean that the best active managers will be able to find opportunities whatever the external market environment.
However, as Bales outlines: "While the final outcome of tightening credit conditions in the US remains to be seen, it is possible that many smaller cap US companies could face a difficult operating environment if the US economy slows more than is currently priced into the market."
Janus, like any fundamentally based investment manager, says that one of the most important components of its research process in difficult operating environments is the quality of management.
Choosing small and mid cap managers in a much more uncertain environment ahead may put more onus on such skills.