MASTERCLASS: Small Caps - October 2018

As small caps have been underperforming up until this year, investors are playing catch up, shifting to other opportunities and pivoting portfolio construction techniques in a relatively positive economy.  Four experts, who have been putting portfolios together for decades, join together to discuss those opportunities, the affects on world trading and what's to come in 2019.

  • Kevin Ross, CFA - Senior Vice President, Portfolio Manager at Advisory Research Investment Management

  • Craig Hodges - Partner at Hodges Capital Management

  • Catherine Nicholas- Managing Partner and Chief Investment Officer at Nicholas Investments Partners

  • Jay Kaplan - Portfolio Manager at The Royce Funds

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  • 51 mins 05 secs

LAURA: I'm excited to be sitting down with four experts of small cap investing who have been portfolios together for decades. Anyone following stocks this year of course knows that they've been on a tear. And small caps even more so. Outperforming the broader market. And that's where we'd like to start our conversation welcome to small caps master class.

LAURA: And exactly, let's start there. so maybe Craig, since you're the front end of the table there, you can just start by just where are we at at this point in time? The Russell keeps going up, up, up. What's behind that move?

CRAIG: You know I think we've got a really great, underlying economy underneath us and really small caps haven't underperformed until this year. You know, or the last couple of years. So there's a little bit of playing catch up, but we have a great economy, um, there's a lot of positive things I believe happening in the economy. To me it's a very good scenario. And small caps really don't have some of the issues of the large caps, especially with the tariff sabre rattling you hear about. So I think that's somewhat played into it. Um, and you know there's parts of the market that are very expensive that are very scary but the majority of  the market is not. And that's where an active manager like the Hodges funds and the Hodges market funds where we can find those kind of uncovered uh, areas of the market that have not been recognized.

LAURA: Right. And we'll talk more about those opportunities later in the class. But Catherine, you too. Where do you see this value coming from? If you look back from last year. I mean small caps were not performing.

CATHERINE: Right. But I mean you've ...just as mentioned earlier the business environment is very pro-growth, uh, the regulatory environment is positive, interest rates are friendly, uh, you've got MNA that's been strong and the company's are just reporting their earnings and sales and these are just reporting earnings and sales much better than expectation. And we're seeing a lot of companies with innovation. Whether it's in technology, health care or consumer discussion are really getting rewarded by the market.

CATHERINE: And we're even seeing the second half of 18 numbers being revised upwards on revenues and earnings and most recently 19. So the environment is very friendly. Um, you know there are concerns with the strong dollar, with what's happening in emerging markets, you know today Brazil, last week, two weeks ago Argentina. Uh, we don't know what's going to happen with the tariff’s but you know so it looks good near term.

LAURA: Kevin, anything to add?

KEVIN: Yeah I would just add also we haven't talked about corporate tax rate reductions. I mean small caps, given their predominately domestic exposure to the US related economy benefit more than large caps from the corporate tax rate reductions. I would echo the point about the strong dollar. It's been a strong driver of outperformance for the US small cap markets relative to international small caps as well as emerging market small caps. And we think that the dollar is likely to continue to rise on the back of interest rate increases from the Fed.

LAURA: Yeah Jay you look like you want to jump in there.

JAY: Well yeah GDP growth has been terrific, employment is great, unemployment is low. Not only have taxes been cut there's been repatriation of corporate cash that's gone into dividend increases and buy backs. That's all really good. But there are definitely some warning signs out there as well. Um, some that we don't even know about yet. Let's look at what happens in the mid-term elections for example. Where do tariffs really shake out? So things are good but there are always landmines around.

LAURA: Let's go into that a little bit further. Trade tensions of course have been rising as we're going toward the close here of 2018 and I mean, thinking about small caps obviously they are very weighted towards if you're looking at the US, I mean they're very domestic,  wherever you're looking at a small cap. For the most part. But are they insulated then from trade wars? Because they're not looking internationally?

CATHERINE: It's pretty much been ignored and especially the progress that’s been made with Mexico and then Canada most recently and now there was some discussion today. We saw the market really rally hard, that there may be some potential progress in China. But one of the companies that we invest in and what we look at, there is ...some of them have component exposure but I think it's been uh, pretty much ignored at this point because uh, I think investors think it's more sabre rattling then what exactly going to happen. We'll see.

LAURA: When you say ignored you mean it hasn't really affected the stock prices of these companies?

JAY: Not a lot, but, but when you talk about management teams and we do that a lot at Royce. They're worried about it. Uh, we don't know how it will shake out and small cap stocks people think are insulated from this, and in things like banks they are, and in rates and utilities that are domestic they are. But companies that make stuff, and there are a lot of small cap companies in the industrial world that make things, there's a lot of global trade. Whether they're selling overseas or importing components and steel.

JAY: So there's a lot going on and some of this could even cause inflation in their supply chains. And I think inflation is another overlook thing by investors. There could be a car load of trade wars.

LAURA: And I wanted to grab onto that point just a little bit in terms of thinking about this overall broad picture. Because I know Jay, you've been looking at ...when we talk about the overall market here, the small cap growth stocks have outperformed the ones that are considered value. And maybe you could just help us, you know, as we get into our discussion here, where we're at with that.

JAY: Well the outperformance of small cap growth over small cap value is kind of coming up on 3 years now. So this year so far small cap growth is about 1,000 basis points ahead of small cap value year to date. And that's, like I said, been going on for a while. And it's been led for the most part by health care companies and technology companies. And within that it's mostly biotech companies and Internet and software companies. Most of which actually don't make any money.

JAY: In the neighborhood of a third of the companies in the Russell 2000, have no profits. So one of the risks out there in small cap investing, particularly in passive investing, folks are buying the Russell kind of blindly, don't realize that a third of what they own doesn't make a nickel. But those stocks are working, part of that is the function of low interest rates and long duration assets like the non-earners, get marked up in this environment. Over time, as interest rates start to rise, some of  those stocks could come under pressure. But now they're working great. There's plenty of momentum. People are buying them and they are very happy. But you know, we think that that could end at some point. I can't tell you when.

LAURA: And Craig. You had something to add?

CRAIG: You know there is more have and have not’s in the Russell 2000 then you can imagine. I saw an interesting statistic about the Russell 2000 in the last five years performance. If you rank the Russell 2000 just by the number of indexes that the individual stocks are in, the top 30%, the ones that are in the most indexes, have returned 12.6. The bottom 30 has been 5.2. So really it comes down to the last five years is how many indexes are you in has really been the key ingredient to how well you've done.

CRAIG: So what that tells me, and what that tells our research staff at Hodges, is that there are a lot of mispriced underappreciated stocks that haven't gone up just because they're not in indexes. There are not as many indexes out there. So that tells you there's a lot of opportunities out there.

KEVIN: I would just add in the International, non-US markets, the dynamics are similar but a little bit different. The magnitude is a little bit less because you don't have the biotech and technology drivers that you have to that extent in the US. So we look at over the last five years growth has out-performed by about 200 basis points per year. That's come down over the last one to three years to where growth has outperformed by only 50 basis points. We think that if you look at over a full market cycle, we would expect that value stocks should outperform and that's based on the evidence that we've seen from International small cap investing over the past 20 years.

LAURA: Well and maybe we should really move on then to the outlook. You know because I think again sort of being in the file here, small caps, as I've been told don't necessarily perform all that well going into the end of the year. Um, but I'd love to just understand for people who are investing in small caps, what should they be expecting the back half of 2018 and also the front half of 2019?

CATHERINE: Well, we're seeing continued strength in the investments that we have. We think it's a good environment for small cap but uh, getting back to this uh, blind buying by these passive accounts, I think you have to be a lot more sensitive to valuation because if we do get a hiccup there's no valuation floor for some of these companies. I mean, I can tell you in the SaSS space there's names that are trading at 17 times sales with no earnings. And I think it's an environment that you need to be conscious of that. But I will say that there's a lot of innovation in the market, particularly in health care and technology. Even consumer discretionary has been one of the strongest sectors with the strength of the consumer and consumer optimism.

CRAIG: I think that's an underappreciated point. How we make about 2600, 3000 company touches over about 800 companies and this is the most optimist I've heard these management teams. Not you know not braggadocios optimistic but you can just tell that they, they feel like they're in an environment where they can under promise and over deliver. And you look. Tax cuts are just now hitting and you know, big companies have loopholes that they've already been paying low taxes. These small companies have not. The decreased regulations they have ...big companies have lots of lawyers and they get around a lot of these regulations of small companies.

CRAIG: So we're just now getting to the point where it's getting good for small companies, I believe. And so uh, you look at the data that's out there about mid-term elections and typically, since 1946, nothing really happens in the market until the fourth quarter. And then the average rate of return in the fourth quarter of a mid-term election is, I believe, 7.9%. So it's really setting up ...and there's never been a time, in the 12 months after a mid-term election that the market has gone down. So there's a couple factors that are really significant there and I think it's a great time to be looking at small cap stocks.

KEVIN: Yeah for the non-US small cap markets that we look at, we think there's a couple of supportive points that provide a positive outlook. One the asset class is still trading at below historical valuation levels, at 15 times forward earnings. Earnings growth is about 10-12% over the next two years. We also see an economic recovery that lags the US by a couple of years with the EU expected to grow by 2% and Japan by 1%. We think there's a lot of supportive points which should allow for a favorable outlook for non-US small caps.

LAURA: And Jay, what about you? I know earlier we had talked about complacency. Is that something investors should be thinking about as we go forward in 2019?

JAY: Well they always should be, and you know if you believe in any degree of market efficiency, markets priced in what they think they know and when we have market hiccups it's about the things that people didn't expect. So, what does happen in the mid-term elections? I don't know. It could be a surprise. Inflation could be a surprise. Um, lack of liquidity could be a big surprise if folks ...passive folks head for the exits. So, you have to be careful. But like we talked about before, the long term systemic underperformance that small cap value stocks have had in an environment that is increasingly better, no matter what happens in small caps, whether the market goes up or goes down, I think value stocks have the opportunity to do better than small cap stocks over this next leg.

LAURA: Okay well I want to just jump in there, because you guys brought up the mid-term elections. Obviously a big thing on the calendar. We saw two years ago was it? The Trump bump, you know after that election no one was thinking that Donald Trump would be elected as US president. It lifted up a lot of stocks led by the financials of course, thinking about this era of de-regulation. Do you have any outlook as far as what to expect if more Republicans come into the House and Senate versus Democrats?

CRAIG: I think the data shows that it really doesn't matter. And I believe most people think ...and most investors and most companies want to know ...they want a stable environment. So most likely we're going to have a divided government. Which is good, because that means not a lot of new things are going to happen. They can make their business plans. So I think um, no matter what happens I think just the fact that it's settled is going to be bullish for the market.

LAURA: Anything to add there from any of you on that?

JAY: I kind of agree that gridlock and benign Washington's probably pretty good.

LAURA: Yeah better for companies, as you said because then the management teams have an understanding of where health care's going, where the tax picture is going and possibly even where interest rates may be going. Which is the next thing that I wanted to touch on with you all. If there is a point where we would have to see the Fed coming to ...if there were an inflation spike and the Fed would have to raise rates very quickly, would there be any impact on these small companies?


KEVIN: Well it all depends on what is driving the rate hikes by the fed.  I think if it's driven by a supply side shock from say a spike in oil prices or commodity prices that would be more negative then if they were raising rates because global growth is over heating.

LAURA: Sure. So where it's coming from matters?

KEVIN: Exactly.

CATHERINE: I think that's really important about rates moving up as if outside the US they keep rates low and us we move rates up. You know that has a lot of impact on emerging markets and you can get these shocks where they have the dollar denominated debt and you know these high PE stocks that all these passive funds have bought. All of a sudden there's risk in the market and you have liquidity go out of the market and you have forced selling. I mean that could be a difficult environment.

JAY: You know it's interesting so when you talk to industrial companies there is inflation in the system, in the US. It's crystal clear. Whether it's wages, whether it's input there is inflation. If it picks up at a greater rate, what does the fed do? Does the fed raise rates enough to start choking off the growth that we have? I don't know remains to be seen. Now the other side of that equation is of course the flat yield curve now, and does the yield curve invert and what’s going on with our rates relative to overseas rates or low rates overseas keeping the long end down. And historically, if the yield curve does invert, that's not a great thing. So we'll have to see what happens. Is it out of high probability? I'm not sure, but I think that's something to look out for.

CRAIG: And even if we are in peak earnings, and we do see the yield curve invert, uh, history shows that you still have ...basically 41 months between peak earnings and a recession. Let's say the market discounts that by  a year and a half. That would give you, you know, almost 20 months of good market runway until things started to really look negative. But yeah interest rates everyone’s going to be aware if they start going up and all of a sudden there's competition for the market. That’s the other thing, when rates go up.

LAURA: And when you say that Craig, are you saying that from where we are now. Let's say point happened, we'd be at peak and then we'd maybe have ...what did you say? 20 months?

CRAIG: Probably 20 months of good market, uh, that history has shown from market peak to recession has been on average about 41 months.

LAURA: Wow, so as I keep seeing the Russell 2000 go higher and higher every day I might expect another 20 months of that at least, it sounds like.

CRAIG: Anything can happen, of course any event can come along and change that perspective and it doesn’t always have to go what history shows. but to say that we’re at peak earnings and all of a sudden that we're within a few months of a recession, I don't think that's, that's accurate. Because you know, I think most analysis out there are going to have to raise their 2019 earnings and you know the overall market at 17 times earnings, all of a sudden's going to be 13-15 times earnings by the time the analysis’s come out and raise their numbers.

LAURA: Similar to what Catherine had said before, some of them are already doing that.

CATHERINE: Right. That was a surprise. I was speaking to an analyst here in New York yesterday and that was a surprise to me that numbers for 2019 are going up in the revenue and the earnings cycle already. I don't think that's priced into it.

KEVIN: I mean if you look at the global GDP outlook published by World Bank or the IMF, they're targeting 3.9% this year and next year, which is the fastest pace of growth since 2010, 2011. We see inflation coming through in markets like Japan, which haven't had inflation in many years. So they're finally able to get pricing power come through, which is driving higher margins and higher earnings growth. So we still think globally things look relatively positive.

LAURA: yes and thinking about that, Kevin, I know Japan is an area of focus for you. IS that a market where you think the outlook could be quite good for investors who maybe haven't wanted to take any risks in the emerging market picture right now?

KEVIN: Yes. Japan is the largest developed market outside the US. We are particularly bullish on the outlook there. We think inflation is running about 1% right now, GDP growth is a little bit north of that. We think valuations look attractive at about 13 times earnings. We're particularly targeting companies in the industrials as well as consumer discretionary sectors. There's a lot of inbound tourism coming from China that's driving up the consumer sectors. You also have a lot of demand coming for machine tools and factory automation.  We talked about innovation earlier. Factory automation, industrialization is boosting a lot of the industrial companies in Japan and then you also have as I said, pricing power coming through from rising inflation.

KEVIN: For example, one of our machine tool companies right now is pushing through a 10% increase which is allowing them to see enhanced margins.

LAURA: Hm. Okay, and what about other ideas in other sectors that are US focused and you guys are really interested in for the back half of the year here?

JAY: Even within a value fund technology can be very, very interesting now. um, as a value investor at Royce, we're more of a technology pick and shovel kind of investor than an innovation investor, but that's okay because the innovators need picks and shovels. But the market is positioned now I think, where there's a belief that we've just hit a cyclical .. the beginning of a cyclical downturn. Uh, that I think the market believes will be long and deep and a lot of multiples have become very very low against that. And I think that we're at a point where maybe this cycle won't be quite as long, won't be quite as deep, and a lot of that I think, believe it or not is going to be driven by automobiles. The electronic content in autos is growing exponentially, you know autos are designed 3-5 years ahead of time. So, autos are being designed now, for 3 years from now with a lot more electronics. So, the picks and shovels behind all of that probably make this cycle, this down cycle shorter and less deep than before.

JAY: So I think, if you look hard there's a lot of value in small cap technology.

CATHERINE: We're seeing that also but we're more growth and we're seeing a lot on the SaSS, artificial intelligence, robots, block chain, driverless cars, and we're seeing a lot in healthcare also with personalized medicine, robotic surgery. So we've seen a lot of opportunity there and we've seen a lot of technology like in logistics, just intermediating that. We've even seen at retail, like stitch fix the fact that people give that much information about themselves. You know? So we're just seeing technology and health care really a lot of really attractive ideas but there again you still have to be sensitive to valuation at this point in the cycle.

LAURA: But Catherine I want to delve into that a little bit more. We can touch on it again when we talk about our innovation a bit later. But you know thinking about block chain and AI, I mean those are very new areas of focus, very new businesses. So when we talk about earnings and we talk about going forward, I mean how do you really comb through some of those companies and really think about new ideas?

CATHERINE: Well there's companies that are making it possible or available. Like GE's really ...which is way too big for us, is doing a lot that Maverick[?] is using block chain. And so we have a lot of companies that are embracing block chain. Uh, and on the robots we have certain companies that are doing that. On the driverless cars we have a lot of the suppliers into the chips and the sensors. And then on the surg ....the robotic surgery there's several companies that are doing that. So, there's no shortage of ideas or innovation.

CATHERINE: Um, what our focus is you know they’ve moved significantly and it's benefited our portfolio but with potential shocks and not really a valuation floor. We've been somewhat taking some profits in them.

LAURA: I was going to say, Craig, as valuations go up and up, normally you would think of ideas being harder to find for that value bargain out there.

CRAIG: Yeah and not just small cap, we're a core fund so we can buy growth or value. But we find ourselves gravitating to value here because we're in a market place that doesn't pay attention to earnings, it pays attention to not only revenue growth but increasing revenue growth. Even if your revenue growth slows a little bit, you're going to be thrown out, the momentum's out.

CRAIG: So, that's a dangerous game. So we play ...we're in that area somewhat in that we have some high growth areas. But I find more and more opportunities in, in the value. And there's a lot of stuff that's just been left for dead. Industrials, commodities, energy, even some of the airlines. homebuilders. There's a lot of things that if you’re not technology and you’re not health care, you've kind of somewhat been somewhat forgotten. So it may take some time but that's where the money's going to be made in the next few years is in those things that are still doing well, still growing and have great balance sheets. Have great management teams and have an outlook over the next two months are very favorable.

LAURA: Yeah because you mentioned earlier you know about companies that maybe don't have to meet the expectations that they might normally have telegraphed to the market. So do you see some that where some of the value is coming from? Some of the ideas? Because they're the overlooked places?

CRAIG: Yes, and a lot of the things we followed for years and years and have a good ....we almost know what the intrinsic value of the company is and in a lot of cases they're trading below what if you sold the company off and shut down their businesses you know the stock would go up because it's worth  a lot more.

LAURA: The value of the cards.

CRAIG: But there are value traps out there, you’ve got to be careful so you have to be sure that you’re in an industry and a situation that you’re not buying it just because it's cheap. Cheap is not a catalyst. You need to find companies that are going to be able to have a catalyst that will go up and there's something out there that's going to make the public realize this is under valued. This needs to move up.

LAURA: Right. Jay you're nodding your head a lot.

JAY: Well you have to be careful, there's value everywhere. Craig mentioned airlines, for the last 18 months it's the first time in my career that I've owned airlines. I mean I own a bunch of airlines, I owned some bonds, I was a junk bond guy when I was a kid, but I haven’t owned airlines in forever.

CRAIG:  You and Warren Buffet?

JAY: I was there first but he's better than I am for sure. So there's lots of places that you can look community banks is some areas where there's some emphasis. They did very well when Trump got elected and then the yield curve started to flatten and they've done terribly. They’re going down every day, but at some point if inflation does come back, rates go up, the yield curve steepens, and financials should do really well. In fact, that's an area where financial starts to do well, that could drive small cap value up because financials are very large part of the small cap value market.

KEVIN: One other emphasis that we've been focusing on recently is companies that have ...I think as Craig alluded to, strong balance sheets and can self fund their growth. We think free cash flow generation is of critical importance in a rising interest rate environment. One area of the market that we've been targeting is paper and packaging companies because they benefit from structural growth with e-commerce demand.  On the supply side you have very limited supply growth over the next two to three years and you've also got consolidation in the industry which is driving up the multiples of many of these companies. Given their strategic and immanent value.

KEVIN: One of our portfolio companies, for instance based in Ireland recently, turned down a bid by a US peer because they felt that the valuation was too low and we would tend to agree. We think that there's significant potential upside going forward from this particular idea.

LAURA: Right and MMA might be a big driver, whether it's the community banks that are consolidated or this space it sounds like as well.

CATHERINE: But the market is not rewarding MMA and community banks right now. Actually it's ... when they announce [LAUGHS] because the perception is you're buying them so late in the cycle and ...

LAURA: You're overpaying.

CATHERINE: Not only overpaying but what kind of loans have they underwritten? So we've had a small exposure to the banks but it's been that the net interest margin has not expanded due to rates being so low. But the other phenomena that's different is that you would think at this part of the cycle wit them strength of the economy that loan demand would be accelerating, and it's not.

CATHERINE: It's flat, and you know some of the concerns out there is they have other options.

LAURA: I'd like to move on a little bit to the comparative places where we might look for value in returns. We talk a lot about small caps, that's what this class is about, but obviously there are other classes out there that people can look at large cap stocks. So why should an investor at this point in time now or anytime in the future be interested in the small caps? Why should they consider them in their portfolio? Kevin do you want to start?

KEVIN: Sure. Yeah I mean I think ...if you look globally the small cap phenomenon has been proven by academic research. Small caps outperform large cap stocks. In international markets the spread between small and large over the last 10 years has been about 400 basis points. And if you look standard deviation the way that we think about risk, there's not a significant difference in the risk between small and large caps. Consequently on a risk adjusted return basis the small caps generate better risk adjusted returns and higher sharp ratios as compared to large caps.

KEVIN: We think that a lot of those inefficiencies that have been in place over the last ten years should be continuing over the next 10 years to allow that to continue.

LAURA: And efficiency really is sort of the name of the game in some of these small cap companies. You know you’re not having as much trading, there's not as much stock research, what are your thoughts on that going forward?

CRAIG: There's something that I've become keenly aware of, just in the last 4 or 5 years and I don’t her anybody talking about it, is how thin the small cap markets are. Ten years ago if you were to go to the market with 100,000 shares at a 4 million dollar stock you could do that fairly easily a day. Without affecting the price. And since uh, decimalization and the fact that they've kind of taken the profit motive away from market makers, markets are so much thinner. And so you'll get you know probably ten thousand shares of the bid and then they'll offer you the next 20 with the 3% discount in the next 50 with 5% discount. So if you're wanting to get it all done that day.

CRAIG:  So what that does at the end of the day, it creates inefficiency. There's a lot of missed priced stocks because of the ebb and flow. The other factor is is that small cap research has dried up. We've probably had 18 firms selling us small cap research 3 years ago and that’s probably under 10 now. It's not a very good profit center for firms and so they just don't do it. And so what does that mean? that means there's a lot less coverage out there. It doesn’t mean good or bad but it means that there's a lot more opportunity. There's a lot uh ..there's a lot of things that fall through the craps and create inefficiencies of the market.

CATHERINE: We see that too that the coverage has lessened on the securities but that creates the opportunity and the inefficiency so that if you can do the work, uh, that you can actually make some real money with the positions. Um, but one of the things hat we've done is we've really focused our quantitative efforts to identify new investment opportunities and to use that traditional research just to confirm the fundamentals and ....

LAURA: So not getting those ideas from the outside but confirming ...

CATHERINE: That has very much changed.

LAURA: Have you noticed that? Sorry, just the myth inside. You know with the new European rules coming in and really truncating a lot of the different research houses?

KEVIN: Yeah I mean MIFID II which came into play this year, at the start of the year, but will also most likely expand to US asset management industry. The budgets for the European asset managers are estimated to go down about 20% this year which means that both the quality and the quality of sell side equity research is going to go down.  If you look at over the international small cap universe average analyst coverage is about five compared to 20 for the large caps. That inefficiency which already existed we think will continue to get greater, which will provide a lot of alpha opportunities for active small cap managers.

JAY: When you roll all of this together, I think you need to also talk about active versus passive.

LAURA: Which is a theme you've all highlighted already.

JAY: Well it's the bane of probably all of our existence to some degree [LAUGHTER] and I think you know, the liquidity issue, I think a lot of the active passive drives a lot of that. A 4 billion dollar company would be a big company for me and a couple 300 million dollar company is even worse. Years ago, when active managers still existed. There would be a group of value managers that when stocks really got pounded on bad news and were down 20-30% at some point there would be bids. Because there were folks who trafficked in those stocks and they knew when the intrinsic value was there and they would be there.

JAY: There are fewer of us left so there are no bids. So in large caps when a stock misses earnings and it goes down 5 or 6% and you hear about it on the business TV news, that's a big deal. When our stocks miss they go down 15, 20, 25% in a day and there are opportunities there but you know you need to be careful and you need to understand the companies that you invest in and you know at Royce we do that everybody here does that. So the market dynamics have changed a lot because of active passive and there's also a lot of risk out there I think in passive investing today.

CATHERINE: You know we've taken to the extent that we look quarterly what ETFs own our names. Because a lot of times it crates an opportunity that it gets marked up for no apparent reason but just liquidity and its a liquid that creates an opportunity to take some profits but we also have the other side that a stock is getting hit for no reason. you can't find anything and you want until that ETF or algorithm, whatever it is, finishes selling and it creates an opportunity in it. To add to existing position. But that gets back to you really have to know your names. Because there’s' a lot of noise out there that's been created by all of this passive planning.

JAY: There will be days when you can look at one particular sector in your portfolio and you'll see that whole sector move because someone has put on an ETF sector trade. And you know, that can go both ways. Sometimes it's good when they mark your merchandise up and sometimes that can present opportunities when they mark your merchandise down.

CATHERINE: But some of those baskets are just names that have a high correlation to what you want to express and there's no fundamental overlay you just throw it out when ...[TALKING OVER]

CRAIG: Along those same lines is another thing I hear nobody talking about, is the scarcity of companies and stocks. You know? 20 years ago there were 7800 listed US securities that you could buy. Now that's under 3500. And you look at the small cap that’s' even ...there are a lot of companies that aren't becoming public nowadays because of private equity. There's a lot of money there and when you’re a small company it's a little bit hard to be public, because you’re not only running your business, all of a sudden you have to answer to share holders. So there's a propensity not to become public. So in the areas where the four of us run there's fewer and fewer names that are viable if you will. And I think that that's a bullish thing for the whole industry.

KEVIN: I think in the non US market it's a little bit different. I mean if you look at international small cap universe its' about 5000 securities. That's been relatively stable in the international small cap universe. That's also north of 5,000 securities in the emerging markets space but it has been increasing as a lot of companies mature and go public. You've also got China A share index inclusion coming in this year, consequently looking outside the US and global small cap universe it's very large and diverse and we think it will continue to grow.

 LAURA: And do you have any concern at all Kevin on the emerging market side thinking about small companies? I mean generally they have some more risks that we've just been talking about.

KEVIN: I think emerging markets in general play a positive diversification role in every investors portfolio dependent upon the risk tolerance of the investor that you’re talking about. Valuations look attractive on a long term perspective. We think the small cap universe is very large and active managers can add value through a bottoms up fundamental research in that universe.

LAURA: Any thoughts on International? I know we've mostly been talking domestic on the panel.

JAY: I occasionally wade into Canada, that's about as far ......our firm has international politics. I sort of stick to a little bit of Canada.

LAURA: And maybe that is affected on the trade wars as well as we think of autos you mentioned earlier.

JAY: Canada has not had a very strong market but there's still saber rattling there so we'll have to see how that turns out. Canada is a friend.

CRAIG: At Hodges we're purely domestic.

LAURA: Okay. Um, well then I wanted to bring in risk into the conversation because we've talked about that a lot. And it's in all of our minds. What is the way ...are there ways that each individual investor can think about risks when they think about the small caps? is there a way ...I mean you mentioned Catherine sort of playing against the ETFs in some ways but when you see that 19, 13% drop in your stock, what kind of thins can you do to mitigate those risks given that you've got a lot of these in your single portfolio.

JAY: Well if you’re an individual investor it's a little tricky to do that. Individual investors need to have diversified portfolios. No individual investor should have 100% small cap portfolio. That probably doesn't make a lot of sense. But because of the long term performance of small caps it does have a place in every portfolio, I think. Um, equities have to offset inflation over time for everybody, even retired folks. But when people have asset allocations and markets move around and asset allocations move around you rebalance and that's all well and good and I think that you know back to active passive, and maybe I'm a broken record. But I think that passive products don't manage risks, active managers attempt to manage risks, the supposition that I would have is that if things really get ugly good active managers can do less bad than the passive products, right?

JAY: And a really terrible tape, will we all have positive performance ?That's very difficult but could it be not as bad as the broad averages, maybe so.

CRAIG: That's one of the big wild cards, we've only seen the proliferation of ETFs and passive management during a long [UNSURE] market with inflows, what dos that look like with outflows? Especially these market weighted products? So, right now if you put a million dollars in the market the majority of it goes to the things that have done the best, because those are inflows. What does that look like on outflows?

CRAIG: That means the ones that are the most weighted, they will do the worst. And so we haven't seen the other side of that. So I think that's really where if you're, if you're in passive management, if you're buying passive investments, you're buying the market. You're buying everything. But if you’re buying active, you're buying individual, selected securities in the market and there's a big difference there.

CATHERINE: Who's going to be on the other side when all you have is liquidations of the Russell 2000 growth and there's companies that haven’t been earning anything, they don’t have a great management team. I mean who, who is going to be ...I mean I remember the days, I hate to date myself, in the early 90s, the  only buyer of our companies in the growth universe that got had down 20% was DFA. They would just wait, wait, wait. But who was going to be on the theory side of this?

LAURA: Because you don't have the banks anymore either.

CATHERINE: Right. And you don't have market makers so ...and you know we can have one of those mini crashes, we'll see. We don't know it's unchartered ....

LAURA: It sounds like you are all very worried about you say as these outflows are happening, ETFs must sell for the most part. You know who can be on the other side?

JAY: We don't know.

CRAIG: Unchartered territory is exactly right.

JAY: We'll find out.

LAURA: A lot of unanswered questions on that front.

CRAIG: That's what you want a manager like us for.

LAURA: Yes that would be the time, if no other time. Maybe we can move on then a little bit to some of the portfolio construction techniques as well. You know, we've been talking a lot about ETF's but let's also think about moving that aside and thinking about small caps in general. You know thinking about he wider, holistic picture. how can investors get the best exposure to this class?

KEVIN: We think that active management makes sense in International small cap investing. There's only one ETF on the market right now which charges about 40 basis points. Also because of trading challenges when you’re dealing with a lot of different currencies and different markets it tends to lag the benchmark by about 60 basis points annualized per year. And we've talked a lot about market efficiencies that are available in small caps both in the US and outside of the US. We think active managers are best positioned to take advantage of those.

LAURA: What about thinking about companies that are suitable investments? How do you look at those?

JAY: Here’s how we think about the world at Royce. We try and buy companies with really good balance sheets and good financial strength. So if they get into trouble they don’t go away. And that's important in small caps, I think. We look for companies that have proven track records of good returns, whether that's return on capitol, return on assets, so companies that earn well, and then we try to buy them when they're on sale. Um, the problem with that is really good companies with really good financials are only on sale when there's some issue. Probably. Could be a company issue, could be an industry issue. It could just be an issue of perception. Uh, so you want to find really good companies, when they're on sale, when you know the issue's going to get fixed.

JAY: And you can try to handicap that so that you can get upside on your multiple. And you get upside on your earnings as things work out over time. And if you have a large enough portfolio of those your always harvesting the ones from a few years back, and you're sewing seeds of new ones today. History has shown that if you do that over time, over market cycles, and we're in a different kind of cycle right now, but over market cycles that can be a pretty good return proposition.

LAURA: But thinking about that as we have let's say trade wars as a good example, we can leave maybe taxes for another time, but where .....I mean do you rotate into certain asset classes then? Are there certain multiples that you try to avoid? I'm just trying to think about ways that investors can think you know at this current moment. At this cycle.

JAY: Well if you want to hide from trade wars, you probably want to be in companies that sell services and sell them in the US, and don’t' import, export, don't buy stuff and resell it. So software as a service kind of companies. Um, not exactly my stock in trade. But you know, I think we have to be careful in thinking about trade wars because we don't really know where this is going to settle out.

JAY: A lot of this is negotiating. Some of this will start down the trade war path and come back. So I think it's very difficult to try and make bets on those unknowns and I think a better idea is to find business that should do well. Maybe they'll have a hickey from trade wars but still should do okay. And one of the things to consider is, companies that would be hurt by trade wars. Probably all of their competitors are as well, because they all compete in the same markets, buy the same stuff, sell the same people in the same places. At least none of them are disadvantaged relative to each other.

JAY: Could there be some pressure on profits? Yeah there could be, but I don’t think we know what's really going to happen.

KEVIN: I think one other point on trade tariff's, it's not all negative in a sense. We own companies, for instance, that own production plants here in the US and are benefiting because prices are rising for stainless steel for instance. We're seeing rising prices and rising earnings as a result of that.  As active managers we can analyze where the production and costs and sales footprints are of a lot of our companies as compared to ETF's that are just overall buying the market and maybe suffered more as compared to active managers.

CATHERINE: And on the growth side, what we’ve been doing is really focusing on companies that have control of their destiny. So they're not depending on overall GDP. I mean yes, if we went into a recession that's a different scenario. But we're looking for companies that have something specific to them that's leading to an acceleration in the revenues and their earnings and they have a great management team, they have a good business plan. Uh, a balance sheet. But then still because we're 9 years into this recovery, and we have seen such a big move in health care and tech, still being somewhat cognizant evaluation.

CRAIG:  And you asked kind of, how does an individual kind of position themselves? What I continue to .....what we talk about at Hodges Capitol, at the bottom line, kind of almost our mantra is be in industries that have high barriers of entry.

LAURA: High barriers?

CRAIG:  Yes. At the end of the day that's what you want. You mentioned corrugated paper, that's one. If you look at steel it's impossible to get into the steel business. Cement, impossible ...there will never be another new railroad ever. Even airlines are now very hard to get. It's now a high barrier of entry industry. So those kind of things are going to have pricing power if you don’t' have a lot of competition. On the inverse of that, stay away from things that are easily duplicated. If someone can come and knock it off you know beware. So if individuals can position themselves and look at the industries that they're in, and make sure they’re in things that can't be duplicated and have high barriers to get into.

LAURA: That's interesting when I try to think about innovation Craig, because you know, a lot of the companies you're mentioning are more industrial based uh, you know where it's obviously a lot of cap x that would be required to get in there. But when I think about innovative companies I usually am thinking more to the tech side of things. So can you give some examples of companies that would fit both of those angles?

CRAIG:  Yeah you know we see something’s out there that are kind of game changers out there. One stock that we're in is a company called health equity which uh, you know these uh, medical savings accounts. We kind of think this industry is where the IRA business was 25-30 years ago. And we think in 5 years just about ....even our firm we just now started where you can get into these health savings programs. So health equity is the leader there and they're kind of bringing that into the forefront. You're seeing insurance companies now jumping in and benefit companies now offer these things. SO that's something. Or a company like teledoc where now more and more insurance companies are saying instead of going to the doctor if you make a phone call you can save a bunch of money. Those are real innovative kind of game changers. Things like goosehead that is wrapping up the independent insurance agents. Things again very early, but these are things that not necessarily technology but they’re kind of changing the way uh, the way we do things.

CRAIG:  So there are some out there.

CATHERINE: Even smart farming and smart mining. You know there’s' companies using AI for that that are on the industrial side.

LAURA: And where do you get these ideas Catherine? I've never even heard of smart farming. Where does that come from?

CATHERINE: Well we marry quantitative research with fundamental research and here again, I’m dating myself again. I've been in the industry for years and so you have a really good network of analysts that we talk to, but we really do rely on our quantitative effort to generate the ideas and our quantitative effort reflects our investment philosophy and process. So it's a three factor model with signals and it's fundamentally driven. So it generates the ideas and then we do the research on the names.

LAURA: Go ahead.

KEVIN: I just had one thought on this point. We have some traditional companies, for instance we own a self storage real estate company and they're using their IT infrastructure technology to gain market share. It's a very fragmented market over in the UK and Europe. And this company there's two dominant players in the market that have the balance sheet and the capital investment required to support this IT infrastructure and now today that drives about 80% of their customer acquisition. We have all of these mom and pop operators out there who are not able to spend in order to have the online platforms in order to acquire customers. Consequently the two large players are able to use their technology to help grow market share and consolidate the market.


LAURA: Any new ideas on disruptive companies for you Jay?

JAY: I'll give you a nameless example. I met with this company yesterday that I've owned since it went public. And they contract manufacture optical equipment. So all the electronics that go into communications networks around the world. They, as an outsource manufacturer, probably manufacture 25% of every piece of optical equipment hat goes into and between server farms and data centers. And that business continues to grow. They also have a business that does contract manufacturing for laser companies. So, for example, when we get to autonomous automobiles they will all have lasers and this company is well positioned to be the manufacturer of the lowest level of the laser within the products. So, the brand name companies outsource the optical electronics and the glass to be assembled by these folks. So they are agnostic to the technology that wins but they're going to likely be in every winning technology.

LAURA: When I think about some of the ideas that you guys have brought together in these companies that are innovative or disruptive in some way,  You're obviously very excited about these companies. How much of a percentage of your portfolio can you put towards those kinds of companies, which you know, you don't know as well, they're newer, compared to some of the others that you've maybe owned for a very long time.

CATHERINE: Well we feel that we know them as well. And being a growth manager we have exposure to that. I would say between health care, tech and consumer discretionary we could be as much as 40-50%. But I keep pivoting on this whole valuation because they have moved, you know, significantly. Um, you know some of these Sass companies as I mentioned earlier, 15, 17 times not earning anything. You know we have, we have taken profits and moved out of some of them. And the fundamentals are good but if you have any type of a hiccup there will be no valuation um, to stabilize.

JAY: As value investors, very few of our companies are brand new. So even if they’re innovating since we really require a good return, they've probably been around a while. So that newness and unproveness that's one risk that I think is out of our equation.

CRAIG:  And the fact that we've all done this for so long, you live and learn. Anything that's kind of new and expensive and merging, you know you don't want a full position in it. You want a smaller position. And as it grows you have room and it will eventually miss or have hiccups. then you add to the position. So you kind of go full positions on the ones you're extremely convicted in, and then more of a, you know of a token position if you will initially. And as you get more and more confidence to add to that.

LAURA: I was going to say you can always add to it as they perform to your expectations. Exactly.

CRAIG:  Even at extended levels you know, sometimes you can ...even if they’re up two and three times sometimes you get more and more confident and it's still in the early stages even though it's gone up two or three times. So it's kind of the nature.

CATHERINE: The one thing we are seeing in the IPO market is healthy. And you’re seeing a lot on the biotech and the tech space so that is adding names to the Universe. And the other positive is they're not ETF's.

LAURA: The ETF's don't come into the IPO's?

CATHERINE: Right. So it's inopportunity to own names and then add to them after they go public. You don't have the passive money in them.

LAURA: Right. It seems like that's important to find spots where the ETF's don't run?

CATHERINE: Well because they create noise.

LAURA: Yeah. But is that something that you also focus on a lot? I mean we've talked mentioned Jay that these aren't necessarily new companies but that they're just starting. Maybe they're just IPO. So how much time do you really spend you know with maybe it's the new syndicator or the banks that are hoping to market these. are those things that you pay attention to as those IPOS are coming to market?

JAY: I think for us it depends on the tenure of the IPO market at any point in time. After you’ve had a 9 or 10 year bull run where the market's being led by tech and bio tech the IPO market is very very buoyant for those kinds of companies. Uh, and on the other side where more companies that have gone into the hands of private equity are staying in private equity. Whereas 15, 20, 25 years ago after five years they would come to public markets and they’re not anymore. That would be more fodder for value folks. So for us it depends on what the product looks like at any point in time.

JAY: Right now because of the frothiness of the market, some of the products are pretty tough for us to do.

KEVIN: We tend to prefer spinouts actually because we can look to the parent company and look at the execution and track record over an extended period of time ...

LAURA: And maybe the management too?

KEVIN: And the quality of the management team, quality of the business, and we have something we can point to to understand what the outcome is going to look like going forward. As opposed to just brand new IPOs.

LAURA: Right. And would you be agnostic as far as where they would spin out? Obviously you're focused in some international markets. Would it matter to you which jurisdiction it actually goes in terms of the spinoff?

 KEVIN: NO, we're pretty agnostic in that we have exposure to 40 different countries. I think liquidity is important so depending on where the countries domicile, where they generate most of their revenues, that tends to drive the decision.

LAURA: Well I think that does it for us today, you guys. I really appreciate you coming in, we really appreciate all of your insights for the small cap materials and we hope that you will bring back those insights for us next year as we go in and really head off for 2019. Thank you so much. Thank you for watching ,this has been the small caps master class. I'm Laura Keller for Asset TV.