MASTERCLASS: Small Caps - December 2018

Looking across equity markets this month, investors have seen volatility reappearing and stock prices falling. Three leading stock portfolio managers join together to discuss primary issues in small caps stocks, where the future is heading, how investors can better prepare.

  • Miles Lewis, CFA - VP & Portfolio Manager, Small Caps Value Portfolios of American Century Investments

  • Charlie Dreifus, CFA - Portfolio Manager, Managing Director of Royce & Associates, LP

  •  Bill Costello - Senior Vice President, Co-Director of Equity Portfolios, Senior Portfolio Manage of Westwood Holdings Group

For Financial Professional Use Only / Not for distribution to the public.

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  • 58 mins 57 secs

Laura Keller: Hello hello. Welcome to Asset TV. I'm Laura Keller. Looking across equity markets this month, investors have seen volatility reappearing and stock prices falling. The Russell 2000 today is trading just below the level it started out at at the beginning of 2018 leaving investors feeling like this year's gains are being erased. We thought this would be an opportune time to talk to several leading stock portfolio managers to assess where things are [00:00:30] heading and how investors can position themselves. We'll look at these active managers and ask them to talk us through prominent issues and small cap stocks. About whether a debt binge is coming to an end, and on the dangers of non-earner firms. Welcome to the Asset TV Small Caps Masterclass.

Laura Keller:  Let's welcome to our New York studio Bill Costello, Senior Portfolio Manager Westwood Holdings group. Miles Lewis, Portfolio Manager American Sentry Investments. And Charlie Dreifus, Portfolio Manager The Royce Funds.

Laura Keller: And so as we said, there's a lot going on in markets these days. Could you just walk us through how the performance has been for stock investors, let's say the last couple of months of this year in the fall. Bill.

Bill Costello: Sure. The small cap performance has been rough in October, obviously. A lot of things changed in the marketplace. Things that had been working no longer were working. [00:01:30] There were certainly a lot of different investor sentiment shifts in the marketplace. It's been a difficult year in general for small caps, but certainly exasperated in the October/November timeframe which we think creates the opportunity to invest in the class.

Laura Keller: Right. We'll talk more about that. Miles, your take.

Miles Lewis: Yeah. I think it's been interesting. If you look at small cap performance, small caps and aggregate have underperformed the [SNP 00:01:58] in the fourth quarter by about 400 [00:02:00] basis points. If you peel back the onion a layer, what you see is that small cap growth stocks have been the bigger driver of that. They're down almost 13% in the quarter versus the overall Russell 2000 down a little over 10%. That means that value stocks have actually done a little bit better on a relative basis but have still underperformed large caps. I think that part of what's going on here was that earlier in the year, a lot of small caps were viewed as safe havens in a trade war setting. I think that while that may be [00:02:30] true in the short run, in the long run it affects everybody. Ultimately, people realize that larger cap stocks, larger cap companies are more safe, more defensive, more stable in their eyes. That's part of the reason for some of the underperformance in small caps.

Charlie Dreifus: Picking up on both Bill and Miles, there's something particularly that Miles said that resonates in that it's actually a longer term phenomenon. [00:03:00] Post-March of '09, the central banks had huge amounts of quantitative easing. The real economy still was doing very poorly. The excess monies flowed in to financial assets, but people selected companies that had growth prospects because there were ... It was so scarce. So they bid up growths so we had, you know ten [00:03:30] years, nearly ten years of really strong headwinds against small cap value. That also was reflected until earlier this year in February. Now October/November in the volatility index. The VIX index.

Charlie Dreifus: So the VIX index has been in essentially a coma for [00:04:00] ten years. It's now ... As interest rates rise, there's a very historic relationship. Interest rates rise, people get concerned about the economy, it translates into fear. The VIX index is a fear indicator. Stocks go down. We have regression back towards the mean. This happens every once and a while. The market doesn't go up forever.

Laura Keller: And is that kind of what we should be thinking of that we've seen this shift you know maybe there was, as you said, growth was scarce. Now things are changing? Is that what you see as a panel?

Bill Costello: Probably to some degree. I mean I think to Charlie's point, I think it's healthy to have this type of correction in the marketplace from time to time. It is just a natural part of the economic cycle and the stock market that we have these trends going on. I think growth is still very scarce. [00:05:00] One of the things we do in our fundamental work ... You know, we call ourselves value investors, certainly, but we are looking for pockets of growth. We love to see secular growth companies when we can find them at a reasonable price that we think translates into a value investment for us.

Laura Keller: Not to overpay.

Bill Costello:Not to overpay, definitely. We definitely would like to see our companies be able to grow. We're not a deep value player where we're ... turnarounds, restructuring. That's not really our game per se. Even though there's people who are excellent at it and have done very well over the years.

Charlie Dreifus: I don't necessarily disagree, but having been in the investment management business now for 50 years, I've seen this movie before. It happened in '73/'74 with the Nifty Fifty. It happened in the tech bubble. People get overexcited about the growth prospects. Sometimes it occurs as it did in '73/'74. Also when the economy was doing poorly. Then it was caused by an oil embargo and inflation. You have circumstances that compel people to pay prices that make little justification. It's a multiple of sales. Obviously many of these companies operate with negative and yet they are in the atmosphere in terms of valuations.

Charlie Dreifus: If the economy, and it's an if. The jury's out. If the economy can continue to grow, albeit at a slower rate, I think the value side of this can endure and the growth and earnings will be there. And people won't have to pay exorbitant PEs [00:07:00] for growth.

Miles Lewis: I would echo what Charlie said. To put a finer point on that, the valuations in small cap growth stocks, on a forward earnings basis, are 34 times. The Russell 2000 value index by comparison is a little less than 15 times. That spread is about three standard deviations above the long term average. And it says why does it spend since the dot com bubble? While growth certainly has been scarce, the price you're paying for that growth is pretty [00:07:30] aggressive, and I think the assumptions embedded in that multiple are also aggressive. So we just think as value investors we can make a much more reasonable set of assumptions in terms of what the next three to five years might look like. And you were starting point at a 15 times or less PE is a much better, safer starting point.

Laura Keller: How do you get ... How do you just get that 30 times multiple. What underpins that? Why are people even paying that kind of price whatsoever?

Miles Lewis: Well, it's sort of what Charlie said. Growth has been scarce. [00:08:00] It's been a very slow, anemic recovery up until the last couple of quarters. We don't know if that's sustainable or not. Tax reform seems to be sort of the catalyst that's stirring up growth again, but we just don't know if it's gonna last. Up until this point, if you had any semblance of growth, the market was willing to pay up for it. At the same time ignore slower growing but stable, profitable, high quality companies that we look at. I think that's been a big part [00:08:30] of it.

Charlie Dreifus: There's another part of this puzzle. That has to do in that long ... until, again, three quarters ago four quarters ago we had low growth and the system was a wash with liquidity. Rates were still low. The fed hadn't started running the balance sheet off, hadn't started raising rates. You had a free pass to zombie companies. You could be a terrible company that actually [00:09:00] should have gone out of business during The Great Recession and ended up having access to capital at really low interest rates. That also is changing.

Charlie Dreifus: Part of that Russell Index is constituted in these zombie-like companies. There are gonna be a lot of bankruptcies. A lot of companies are gonna be going out of business. Even ... Actually, it's interesting. Probably [00:09:30] the stronger the economy, the more likely they go out of business which is counter-intuitive because the stronger the economy, the higher the rates go. If the economy collapses again and the fed unleashes liquidity and rates drop, they probably persist. But if rates go up-

Laura Keller: And let's talk about that ... more of details on that in a moment, but I want to talk just broadly then about rates. You know, as we see the fed ... Fed governors did not up raising in October in that meeting they chose [00:10:00] not to. What kinds of implications with the rising rate picture have for some of the companies that you invest in at the end of 2018 and going into 2019?

Bill Costello: I think it affects a lot of the companies differently. When we look at our companies, we try to find companies that have lower leverage that are high quality, financially stable. It shouldn't really affect our portfolio companies like it would a lot of the broader market. We [00:10:30] think there'll be a gradual rise in interest rates. We're not really afraid of that for any of the companies that we own per se, but we think there is a lot of companies out there that are in harm's way.


Laura Keller: To Charlie's point.

Bill Costello:To Charlie's point, exactly. I cover the energy industry. With the collapse in oil prices in 2014, we did have some bankruptcies in the system. Some of the smaller, heavily leveraged companies. We didn't have enough. More companies should have gone away. The capital markets [00:11:00] for whatever reason remained open. They let them do equity at almost any price. They let them refinance their debt. The whole industry would've been better served had a lot more companies gone to the wayside.

Laura Keller:    11:15   Right. Any other remaining problems, though? Just generically in terms of rising rates. Or maybe your outlook for them.

Charlie Dreifus: Well, rising rates will obviously impact companies. Particularly those ... There are a lot of companies ... There's a wall of [00:11:30] refinancing coming up. 20, 21, 22. There will be a lot of companies that will not only face higher rates, but the terms of the loan may be changed so that it'll be [lie-boor 00:11:45] or Prime plus 400 basis points rather than 200 basis points.

Charlie Dreifus: The other thing that goes back to why growth stocks might suffer a little more under rising rates. A conventional [00:12:00] way of valuing growth stocks is discounting back the terminal value based on the assumed growth. That discount rate is a function of interest rates. And the higher the interest rate is, the greater the penalty in the discounting back to present value.

Charlie Dreifus: Just generically, growth stocks suffer mathematically as interest rates rise.

Laura Keller: Same thing [crosstalk 00:12:29]

Miles Lewis:I agree 100%. [00:12:30] I mean, growth stocks are effectively long duration assets or long duration bonds. They're very sensitive to changes in interest rates. Multiples in general are sensitive to changes in interest rates. But growth stocks are most susceptible to higher rates.

Miles Lewis: The other thing that I think has been a tailwind to the market as a function of low rates that could become a headwind is [M&A 00:12:52] and share buybacks. So if you think about the IRR that you need as a company to acquire another company. If you have to pay the same multiple and your [00:13:00] financing costs go up then you get lower returns. So you're less likely to do that deal. Similarly buying back your own stock is less attractive if the financing costs to do that are higher. That's something that's been a big tailwind of the market over the last few years. It may not be there going forward.

Laura Keller: And maybe music to the ears of the fixed income investor who doesn't want to see those buybacks, but not to the investors that you serve.

Bill Costello: Right.

Miles Lewis: Yeah.

Charlie Dreifus: Yeah.

Laura Keller: Let's talk ... You've dived into these areas of concern, but let's really bring some of those out. The debt concern is something that I know [00:13:30] when we all talked in preparing for this panel we all looked at and said this is a problem in this market whether you call them zombie-companies like Charlie has said or really just identifying these different factors that cause concern.

Laura Keller: I know we had a chart here that you guys had looked at earlier. This is just looking at small caps total debt. If we look at that overall total debt of this universe that we've been exploring here. That's over 1 trillion dollars at this point in time. That's been rising [00:14:00] steadily whether we're talking fixed or floating.

Laura Keller: I wonder if you could just talk a little bit through about, again, why that should concern investors as they look at these types of small cap companies.

Miles Lewis: One of the biggest concerns that we have is that we think the leverage maybe is arguably understated because if you look at not only the debt on an absolute basis like that chart, but you look at it relative to the earnings of the company, leverage is at thirty year highs. Profitability is very strong. We're at ... [00:14:30] Potentially towards the later inning of the economic cycle, but a lot of companies that have issued a lot of this debt are very cyclical. Meaning that on a forward looking basis, at some point there's gonna be a cycle and their earnings are gonna go down which means the leverage that they have today is actually understated. We think that that's-

Laura Keller:Mathematically, the leverage would then go [crosstalk 00:14:48] the earning are following.

Miles Lewis: Exactly because the leverage won't change, but the earnings will go down so the ratio will go up.

Charlie Dreifus: Well yeah, the fixed charge coverage or the relationship of EBITDA to [00:15:00] debt has risen. There's that problem, but there's also an even more subtle item going on in that the debts that's been issued has been covenant-lite. They haven't secured the debt the way they used to and in fact in some of these leverage calculations of EBITDA in relation, a lot of companies are using forward synergies to justify making, suppressing [00:15:30] the degree of leverage or overstating, in essence, the quality. There-

Laura Keller: And just to break that down for the investor who maybe isn't familiar with that, essentially they have a number for earnings, EBITDA, and they're able to add certain things back or certain assumptions that they believe they'll get whether it's a cost or some kind of one time earning and add that into their earnings picture such that it looks brighter than it actually is.

Charlie Dreifus: That's [00:16:00] exactly right, Laura. Companies have embellished numbers for a long time. As it relates to debt, this is something new. This notion of taking future benefits and using them ... unearned. You don't know. These are expected benefits. These are not guaranteed benefits. And using that to justify the issuance of the debt.

Laura Keller: [00:16:30] But when you scrub through these numbers, you as portfolio managers you're highly advanced, highly sophisticated. You've got analysts who help you out, but how should the advisor, or better yet the investor, be looking at these things. Can they only look at gap numbers? What should they actually look at?

Bill Costello: Well, I think it's complicated. We do look at the gap numbers. We obviously do look at the adjusted numbers that the companies report and, you know, tell us about. We always do a comparison. [00:17:00] Quite frankly, there's a lot of times when we will shy away from a company when the gap earnings have no relationship to what they're telling you they actually earned. 'Cause they add everything back. Like, different things like stock compensation. Pretend that paying their employees isn't a cost of doing business because they give them kind of funny money if you will.

Bill Costello: We're very skeptical about that. We do three to five year financial [00:17:30] projections. We try to do it with real numbers as opposed to the ones we're spoonfed by some of the companies, and make a better assessment of the valuation going forward.

Miles Lewis: Yeah, what we do is we largely try to avoid those companies in the first place where leverage might be overstated by focusing on higher quality companies that have less leverage to begin with. Then the other thing that we do similar to what Bill's process is, we look out three to five years, but we also stress test. So for every company that we have a model on, we build out [00:18:00] a bare case scenario. We go back and say, "what happened in '08 and '09? What does it look like?" And what's the leverage profile or the interest coverage look like in that scenario? Only then do we get comfortable with the leverage profile.

Charlie Dreifus: Laura, you may have opened a can of worms because I go around the country speaking to CFA societies about the gap in gap. I was blessed in graduate school and then having that individual as a mentor for my entire career. A guy named Abe [Riloff 00:18:29] [00:18:30] who was this leading forensic accountant, and if he were around today he would be writing and speaking about this so I've taken up the mantle. We've gotten to the point where non-gap is earnings before bad stuff. Okay?

Laura Keller: A new acronym right here on this panel [crosstalk 00:18:49]

Charlie Dreifus: EBBS. BS you can take as you wish, okay? It's earnings before bad stuff. It's proliferated not only [00:19:00] in terms of guidance, and that's obviously ... You give the guidance and if ... you can manufacture those earnings. If you ... it's interesting. Obviously companies that don't need guidance get really penalized because that's the ultimate thing. If you can't meet a manufactured number, there's a problem. Where it's actually bled into, which is even much more [pronitious 00:19:27], is in the incentive comp. [00:19:30] If you deep dive into the proxy, you find that their ... the cash incentive comp is predicated on adjusted earnings. They make acquisitions, but they don't want to be charged for the amortization of intangibles.

Laura Keller: Yeah. Back up for a minute here. As we get into these more arcane metrics I think it's good to bring it out for the advisor. But why look at compensation? You've mentioned that. Is that because of the world and the universe that we're in here? You really pay attention to executive [00:20:00] compensation, incentive compensation?

Bill Costello: sure in our-

PART 1 OF 3 ENDS [00:20:04]

Laura Keller: Compensation, incentive compensation.

Bill Costello: Well, I'm sure in our case, and I'm sure with my panelists, we've always looked at that. Corporate governance is a real big factor in investing in a company or not. So we've examined compensation probably since day one at Westwood. It's in every one of our reports. To Miles' point earlier about stressing downside, that's the one thing we do on the fundamental side. Before we decide to recommend [00:20:30] a stock or put a buy on a stock, the first thing we have to do is have a downside that's quantifiable and realistic. But part of our process is always describing the corporate pay and what drives that pay so we know what the incentives are. We want to be aligned with the company so that their incentives match up with what we want to see, which will drive stock performance over time. Doesn't always work, but we try to do that [00:21:00] going into the picture.

Laura Keller:   Matching those philosophies.

Bill Costello:   Yes.

Miles Lewis:Yeah. Incentives matter a lot. There is a former portfolio manager at American Century that said, "If you want to know how we manage money, ask me how we're compensated."

Charlie Dreifus: Right.

Miles Lewis:    21:11   And it's no different in corporate America. We do the exact same thing that Bill does. We evaluate the quality of the management team, and as a part of that we're looking at the compensation structure. And we want to see metrics that they're focused on that are aligned with how we think of investing as equity investors.

Charlie Dreifus: Yeah. And it also drives capital allocation. [00:21:30] You want it that they end up directing additional investments in areas that add value. It's value creation rather than value destructive. And so the metric has to be that way. And we've gotten to a point, not universally, but larger than most people think, where management, heads they win and tails they win. They get compensated either way, [00:22:00] and it's interesting. The SEC and the public company accounting oversight board now, those of you who do read the proxies, you'll see there's a requirement now. They have to show what the CEO's compensation is as a ratio of the average employee's compensation, so people are focusing on this more.

Laura Keller:Going back to this debt discussion again, because it is again [00:22:30] something that we've really been harping on. How do you find companies that have a little bit of that less leverage, or maybe aren't using some of these accounting gimmicks as much? There is obviously a large area, a large broad spectrum of companies to look at. But how do you find those ideas?

Charlie Dreifus: Well, most professional investors screen for candidates, so there's much that you can do to narrow the universe to accomplish [00:23:00] what you're looking for, no matter if you're a growth investor or value investor. You have some valuation metric. You have some quality metric, again, a ratio. And similarly, there's a ratio for debt. You can screen for lower debt companies. The nuances with accounting and governance are much more deep dive. That's labor intensive and that's qualitative rather than quantitative. You can come up with some [00:23:30] measures of quality, but regarding specific digressions that companies take, it's usually a mosaic, and you come about it by going through the document. But you can screen for leverage, for example.

Miles Lewis: Yeah. We look at leverage on the balance sheet, but we also consider it in the context of the cash flow profile of the company, so I don't think that all leverage is created equal.

Laura Keller:Some is more expensive.

Miles Lewis: Some is more expensive. And [00:24:00] then some cash flows are more stable and predictable than others. I mean, utilities are sort of given a pass when they run at four or five times leverage because they're regulated entities, and everybody knows what the earnings will be. Certain types of companies have very stable, predictable cash flows. Much more cyclical companies, who are going to see those cash flows and earnings decline in a down cycle shouldn't have the same amount of leverage as other companies.

Bill Costello:And the other thing that's labor intensive too in doing that, that you might not pick up immediately with [00:24:30] the screen, but as fundamental analysts, we look at it as the companies that have capitalized leases, and you don't see that necessarily as debt on the balance sheet, but you've got to be aware of that. If you've got a retailer that leases all 100 locations they have, but yet they're tied into paying a rent for 20 years and the leases aren't in good locations anymore, maybe something's changed, they have that obligation there. But you necessarily [00:25:00] don't see it if you just look at long-term debt on the balance sheet. But that's what we as fundamental investors are paid to look at and do the analysis.

Charlie Dreifus: As Bill just pointed out, that's always been an issue because a good accountant/lawyer could structure a lease so that it would not have to be capitalized. So the accounting profession now, starting a year out, is going to require all of these leases to be capitalized. Slowly, [00:25:30] in by gone days, companies didn't even have to ... They may adjust for ... Another point that Bill made about stock option expense, years ago it wasn't included whatsoever. It was a footnote. Now it's included, and so companies then take the elective of saying, "It's not a cost."

Laura Keller:But in terms of this, you bring up a good point, this idea that things that really should probably be counted as debt aren't necessarily looked at that way. What about floating [00:26:00] versus fixed? Is that something you also look at? Because we picked up a company that has a floating rate, but most basis of what they're borrowing versus a fixed would come up the same in your leverage screens. But may, I would imagine, face more problems if you're on a floating rate note right now given where rates are heading.

Charlie Dreifus: Well, yeah. I mean, floating rates by definition in a rising rate environment that we're in is going to produce more stress. And again, it depends on [00:26:30] a company that has a stable business, but a cyclical business or a business that all of a sudden the business model is challenged and you have the ... That's again where we come into these zombie companies, companies that are vulnerable to that. It's interesting. I run a very conservative portfolio, so I'm probably the contrarian that I have a portfolio that actually got hurt by low rates. I benefit [00:27:00] by high rates in net income. I look at operating income, and it doesn't affect operating income whatsoever. But in earnings per share, there's a line on the income statement, other income. And if you have net cash, it likely will be in treasury bills or something like that. So low rates mean low income. Higher rates mean higher income, so there are portfolios around, and certainly stocks around, that actually benefit by higher [00:27:30] rates. But your point, Laura, is absolutely correct. Floating rates can cause damage.

Laura Keller: Do you have any sense for when we'll see this wall of maturities really hit, or when companies who have a lot of leverage, whether it's floating rate or fixed, won't be able to refinance? Is there any picture in your mind on when investors might really see that come to a head?

Miles Lewis: I think it just has to do with the availability of the credit markets and how open they are. To Bill's point on energy earlier, we expected there to be a lot more bankruptcies in the energy patch than there were, [00:28:00] because despite a little bit of stress in the credit markets, they were generally wide open for decent borrowers. And so we don't know what causes that. It could be rising interest rates. It could be a slow down in growth. It could be a variety of different factors. But if and when the credit markets tighten up, that'll be when the companies that have to refinance, potentially in the face of declining earnings, will have a lot of issues.

Charlie Dreifus: There have been some firms, I haven't done the work, but there's been some strategy firms that have [00:28:30] suggested there's a wall of maturities. Again, 2020 through 2022, because we know the terminal point of public debt. And you also, the revolvers have a terminal date as well. So one can compile the data. Again, it's a tedious task.

Laura Keller:    28:52   And you don't know when, to Miles' point, when those are going to close up. And we've heard about maturity walls in the past, whether we were looking at energy markets, high yields. [00:29:00] It doesn't seem like those markers are always so correct right now. High yield seems to be taking off again. And yet, stocks are not doing as well. Any thoughts there?

Bill Costello: The only thing I would say is, to the point of when the credit markets tighten up, I don't think it's ever obvious. I think in hindsight you can point to some things. But when it happens, it just seems to happen.

Laura Keller: It all seizes up at the same time.

Bill Costello:Right.

Charlie Dreifus: Well, there have been also some studies. Again, referring to the people who do the deep dive into the macro things, I have seen some studies where they show that even an investment grade there's a much greater proportion of triple B in investment grade than there used to be. We all get ... It comes basically back to people not having to be [00:30:00] concerned about quality. And that's why non earners, non dividend payers, the worst of the worst, not only survived, but actually thrived during much of the period post great financial recession. And we are certainly, one thing is certain. For now, that has changed. Will it continue on its path or not? We don't know. But it has changed.

Laura Keller: Right. Well, speaking about those non earners that you've brought up, we also were looking at that earlier too, just thinking about the percentage of these companies that exist in let's say, the Russell 2000, around 36% right now of Russell 2000 companies are non earners. When you look at that, do you screen out for them? Are you aware of certain companies that will become non earners? How should you think about that in the portfolio?

Bill Costello: I think it's just an astonishing amount. We tend to screen [00:31:00] out for those, not in every case. All the companies in our portfolio at this point and time make money. But at times, specifically in our energy holdings, that hasn't always been the case. But typically, with our focus on the quality metrics, earnings is certainly one thing that we focus on and we want to see. You'll never see us own a biotech company. That's just not what we do. We can't [00:31:30] figure out binary outcomes or a company that looks like it's not going to earn money for the next five years or anything. Companies like that, we definitely screen out. But it definitely is part of the process and part of our screening process.

Miles Lewis: Yeah. We're in the exact same boat. We have a big focus on quality companies. I think every single one of our companies, even when they're not doing well, is still making money. They're just making less of it. And not to change the discussion towards active management, but I [00:32:00] think that's one of the big value adds that we have as active managers, is that if you go out and you buy the Russell, you're going to get 36% [inaudible 00:32:07]. And when the debt refinancing waves comes in and those companies have trouble, as and index or a passive holder, that's what you're getting. And you're going to get a lot of stress, whereas we as active managers hopefully are avoiding those value traps in the first place by focusing on quality, focusing on the companies with strong earnings and cash flows, and then sidestepping that when that happens.

Charlie Dreifus: What Miles said has to be emphasized [00:32:30] because I am actually one of the active managers who says there is a place for passive management. It's at market bottoms because all you have to do is be in the market. And because of momentum investing and algorithmic investing, weights matter. And so being in the market at the market bottom, pick your poison. Okay? But at the market peak [00:33:00] or at least at high valuation levels, it's a weapon of mass destruction. It's going to come and hurt you because those non earners and the companies that are most levered are going to be the casualties of that zombie eradication. And also, momentum works in both directions. And once these ETFs and passive strategies [00:33:30] have redemptions, all of a sudden, this cascades on itself. This is not a time, as comfortable as it may seem, to go passive.

Laura Keller: Right, because you point out basically that these passive strategies that mirror the index, they don't weed out these zombie companies. They aren't concerned as much about these overly leveraged ones. But concerning that passive investor, [00:34:00] what kinds of things, what other factors might they not be aware of? These two things I think we've harped on for a while, but besides just being a tracker of the index. What other things does passive kind of hurt the investor on?

Miles Lewis: I kind of have a view that ... I agree with Charlie. There are positives in passive investing, not to mention cost. And I think in certain asset classes, it serves the investor well. Small caps would not be one of them. We're the least efficient market. I think it pays to have active management. But [00:34:30] if you think about the role of active managers, we are here to exploit differences between price and value. In other words, we're here to try to keep markets efficient. And so if the majority of the assets are managed passively, or every incremental dollar, or more and more incremental dollars go towards passive investments, then the role of active managers and their ability to exploit differences between price and value is diminished. Those of us that survive in the long run, I think will have greater opportunities because there will be more mis pricings, [00:35:00] ironically or counterintuitively because of the rise of passive investing.

Laura Keller: Feeding frenzy.

Charlie Dreifus: The inefficiencies rise as passive becomes more dominant. And there are a lot of companies that have zero analyst coverage, and anomalies, inefficiencies, there's always been a discovery factor in small cap. And by definition on the index, it's unlikely you're discovering or concentrating at least on those [00:35:30] real opportunities. A lot of this has to do with also the timeframe you want to evaluate. People, again, the last 10 years is not necessarily the best 10 years to judge passive against active. You need a full market cycle. You need at least one major draw down. And if it's the same manager with the same discipline, the longer the [00:36:00] plot, that longer the time series, the more valuable. And there are managers around that have beaten the index by meaningful amounts after expenses for long periods of time. Does it happen broadly? No. But it can and does happen. And it's more prone, as Miles said, to happen in small caps.

Laura Keller: Certainly. Well, and thinking about that though, that sort of broader picture that I think we've come to now, this idea of [00:36:30] a correction and how and who might benefit from that. Is a correction something that you think maybe there had already? Or will we see more of that? Basically, will the small cap market fall farther, or are investors kind of poised where they might see a bottom here?

Bill Costello: I think it could really go either way. I mean, we've seen a correction. I think the corrections have been healthy. But I think the market going forward will be more volatile than it has been [00:37:00] in the past few years. But I don't think that's a bad thing. I think being active, doing fundamental research, I think we can exploit that volatility to drive better returns going forward.

Laura Keller: Volatility is here to stay though, in your view, Bill.

Bill Costello:I think so.

Miles Lewis:    We're bottom up stockbrokers. I have no idea what's going to happen with the market, but I do think we like to study the markets and past cycles. And back in the dot com bubble, the [00:37:30] overall market went down. But value stocks as a group were up.

Laura Keller: So it's about choosing the right ones.

Miles Lewis: It's the growth stocks that went down. One scenario that we could see playing out would be that if this divergence between value and growth ever mean reverts, you could see value stocks do fairly well in an environment where growth stocks drag the overall market down.

Charlie Dreifus: Laura, unfortunately I can't comfort your viewers by dispensing Prozac because what I'm about to say is going to depress them. Okay?

Laura Keller:Okay.

Charlie Dreifus: I do [00:38:00] believe that the combination of high levels of valuation, and in the last 10 years the S&P has not declined, has not had a yearly decline. And the Russell 2000 has had two small declines over that period of time. That is not normal. And there's a very strong force in the marketplace, regression to the mean. And we [00:38:30] have over earned, which to me says that a minimum future returns for some period of time, probably five to 10 years, are going to be lower. That doesn't mean they have to be negative. A correction can happen also by the market doing nothing for five or years and letting the earnings catch up to valuation levels.

Charlie Dreifus: But the 10% and extending beyond 10% if you incorporate November, is not the draw down that [00:39:00] one should think of in a correction. The corrections are 20% to 30%. And the way I go about populating a portfolio, frankly I need that now because in this, to me, expensive market I have trouble finding candidates. I have no trouble finding names that I own that I have to reduce because of valuation or ultimately eliminate because of valuation. My challenge these [00:39:30] days is finding new names. And everything has gone, in my opinion, so far ahead of itself. I have, for me, a relatively high cash position now. But it's not because of a macro bearish concept. It's the discipline says buy only when you can get these kind of attributes, and I can't. On the other hand, those that I have no longer have those attributes. [00:40:00] The market, obviously there's a buyer and a seller. But the ...

PART 2 OF 3 ENDS [00:40:04]

Charlie Dreifus: The market, obviously, there's a buyer and a seller, but the notion that we've gone through ... And again, it's a function of, where do interest rates go? Where does inflation go? All those black swans, we have a gazillion black swans out there, both domestic and internationally.

Charlie Dreifus: We've seen how volatility, and the thing I am, and we touched upon it a little bit, in [00:40:30] the discussion passive, when the correction comes it could be much more severe. We got a little bit of an appetizer on that in August of 2016 when the Chinese currency occurred, and the ETFs and the underlying security basket sort of were dislodged from one another. Because of the proliferation of ETFs and algorithmic trading, when the real draw down comes, it's gonna be fast and [00:41:00] furious. It can overstep.

Charlie Dreifus:           41:04   I was managing money on October 19th of 1987. We saw 25% in one day.

Bill Costello: Yep.

Laura Keller: So, Bill and Miles, are you agreeing there that it would be ... I know earlier, Miles, you talked about having individual companies, and looking at them on an individual basis, maybe not so much a whole market basis. But do you agree with Charlie, where you'd almost like to see a correction because it would allow you to buy companies [00:41:30] more cheaply?

Bill Costello: Oh, I mean, I'd love to see that. We'd love the opportunity to buy great companies, some of them that we've watched over time, that we just can't get there on the valuation, that perhaps would fall into the right range.

Bill Costello: But that's kind of when I was saying that the corrections and the volatility are somewhat because it gives you that opportunity to build up the portfolio again. We're happy with our portfolio. We are [00:42:00] carrying a tiny bit more cash as well because we've sold more things that have appreciated and hit our price targets, but it's not a meaningful amount.

Laura Keller: And it's not like you're trying to go to cash?

Bill Costello: No, no, not at all. We are finding opportunities at the margin. We found with this little correction than we had in a while, but it's definitely difficult to go turn over enough rocks to find the gems underneath them. We would welcome the opportunity [00:42:30] to be able to look through a lot more rocks and find some better quality.

Laura Keller: Right, some nice rubies down there.

Bill Costello:Yes.

Miles Lewis: Yeah, I think in aggregate with what Bill and Charlie are saying, but I think if you can kind of be selective and pick your spots, you can find opportunities. We're big fans of US Regional banks. The multiples have compressed meaningfully there. I would argue that they're pricing in a recession not only in 2019, but one in terms of credit quality that's comparable to [00:43:00] 2008 and 2009. We just think fundamentally that's a remote possibility. We think the banking industry is structurally improved, far safer, sound, more profitable than it was in the last recession.

Miles Lewis:If you have a high quality bank trading at nine times earnings, the market's telling you that the earnings are off by 35 or 40%, and we just don't see that. There are selected spots where we're finding opportunities, but in aggregate it's challenging.

Laura Keller: In fact, just to dive into that because we haven't really had a chance to talk about sector opportunities, [00:43:30] but is that because there is a loss or a gain in MNA structures? Why, other than the credit quality question, which I think goes to your point about the banks, what other things are making that trade maybe lower than you think it should be?

Miles Lewis: I think the market is exhibiting a 10-year recency bias, where it's just looking at what happened to the banks in '08 and '09, and what happened leading up to the last crisis. And everybody's sort of fighting the last war. It's a very different industry now.

Miles Lewis: When you look at [00:44:00] a bank and how you stress its earnings, particularly only 12 months out, the easiest way to do that is to hit them on credit costs. You can make assumptions on their net interest margins or their loan growth or their expenses, but you'd have to make pretty silly assumptions to get the earnings down 35 or 40% in a year.

Miles Lewis: You have to stress credit, and that appears to be what the market is pricing in. We just don't see it. We talk to our banks on a real time basis, regular basis. We're gonna have a credit cycle, but it's probably [00:44:30] not gonna be three percent of the loans in the industry getting charged off like it was in 2009 and 2010.

Miles Lewis: It's probably gonna be a more garden variety recession, where it's 75, 100, 125 basis points of loans charged off. If that's the case, then the banks will manage through that just fine. If you're starting point is nine times earnings, you're kind of already discounted that to begin with.

Laura Keller: But that almost brings back this point that I think Charlie had brought in earlier, which is this idea of there are a lot of people who really believe that you should be buying right now, and there are a lot of people who really believe should [00:45:00] be selling right now. That is creating that volatility, so it's a very different kind of market than we've seen over the last few years, where it was just going one way.

Bill Costello:Absolutely, but that's what makes the market, right? You need the buyers and sellers, and it does create opportunities, and hopefully you're on the right side of the transaction, but I do think it's healthy.

Charlie Dreifus: Laura, I would extend the time horizon. I believe you just said [00:45:30] the last two years. I would argue the last 10 years. Obviously, we've never ever had before the kind of quantitative easing worldwide, and it was necessary. I'm not saying it shouldn't have happened, but there were unintended consequences.

Charlie Dreifus: Among them, it's interesting, we spoke about the low interest rates, but we also had super low inflation because the zombie companies that, frankly, [00:46:00] should've gone out of business, continued to produce. So there was more competition in the marketplace depressing prices.

Charlie Dreifus: So an unintended, non-avoidable consequence was lower inflation. The fed is fighting to get inflation higher now. We had a very unusual 10 years, so for people to draw conclusions that the investment or the investment [00:46:30] concepts or precepts of the last 10 years are enduring is subject to strong debate.

Laura Keller: Very strong debate it sounds like. I think, Miles, to your point earlier, it's almost suffering from the remembrance that, "Oh, this is the 10-year anniversary."

Miles Lewis: And by the way, going back to leverage. The banking industry is the one area that's got a lot less leverage than it did 10 years ago. Non-financial corporates have a lot [00:47:00] more leverage. Capital in the banking industry's 35 or 40% higher than it was in '06, and it's higher quality capital today.

Laura Keller: Yeah, we talked a lot about the banking industry as a potential opportunity in our master classes, and it does seem like that is an area that people are really looking to as a potential driver of whatever downsizing they have coming for whatever reason.

Laura Keller: Well, moving on here, guys. We don't have too much time left, but I do wanna make sure we get to the policy picture, a [00:47:30] little bit more about government because, as you know, we just came off of the midterm elections. We've got a divided House at this point. I wanna talk about trade tensions because that is something that is really causing some concerns in the markets, and people seem to be unsure of where that may be going.

Laura Keller: As we head into closing out 2018, are you thinking that small caps or large caps are more vulnerable to those trade headlines?

Bill Costello:I would say just on the surface probably the [00:48:00] large caps. The smaller caps, they're not immune to it by any stretch of the imagination. People probably thought they were at one time, and piled into them erroneously, but I mean, it'll affect all the companies. I think just because we're more US centric, less global, for the companies that we own. I think that's a layer of insulation, but it's not a panacea. It's [00:48:30] not like we're gonna skate through some type of global crisis that's only gonna hit large caps, and we're gonna go unscathed, and sail away into the sunset.

Laura Keller: It will still have effects.

Bill Costello: It will still have an effect. It'll probably be a big effect. I mean, it's just hard to try to quantify it, but certainly I know some of the companies that we own with say steel costs, for instance. It's hard for them to pass them on. When we look at the companies, we try to buy companies with pricing power, [00:49:00] so that doesn't hurt their earnings, but you don't have 100% pass through. There's a lot of our companies who are struggling, with both labor costs and steel costs, to try to maintain margins where they are.

Laura Keller: Right, and are you able to determine if they will be hit? Because I imagine that some of these tariffs, it seems almost like we're getting new introductions of potential tariffs every month. Is it something that you're looking forward as an almost defensive mechanism, [00:49:30] where you're saying, "This company could start to be affected." Or do you have to wait until we know what the potential tariffs might be?

Bill Costello: I think we have to wait a little bit more to try to analyze the situation, and try to assess what might happen. It's definitely something we're cognizant of.

Miles Lewis: I think there's two big impacts of the trade war and the uncertainty around it. One is just simply uncertainty. Companies don't like uncertainty. We talk to our companies, and we say, "Okay, if you have 10% of your cogs [00:50:00] coming from China, what are you gonna do about that with the tariffs?" And they say, "Well, is it gonna be 10% or 25%? I don't know because then maybe I'll move it to Malaysia, maybe I'll move it to the Philippines. Maybe we'll go to Mexico, but we don't know."


Miles Lewis: So they just sit still. When people sit still, then that just slows the economy down. So that's not good, the uncertainty. The second thing is inflation. There is no doubt that a trade war and tariffs are inflationary for our economy, and what does that do? It pushes up interest rates, ultimately, because the fed will have to raise rates to stymie inflation [00:50:30] if we start to see that.

Miles Lewis: I don't think it's good for small caps or large caps. I just think, to Bill's point, that small caps might be relatively more immune to it.

Charlie Dreifus: Yeah, there are no winners in trade wars. We saw this in 1929 to '33. The fact that other country's taking retaliatory measures always hurts. [00:51:00] Small caps to the extent they don't export as much as large caps might, thinking of the Boeings of the world, and Caterpillar. Yeah, they're big exporters.

Charlie Dreifus: It's interesting, exports as a percent of our GDP ... the United States, basically, is a huge island on its own. Relative to the rest of the world, only 15% of our GDP is exports, and [00:51:30] half of that is food goods. While we think in terms of Deere and Caterpillar and Boeing, yeah, they are big exporters. But there aren't that many of them, frankly.

Charlie Dreifus: Small caps are somewhat less hurt in terms of selling into foreign markets, but the core structure ... we live in a globalized economy. Input costs [00:52:00] come from around the world. We had the 10% tariff, which really was able to be absorbed. First of all, the Chinese currency declined by five percent, so that was half of it. Most of the companies we speak to, they said the remaining five percent they split with their vendor, so they absorbed two and a half.

Charlie Dreifus: The big challenge is gonna come if we do go ahead on the 25% because there's gonna be price elasticity. [00:52:30] If you try to pass it on, we want pricing power also, but the consumer may repel. The consumer will say, "I'm not gonna pay that kind of price," and all of the sudden the economy goes into a slower mode because of this.

Charlie Dreifus: The economy, what people have not focused on yet, the economy by definition is gonna into slower mode because every company on earth has been pre-buying. We had huge pick up in third [00:53:00] quarter GDP by inventory build. We're having it now again because everyone is trying to bring in imported stuff-

Laura Keller: Before the tariffs go into effect.

Charlie Dreifus: So the port of Long Beach where most of these container ships come in, there are ships going all the way out to Hawaii backed up. In terms of other people are saying, "Okay, I'm gonna move my production from China to Vietnam." Well, the problem is that Vietnam doesn't have the port structure either to allow. [00:53:30] There's no fix to this.

Laura Keller: But does that mean, to Miles point I think earlier, this idea that sentiment is starting to change, and people, companies, are starting to be more worried, and therefore are making these kinds, taking inventory early, to kind of get ahead. It seems, to Miles' point, that you all would agree that that is problematic for some of our small caps stocks.

Charlie Dreifus: It's problematic to stocks, period.

Laura Keller: Mm-hmm (affirmative).

Charlie Dreifus: Whatever the ... and so, yeah, I mean there [00:54:00] are these measures that are, again, these strategy firms that take weekly sentiment. They survey corporate managements, and there's been ... it's still at a high level, and again the taxes and the rollback of regs, regulations, have certainly improved the business environment. But on the margin, people are more cautious.

Laura Keller: I want to end our discussion here with one point then, [00:54:30] going back more to the US policy, and maybe not how it goes out into the world. But on tax reform, what have you seen companies use the benefits of the reduction of the corporate tax rate for? Are they spending it on CAP Acts? Are there things that you're watching that you do think could help propel the economy more forward given that there is a much better corporate tax structure now for our companies here in the US?

Bill Costello: I think we have seen some of the benefits. The companies that we talk to, the companies we invest in, have taken that money, they've [00:55:00] reinvested in the business with CAP Acts. They, obviously, have a lower tax rate, helps their earnings. They've also done share buy-back.

Bill Costello: Looking forward, that benefit's been here. It's kind of come and gone. The growth that we're gonna see in earning next year isn't going to be that huge one time step up because of taxes. They've really got to run their business, and drive their earnings themselves without that artificial [00:55:30] help.

Bill Costello: Artificial's probably not the right word because it was real help, and it was real cash that came in the door.

Laura Keller: But the fundamentals and operations now need to take over?

Bill Costello:Yes.

Miles Lewis: Yeah, we met with an industrial distributor yesterday who talked about an acceleration in their sales, and it started three or four quarters ago. They're a great read on sort of the manufacturing economy in the US, and the Rust Belt economy. They're seeing it, and they attributed that to tax reform.

Miles Lewis: You can see it when you look [00:56:00] at CNI loan growth as an industry in the banking industry. It started to hook up. There's a good thing going, and we just have to hope that trade wars don't mess it up.

Charlie Dreifus: I'll parlay on what Miles and Bill said. First of all, Bill's point about the anniversary of the tax rate decline is important. I have suggested people focus on operating income, or certainly pre-tax income as a measure of whether the [00:56:30] company's making improvement organically, or if it's all coming-

Laura Keller: No the way to relatively compare it, yes.

Charlie Dreifus: That's item number one, and the other thing is that certainly, and there are small companies that had earnings that were sort of captured overseas under the old tax regime, so they repatriated [00:57:00] that. That's back onshore, which can't harm.

Charlie Dreifus: Unfortunately, I think most ... I mean, the year isn't out, we don't know all the numbers, but certainly there's been ... The buyback through August, as I recall, the dollar amount was more than the entire year of '17. So companies have used it, again, if you dig into the proxy statements, you see some company managements get paid by growth [00:57:30] and earnings per share. You shrink the denominator, and your part of the way there.

Laura Keller: Right, so buybacks have been [crosstalk 00:57:39] by that.

Charlie Dreifus: Right. Having the cash, "What am I gonna do with the cash?" I haven't, frankly, the interesting thing, and the $64,000 question is the CAP Acts part of it. CAP Acts, and we did get some improvement, but I suspect that was largely because it was [00:58:00] a one year write off. You got accelerated full year depreciation, which is a freebie.

Laura Keller:    Right.

Charlie Dreifus: We're not operating in, yes, we have a labor shortage and automation does help, but statistically the operating rate isn't that high that suggests you need a lot of CAP Acts, and we haven't seen it.