MASTERCLASS: Small Caps - June 2020

Jenna Dagenhart: Welcome to Asset TV. This is your Small Caps Masterclass. We'll cover strategies to capitalize on small cap companies and look at how recent market disruptions have created opportunities in the space. Joining us now are two expert panelists, Bill Hench, portfolio manager and principal at Royce Investment Partners and Jane White, co-founder, president and CEO at Granahan Investment Management.

Jenna Dagenhart: Everyone, thank you for joining us and Jane, starting with you, what's your definition of a small cap company?

Jane M. White: Thank you, Jenna for inviting me here today. The simple answer to that question is we look at all the companies within the market cap range of the Russell 2000 growth. So that can be anywhere as low as a hundred million all the way up to $5 billion.

Jenna Dagenhart: How about you, Bill? I know everyone has a different definition of small caps so what does small caps mean to you?

Bill Hench: So at Royce, we generally view it as anything under $5 billion for our product. I'd say the sweet spot of what we do is between about 3 to 800 million, but we do go as high as 3 or 4 billion.

Jenna Dagenhart: And how would you describe small cap investing to advisers who might not be as familiar with the space?

Bill Hench: Well, it's probably the most opportunistic and I might add fun part of the market. It's everything that everybody always talks about. So, all the stereotypes are true. It's less researched. There's tremendous variety. There are tremendous disparities between the earnings capabilities of some companies and management teams. I say fun part of the market because you really get to do your own work and there is still ample opportunity to outperform.

Jane M. White: I couldn't agree with Bill more. When we started Granahan Investment Management 35 years ago, I started it with Jack Granahan and Gary Hatton. We had all worked at large companies where we had to do analytical work on large companies. Where we had the most fun, definitely, was doing work on smaller companies. And the reason for that is because you are engaging with people, much of the time, who are founders of companies, who are extremely motivated, very intelligent. What they want to do is they want you to know about their company and they want you to be excited about it, and to really like it.

Jane M. White: So you're constantly being tutored and in the case of small cap growth, you're being tutored in the most innovative, disruptive companies that are on the face of the earth. So, it's very, very exciting. You're constantly learning and you're always on the edge of innovation. It's so exciting.

Jenna Dagenhart: Yeah, and Bill raised a good point too, I think when it comes to coverage. I mean, there aren't as many analysts covering these small cap companies, which I guess makes it fun as you mentioned, Jane.

Jane M. White: On average, and Bill you could chime in on this, a lot of our companies have maybe two or three analysts. When I first started a long time ago there were companies that actually had no one following them. It will be interesting to see in the future with MFID and all of these things that are collapsing the sell side of the marketplace. It will be interesting to see how many analysts there will be. I would expect it to shrink going forward.

Bill Hench: Yeah, I agree. I think it'll definitely be shrinking. The good news is, is that a lot of industry veterans and some of the boutiques have really withstood the onslaught of everything that's come against them and they're still producing some pretty good work, but it gets more and more difficult and the pool gets smaller and smaller every year. That should be advantageous to firms like ours where we're used to doing most of your own work and not hitting a button.

Jane M. White: Yes, deep dive fundamental research.

Bill Hench: Right.

Jane M. White: I think one of the things that the number of companies, the number of public companies today is only 3,500. In 1985, there were 7,000. So, the number of companies has gotten a lot smaller. So, the type of research that's being done and the people who are out there looking at companies, there's kind of a little bit of a scarcity value there although we're talking about still doing work on 1500 companies.

Bill Hench: Right. Well, there's been really no chance for us to sort of reload the population right, the IPO market now. Most of the things that come public are either mid cap or big cap. Gone are the days when the firms out west like Hambrecht and Montgomery and Robbie Stevens would bring six or seven companies a month public, sometimes six or seven in a week. So, there hasn't been a restocking, if you will. That's probably the biggest challenge I think of the... It's not so much that we don't have as many companies, but I think there's often a vacuum for new and wonderful things to look at.

Bill Hench: You always have a great age with the newer companies because there's no history with them and if you've got some insight to add or if you've got experience with new companies, it could be a big advantage. But that's the thing I missed most is a robust calendar.

Jenna Dagenhart: Especially in this kind of environment, we are not seeing IPOs much with the coronavirus pandemic. We'll get to that in a little bit, but before we do, I want to also talk about what makes small caps unique compared to mid and large cap stocks, Jane?

Jane M. White: So I think we touched on it a little bit; the research is much different. We separate companies from stocks. I think it's really important to do deep dive fundamental research on companies to really be able to figure out if they are good businesses or not, and something that you're going to want to own for a long time.

Jane M. White: So the way you do that is... I mean, most of the people who work at Granahan Investment, the average experience is like 29 years. We tap into our networks and what we're trying to do is figure out who is really a leader here? Who really is taking market share? Are the people who are in the business aware of this company and do they think it's good? We  talk to the customers or competitors and suppliers.

Jane M. White: So I think there's a lot more fundamental research work that you do on small companies and that doesn't really make the company unique, but it makes the processes for identifying them unique.

Jenna Dagenhart: Bill, I see you nodding your head over there.

Bill Hench: I agree. The way I look at it is there's three things that make this sort of a different type of investment than the big cap and mid cap. And its liquidity for a lot of the names especially on the value side. Liquidity is just difficult and it's difficult in good markets and it's really bad in bad markets. So that's different, right? We don't give our traders in order and they don't put it out to the street and have them call back with a finished order in 10 minutes or an easy fill if you will. Everything is a working order, everything is difficult. That is one of the things that's different. Financing is different as well.

Bill Hench: A fair amount of our companies don't have great access to the bond and stock market, and as a result are borrowing from banks. They're not borrowing from big banks or regional banks, but put some very, very small local banks in a lot of instances. The last thing I think that differentiates it is management. There are great management teams in small cap land, but they're thin. In many instances, they don't have backup, or they haven't been around long enough to bring people in right after school and send them through different parts of the company.

Bill Hench: They learn about finance, they learn about manufacturing, engineering, whatever it is. So, you don't have the depth of management. So, you tend to on key people more so than you would I think at the bigger companies. Sometimes that's very good and sometimes you'll be surprised at how much a CEO had to do. When a CEO finds out and you found out that she was not just their CEO, but she was probably their head salesperson too. You sometimes don't see this until it's too late. Then sometimes you do see it, which is a good idea, which is a good thing to happen.

Bill Hench: But there is a high degree of relying on a small amount of people and that's good and it's also a risk. So those are things that I think that really differentiate the kind of companies that we look at versus what you'd be looking at bigger companies.

Jenna Dagenhart: Do any of those reasons you just named make small caps a target sometimes for acquisitions?

Bill Hench: Yeah. We own a lot of companies with a diverse group. So, we get 15 to 20 take over as a year. No one is buying a company from us or from anybody else because they're benevolent. They're doing it because they know that getting it cheaper than what they got. Ultimately realize from it. So, no one's giving us $20 a share for a company because they think it's worth $20. They're taking it because they think it's worth 25 or more. So, we get strategic buyers, we get financial buyers. There's a high amount of transactions every year in the market caps that we deal in.

Jenna Dagenhart: Any misconceptions, Jane surrounding small cap investing that you'd like to address?

Jane M. White: Yes, I think the biggest one is people think that companies that are small are more risky than large companies. I mean that's it in a nutshell and it's because of all the things that Bill just named. They have shorter histories. They have lots of times unproven management, not always. Some of these companies that we invest in, it's a CEO on his second or third time around. So, there's greater dependence on that management and they are wearing a lot of hats and then, there's also more concentrated product mixes. And like Bill said, liquidity can be an issue. It can also be a friend, but you have to be on the right side of it. You have to be buying when nobody wants it and selling when everybody does in order to take advantage of that illiquidity.

Bill Hench: I agree. I think there's a perception and I don't think it's the reality that it's a much riskier part of the market. The difference in risk is that things that happen to companies that are smaller are non-events for big companies, right? So if one of my companies loses a CFO and they've got a lot of debt, you have to worry about the bank sort of pulling back on the credit line or something like that or if someone does something bad at a large company, at a fortune 500 company, chances are, you wouldn't even read about it. But if it's a smaller company, it can be material and that liquidity that we like to have on our side really turns against you quickly when something does go wrong. But I'd say that's the biggest misconception with the risk.

Jenna Dagenhart: Bill, what would you say to someone who says you can't be both attack and a value investor at the same time.

Bill Hench: That's crazy. So, some of the best value players there are tech names and the reason are because they tend to have the best balance sheets out there, right? They have lots of cash, no debt, and they're excellent at spending on R&D, right? They do that spending during fallow periods when their stock isn't doing so well and they get very, very low PEs because they're spending money and not generating great returns. But when those new products come to market or where the sun comes out on their part of the day or the cycle changes, whatever happens to make it more interesting, they tend to get very, very good multiples for that, right?

Bill Hench: So they go from value companies to growth companies by doing little, except executing on the plan that everybody knows is subject to a business cycle. So, it's a great source of names for us and it's not a hit business for us. We're not looking for companies with new dynamic products in many cases. We're just looking for increases in unit volume in many cases, right? So we don't really necessarily care whose phone gets bought, we just hope that somebody buys a phone because everybody's going to have a phone that has a camera chip in it, an IO or memory, you name it, and that's where it the types of tech that we get like things that benefit from nice unit growth.

Jenna Dagenhart: What about volatility, Jane?

Jane M. White: Yes. Well, a lot of people equate volatility and risk. We wouldn't do that here. Volatility can really work for you in the respect that... So, I'll give you a great example. Right now, because of COVID-19, a lot of the companies that supply elective procedures for the medical community, things like knee replacements or just any kind of elective surgery, the stocks have been extremely volatile and have gone down, have gone down a lot.

Jane M. White: What's happening is you're building this huge backlog of people who still need to have all of this done, but it's a great buying opportunity. If you do your work ahead of time, we have monitor lists at Granahan Investment Management where we're always looking at names to see their relative valuation versus everything else in the portfolio and trimming the ones that are doing well and buying the ones that are under pressure for reasons like this. It's a great way to add alpha to your portfolio.

Jenna Dagenhart: That's a great example too with the hip and knee replacements. Just because of the pandemic doesn't mean that people don't need to replace their hip. Bill, turning to you, I mean, I think Jane touched on this but what about upside volatility and that potential there?

Bill Hench: Well, that's one of the... I said this was a fun place to invest and I don't know what the numbers are, but it does seem that we have a lot more volatility in our part of the market and you have to take advantage of it. If you don't take advantage of it, you're not going to be as successful I think as you probably could. It's hard to really add anything more than what Jane said. I completely agree in her example. It was dead-on. It's something that's out there and it is not risk. You don't have to believe me. You could read what Howard Marks has to say, right?

Jane M. White: Right, exactly.

Bill Hench: It's a big part of the market and any serious small-cap investor understands how it affects their portfolio.

Jane M. White: Right. So basically, you have processes in place that help you to be able to deal with that, right? I had someone ask me the other day, "Jane, do you have a self-discipline where if a stock goes down 8%, you would automatically sell it?" My answer to that question, and I'm not trying to be a wise guy here, is, if we did that, we wouldn't own anything! That just doesn't make any sense for a small cap growth investor. So, you have processes in place that guide you on the valuation side, on the stock side. We have something that we use called probability- weighted, expected return, and we create different scenarios, five different scenarios for three different years. We look at our companies relative to all the other companies in the portfolio. We've been doing this for a long time. It works and really helps us add alpha when they're volatile, when there is volatility.

Jenna Dagenhart: We've certainly seen a lot of volatility across the board with the coronavirus pandemic. That being said, I mean we mentioned it with your hip replacement example, but how is COVID-19 impacting small cap companies, turning to you, Bill?

Bill Hench: In all different ways, right? Some industries are just closed, right? So many retail industries have gone more to online, but if you're an entertainment or travel or leisure or anything like that, you're essentially closed, right? If you're in real estate or if you're a lender, you're worrying if you're going to make a payment where your payments are going to get made. So, it's all over the place. Surprisingly tech has held up a lot better than it had been. I think most people realize that it could, and principally in our world, tech is basic components, semiconductors, semiconductor capital equipment, things like that.

Bill Hench: That's held up well. Energy has continued to decline. You're really dealing with a tremendous amount of unknowns. You don't know what the quarter is going to be. You don't know what next quarter is going to be. So, it's lots of valuation work that you have to do to make sure that the asset that you're buying has the wherewithal to rough it out, have a seat when the music begins to play again.

Bill Hench: So it's a big market. Different parts of the market are obviously being more effective than others. If you happen to be making masks and gowns, it's a great time. If you're trying to move products through distribution channels that have no end market anymore, it's a pretty rough go. So, it's everything and anything that you could want in the market because there are going to be tremendous opportunities in a market like that.

Jenna Dagenhart: Jane, how about you? How do you think COVID-19 is impacting small cap?

Jane M. White: Exactly what Bill said. I mean there's the haves and have-nots. On the growth side, we have a lot of companies that are benefiting from work from home. Anything that's tele-, anything is doing well. Anything that's helping education like Chegg which is online tutoring. Anything like that of course is doing extremely well. As a matter of fact, the thing that I think that is so interesting about that, it's actually accelerating adoption of technologies that would have taken, like Teladoc, which would have taken five more years to really get to where they are today.

Jane M. White: Now, there's going to be a downturn after this, but the biggest negative at Teledoc was getting the doctors on board, not so much the patients. Getting the doctors to use the product. Now, all the doctors are using the product. They can see how it works and then just like all of us, we'll figure out how to integrate that into their practices going forward. Then on the other side, you've got all the companies like Bill said that just have no business or can't react in a way that they can benefit from COVID and that is really sad.

Jane M. White: I mean, the companies that I was talking about earlier like hip replacements or collagen injections, stuff like that. There's a backlog for that and those companies will do fine. Their earnings are unpredictable right now. We have no idea what they're going to do. We know they're going to be bad. We know they're going to be a lot worse. But then there's other companies that just might go away.

Jenna Dagenhart: Jane, how would you say that small caps perform, behave overall during turbulent times like we're living in right now?

Jane M. White: Well, in my memory bank, the best way I can answer that question is in 2009 over half of our companies grew their top line by more than 15%. So, at that point in time, that was the worst economic situation I had ever seen. Now, I'm in a new one. But the reason they're able to grow their top line like that is because people are looking for ways to increase productivity by cutting cost, so they go to the innovator. They go to the newest provider of the best technology or whatever it is out there to be able to leverage themselves going forward. So, we end up having some companies that do pretty well. I could extend that to today where we're seeing the work from home companies are doing well because they're increasing people's productivity from home.

Jenna Dagenhart: Yeah. We've heard a lot about how Main Street is hurting with the coronavirus pandemic. That being said is Main Street the same as small cap companies? How would you define them?

Jane M. White: Yes, so that's a great question, Jenna. I don’t really look at Main Street the same as Small Caps. I think of Main Street as being really tiny companies, like your local bakery. I think when we started the company years ago, we tried to figure out the best way to take advantage of all the opportunities that are available in the small cap market. There are lots of stocks in small cap market. So, we divide the number of companies into three different buckets that we call lifecycle categories. We have pioneers, core growers and special situations.

Jane M. White: 35 years ago, most of the people who invested in small companies only bought core growth companies. Those are companies that have lots of recurring revenue, we are expecting more of the same. You would expect the PE to be a little bit higher, because they're great companies and they do a really good job. Somebody like Salesforce.com was in that category. We used to own Salesforce.com before they got too big. But then we were looking at the market and we said how can we really expand the opportunity set for the small cap arena?

Jane M. White: So we started buying companies that didn't have earnings, which were pioneers and most other people wouldn't touch them. But the reason that we bought the pioneers or those companies that mostly didn't have earnings is because they were developing and innovating in new markets, creating new markets and the potential opportunity was huge. A lot of our biotech companies and our internet companies are in that category. Then to offset some of the risk of these very fast-growing companies are special situations and those are companies that have very prosaic records. We're expecting a major change in the earnings growth and acceleration in those earnings and lift in the valuation.

Jane M. White: A great example there, which we don't own anymore because they got bought out by Pepsi is SodaStream, where they were struggling because they were selling sweet sugary soda syrups to put with their canister CO2 that you would bring home. The benefit of doing that was that you didn't have to lug around a whole bunch of cans to your house and you also didn't have to bring them back. So, there was a great green piece of this, but people didn't want the sugary sodas. So, they totally revamped the company and started selling flavored soda water that had no calories, and the earnings just took off, and so did the PE.

Jane M. White: So we use this as a risk mitigation toolIf the special situations are doing really well, the pioneers generally aren’t, and we'll buy more pioneers. So, it's expanded our opportunity set. It gives us a great indication of sentiment in the market and it allows us to mitigate risk.

Jenna Dagenhart: Bill, how are you looking at small and micro-cap stocks given all the recent market disruptions and what kind of opportunities are you seeing there?

Bill Hench: Sure. So typically, and this has happened... Obviously, each time is different but even when you've had these terrific selloffs '08, '02 to a lesser extent, I guess, '11, the liquidity that we talked about being tough really gets difficult. A lot of the lower priced stocks, and then this 100, 200, $300 million market cap names really don't sell anything that's reflective of evaluation or a PE multiple or reflecting the asset. So, it just becomes a number, right? It's a number that someone's willing to sell stock. Get it off my list. I don't want to own it anymore. I don't want to see this anything anymore.

Bill Hench: So we find ourselves taking advantage of situations like that and buying things where you don't necessarily have a good fundamental news coming out, but you've got a price that reflects something much worse than the reality. So, we get opportunities like that and we also are fortunate to get things that were always too expensive for us, right? So, we added a host of names that people on the other side of my shop would call quality. I would call them good opportunities to make money. But things that have really good growth rates that now all of a sudden are a lot cheaper or their market caps have come down.

Bill Hench: We did two things very, very quickly when this all started to happen. One we looked at a lot of the turnarounds that we have. So similar to Jane, we have categories of investments and one of them is turnarounds. Obviously, any turnaround that had debt had to be re-examined or substantial debt in light of what was going to be a new reality for at least three or six months or a year, or what have you, right?

Bill Hench: The other thing was we look for opportunities. So got rid of some things and added a lot of new things. And again, this goes back to what you get in this part of the market. You get actionable events in real time and you have to take advantage of that, and that's what we've done.

Jenna Dagenhart: Yeah. Jane, why do you think that the small cap space is attractive to you?

Jane M. White: Well, what I said before about how exciting it is to do the research. I mean, believe me when I first started in this business and I saw people got paid to do this, I couldn't believe it. It's so exciting. It's really exciting. And the reason it's so exciting is you're getting tutored by experts, and it's a discovery situation. You're looking for the next Tesla. I mean, we owned Tesla. We owned salesforce.com. We owned LinkedIn.

Jane M. White: These are company examples of what you're trying to do. You're trying to uncover these smaller companies today that are going to be huge. That's what is so exciting. I think that when you can take that knowledge, and do all of that research and then do your valuation and turn it into positive performance for your clients so that they can benefit whoever their beneficiaries are, the pension fund or the endowment or whatever it is, to be able to take all of that knowledge and actually turn it into something that can have huge ramifications for grants and pensioners. It's an amazing job. It's an amazing opportunity.

Jenna Dagenhart: I mean, building off of that it’s kind of sounds like you're trying to be first on the scene to the gold rush here. You're out there looking for those opportunities really digging and that being said, what area is in small cap are the most attractive to you, Jane? How do you strategize? How do you capitalize on these areas?

Jane M. White: Yes. So, my background is technology, but across the firm we have technology experts, we have healthcare experts. So, we're going across the board here. What's going on today in the world is like nothing I've ever seen in 35 years. We have so many drivers of innovation. We have AI, artificial intelligence. We have the internet of things. We have virtual reality. We have the cloud. We have 5G. We have computers in everybody's hand all over the world, not just the developed world.

Jane M. White: The last time we had some kind of revolution like this was the '90s where we put a computer on everybody's desktop in the developed world, networked it, and then built the software and we had the big tech bubble. The technology drivers that are going on now are just phenomenal, and there's so many. Then on the healthcare side, because we mapped the human genome, we have personalized medicine. We have gene therapy. We have CRISPR technology. We have all of these... I mean our contacts in the biotech area, you know that Boston is the epicenter for biotech, right? Gary Hatton who's my partner is well known as being one of the major experts in biotechnology.

Jane M. White: Several of his contacts, scientists in biotechnology have said the world is going to be known as before CRISPR and after CRISPR. That's how significant the technology is. So, the kinds of things, the innovations and the changes and disruptions that are going on right now are amazing. It's so fascinating to be able to get involved.

Jenna Dagenhart:Yeah. Bill, what kind of portfolio adjustments would you recommend during this volatile but period of intense innovation?

Bill Hench: Well, we have now and pretty much have always had a large tilt toward tech. So, we're a value fund but we love tech and we love the fact that it is volatile and that when it's out of favor, it tends to sell at really, really cheap levels. But it's also a group of names that tend to have lots of cash and no debt, so they get to reinvest. They get to do things that a lot of companies wish they can do during shallow times. When they do have new products, so when they do release new things, those margins tend to be really good. They tend to get nice big multiples on that.

Bill Hench: And there are as Jane said so many things happening. We love healthcare. We don't do anything in biotech. Not because we don't like it, but because we tend to buy things that have lots of revenues and lots of book value and the biotech’s tend to have wonderful book value and lots of cash and stuff like that, but many in our market cap don't have the revenues that we need. But there are opportunities.

Bill Hench: The nice thing about small caps especially in today's world is that small caps today have so much more at their fingertips than they used to. In the old days, if something came out internet related... When the web first came out, who took advantage of it? Walmart, Prudential, big companies, right? But now all those things that were really available to Johnson & Johnson and JP Morgan are also available to companies that we invest in.

Bill Hench: I used to be a CPA, so what looks like on a financial statement is that most of those things that are costs are now variable versus fixed, and that's really, really important for small companies, right? Everybody outsources their manufacturing years ago, but now you could outsource your phone, your HR, your real estate. Just about anything you get your hands on becomes a variable cost. If you've got a good management team working on a model where more and more of your cost become variable... That's why Jane probably has all those companies in her portfolio that are growing so fast because you could really take advantage of a model like that.

Bill Hench: To me, that's the excitement about small companies going forward is that not only do you have all the innovation on the product side, but financially you could do things today that you just couldn't do years ago. That's why the ramps of some of these companies have been at such a steep incline.

Jane M. White: It's so dramatic, right. Bill, because of the internet, the ability to go viral and get new customers is amazing. And like Bill said, a lot of these companies, they're growing so fast. One of the other big differences between the year '98, '99, 2000 is we had lots of companies coming public that were making something for two dollars and selling it for a dollar. Today, we have a lot of companies that are, what we would call under earning.

Jane M. White: They're not making something for $2 and selling it for a dollar, they're selling it for 3 or $4 and choosing to take that profit and plow it back into the company. It's the Amazon model. What they're doing is they're saying, "Okay. Our margins could be 20%, but we're only going to have them at 2% or 5% so that we can plow money into R&D and sales and really become the market leader in whatever the product is that they're creating."

Jane M. White: So you get these companies that have not a lot of earnings, but tremendous, tremendous top-line growth and free cash flow generation. As a matter of fact, there's a company called Fury Research Partners that does a lot of work on small cap companies. One of the papers they put out recently said that up until the great financial crisis, the amount of free cash that was coming out of growth companies was de minimis, and most of the free cash was coming from value, and you know where that was. That was energy and commodities particularly in the early 2000s, right? Tons of cash coming out of those companies as the prices of commodities rose. But since then, it has completely reversed where the free cash coming out of the growth side is far outpacing what’s coming out of value side.

Jenna Dagenhart: How do you think fiscal and monetary stimulus measures are making their way to small cap growth stocks, Jane?

Jane M. White: I can't give you a specific example of exactly how that happens. But I will say that when you have low GDP growth and low inflation that benefits small cap growth companies. With the amount of stimulus that is being put out there today and the debt load that we will have and that we're going to have, the pressure that that puts on GDP growth going forward is tremendous. So that really drives people to look for growth anywhere and to pay for it.

Jenna Dagenhart: So, Jane, with interest rates so low as part of the stimulus measures, we've seen the fed slashing rates close to zero, what's the impact on small cap companies?

Jane M. White: Most of our companies do not have debt. So, they're not borrowing at lower rates and they're not getting that kind of benefit. But what it does do is it makes people look at small companies that are growing at very fast rates as possible investments. So, it drives the valuation up a little bit. They can't invest in bonds at 1%. They're looking for a return.

Bill Hench: And that's the danger on the value side that what has really hurt value in the last 10 years are the low rates, and what we have now is now a supercharged low rate environment where possibly this could go on for much, much longer, right? And obviously, there's a case to be made. The rates could go up as well. But with rates where they are now, you're really putting any sort of potential comeback by value in a tough place because you've just extended what was one of the many things that have hurt value. With our companies on the debt side, it's a little bit different way of looking at things because most of the companies that we get when we buy them and they have debt, they're looking to reduce that debt. They're not looking to go out and borrow more.

Bill Hench: So the principal benefit is that they're able to refinance. It's a combination of being... As they're fixing themselves, they become a better credit, combine that with rates being lower and its sort of a double bonus if you will. So instead of borrowing at LIBOR plus 6, all of a sudden, they're able to borrow at LIBOR plus 3, and things get progressively better where they pay off that debt. It's hard to find somebody who wants higher rates.

Jenna Dagenhart: And as you mentioned earlier, there are a lot of unknowns right now in the world. Bill, that being said what are some of the challenges of investing for the long term during such an uncertain time?

Bill Hench: Well, the challenges are always the same, right? How do maintain performance? How do you make sure that your portfolio is set up to get the maximum amount of performance when you've got the wind at your back, right? There's nothing you can do it when everything is for sale and everything's falling apart and there are great unknowns and businesses are shutting down. Everybody is going to get hurt, but it's how you come out of that? How do you maintain a portfolio that number one stays within your discipline, but number two provides maximum upside? That's something that you have to work on every day. The more confusing it is, the more the opportunity is but the harder you got to work too to be right. It's always hard, but I think when you do have disruptions like this, ironically that's when you get the best chance to really shine.

Jenna Dagenhart: Historically speaking, Bill, how is small caps performed relative to other investments?

Bill Hench: Well, overtime, you get paid for the risk, and that's why people do this because if you don't get paid for the risk, there's no way to look at small caps, right? The law of numbers will tell you that it's much easier for small companies to grow than big companies, right? I'd argue that it's much more likely that some of the little companies that we own are probably going to double before a lot of these big companies that have run so hard have in the last couple of years. Right now, it remains to be seen what's going to happen, right?

Jenna Dagenhart: And then they might not be small cap companies anymore.

Bill Hench: Right. Although most small companies’ states, most small for a long, long time and some forever.

Jenna Dagenhart: And Jane, specifically why small cap growth after its strong 10-year run?

Jane M. White: Yes. So, I would just point out that if we continue to have low GDP growth and low inflation that is the environment where small cap growth really shines because people are looking for growth and the companies are putting it up. I would also say that the cycle of innovation that I mentioned before is like nothing I've ever seen before. It's not a linear growth curve, it's more exponential. It's amazing what's happening on the innovation side. So, I'm expecting more and more companies that we can select out very specifically that have those major growth characteristics that we're looking for to do well going forward.

Jenna Dagenhart: Yeah. Building off of that, Bill, what are some of the key small cap themes that you're focusing on right now?

Bill Hench: So we're looking for people that are going to come out of this and do much, much better than perhaps the market is looking for, right? So, if there's something that could be some support, competitive advantage that they can do up because of the new world, right? Or if they've been able to improve themselves during a difficult time like this. Anything that's sort of not so obvious we're looking for, right? So, we're looking for turnarounds, we're looking for things that are going to grow better than expected, right?

Bill Hench: So we're a value fund, but as we like to say in our meetings all the time, who wants to own a bunch of value stocks. Nobody, right? So I'm buying things that have value statistics that are cheap now, but hopefully are going to have statistics when they fix themselves, do whatever it is that they need to do, whether it's a new management or cut costs or what have you that they become attractive to growth players and they forget a bit of multiple, right? That could happen in hundreds of different of ways and that's what we look for.

Jenna Dagenhart: Jane, you mentioned the importance of bottom-up research earlier. Why bottom-up versus top-down?

Jane M. White: Oh my god. I Can’t imagine doing top-down research for small companies? I mean, they're all so different. So, you're not making calls on, "I'm going to buy whatever, however many, 567 companies that are in technology in Russell 2000 growth." I mean, there's just no way you could do it. So, what you're doing is you're selecting out the best businesses that exist. So, you have to do it from the bottom up. The main reason for doing that is buying stocks is really hard and making decisions around when to buy and when to sell takes a lot of conviction.

Jane M. White: One of the only ways that you can get conviction is by actually knowing the company that you own, the business that you own, by going to visit them, by talking to the managements, by talking to their customers, competitor, suppliers, and really being able to buy that stock when it's down, right, Bill? If you don't know the company well and market goes down, you're not going to be able to buy it when it goes down. So, you have to do bottom-up fundamental research in small cap.

Jenna Dagenhart: As we like to say in journalism, boots on the ground research.

Jane M. White: Right. It's very much like being a journalist. You're following your leads from one to the next. I mean even if you look in the portfolio, you'll find one company, ask them who's your best competitor and they say XYZ company. We have a case study at Granahan Investment. We owned Patterson Dental and Henry Schein. Henry Schein was a much smaller company years ago. And today, it's the other way around. Patterson introduced us to Henry Schein and Henry Schein had a much better management. That's been a much bigger winner than Patterson. So, doing that boots on the ground kind of research is key.

Bill Hench: It would be not possible to do this any other way than to go name by name and be successful is just to me the idiosyncrasies to this. Quite frankly, that's why indexing doesn't work in small cap. If you see most of the advisors, most of the consultants, the biggest area left for active management is still small cap.

Jenna Dagenhart: Looking forward, where do we go from here, you think, Jane?

Jane M. White: There are so many opportunities right now for growth. Like Bill said earlier, the ability to be able to start a company today is so much less than it used to be. The money that's available from venture and PE, and wherever is outrageous. So, it's just more innovation, more disruption, faster growth.

Jenna Dagenhart: Bill, what's your longer-term outlook for small caps?

Bill Hench: Well, I'm biased and I love it. And the reason why I love it is because there is a tremendous amount of problems today, right? And each one of them has to be worked on and solved which means there are going to be companies and people out there working to do that. The ones that are successful are going to be very profitable investments, okay? So, these all these things that need to be addressed whether it's COVID or poverty, you name it, healthcare, the pollution with energy, all those things are going to have to be solved, and they're all going to be solved by companies. If we could get those right ones, we should have a pretty good future.

Jenna Dagenhart: Any other trends that you're watching, Jane for the industry. Any other final thoughts?

Jane M. White: The world today is very, very different than it was 35 years ago, and the opportunities for people to get involved in today's changing world are numerous. People should be involved on the financial side because it's amazing what's going on. The secular growth and the change that's going on today is simply amazing.

Jenna DagenhartWhat would you tell your younger self just getting started in the small cap industry, Jane?

Jane M. White: Oh. Hold on, we're going for a ride.

Jenna Dagenhart: Bill, how about you?

Bill Hench: I think you just have to remain optimistic despite what looked like just tremendous issues and things that need to be solved. They will get solved and it won't be linear. We'll have ups and downs. But I think if you look at all those things that need to be addressed as potential opportunities not just to invest, but to gain in all sort of positive ways, right? You can't help but be excited. And there are tremendous hurdles to be overtaken. But look at the changes that have come just in the last 10, 20 years. So, imagine if we can keep that pace of change going forward.

Jenna Dagenhart: It won't be linear as you mentioned, but oftentimes when you look back anyways, those bouts of volatility get a little bit blurred anyways.

Bill Hench: Exactly.

Jenna Dagenhart: Well, everyone, thank you so much for joining us. It's been great to have you.

Bill Hench: Thank you.

Jane M. White: Thank you.

Jenna Dagenhart: Thank you for watching this Small Caps Masterclass. I was joined by Bill Hench, portfolio manager and principal at Royce Investment Partners and Jane White, co-founder, president and CEO at Granahan Investment Management. I'm Jenna Dagenhart with Asset TV.