MASTERCLASS: Small Cap Investing - April 2016

Small Cap stocks have been known for strong performance, but what is driving the asset class in current market conditions? Watch as four top small cap experts discuss how to approach small caps now.

  • Jay Kaplan, CFA - Portfolio Manager, Principal at The Royce Funds

  • Reed Walters - Portfolio Manager at Tradewinds Global Investors

  • Jack McPherson - Principal, Co-Portfolio Manager Small & Small/Mid Cap at Aristotle

  • Mark Ashton, CFA - Senior Equity Portfolio Manager at Homestead Funds/RE Advisers

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  • 54 mins 08 secs
Courtney: Jay, Small Caps have had a tough time since 2014, so why Small Caps and why now?

Jay Kaplan: I think there’s been a new day in Small Caps to some degree. We’ve seen it at The Royce Funds last year, last year and a half, very, very difficult, growth stocks really leading the Russell. But it’s changed now, so I think we’re at a point where quality businesses are being rewarded, companies that make money are being rewarded which has not been the case. So I think that managers who have a portfolio of really good businesses that can grow their earnings compound free cash flow over time can do very well. And I think Small Caps stocks, particularly value stocks are a great place to be for that.

Courtney: So a bit of an inflection point changeover from growth to value is where you’re looking?

Jay Kaplan: It feels that way in the first quarter of 16.

Courtney: Alright, Reed, what do you think?

Reed Walters: Yeah. I think Small Cap, it’s interesting. Small Cap over the last 15 years compared to other asset classes, large cap, fixed income, high yield, Small Cap has actually been the top performer. And it’s done that through consistency, and actually performing in the top half of the universe about 65/70% of the time, which is interesting. However, recently Small Cap has underperformed. It’s underperformed large cap as well as other asset classes. So typically when that happens it’s gearing up for an outperformance year. We think that’s the case at Tradewinds, just like Royce. And we think that the valuations are very, very attractive in Small Cap. Overall the average PE in the fund right now is about 13, which is compared to the S&P 500, it’s about 17. So we’re finding a lot of attractive values and we think that we’re well positioned going forward.

Jack McPherson: Yeah. And I think Small Cap is just an asset class that it’s proven itself over time to outperform large caps, again, over long periods of time. And I think for active management … active management has proven to be able to add alpha relative to the benchmark over time in the Small Cap asset class because of the inefficiencies that are there. So timing, making market timing calls is pretty difficult, so we try not to do that. We just try to stay fully invested and really just look for companies that can add alpha relative to the benchmark over time.

Courtney: Yeah, time horizon is such an important lens through which to look. What do you think, Mark?

Mark Ashton: Yeah. I like to think that every time or all time is good for Small Cap, and by class it tends, because it has better growth prospects, in some sense it’s less well understood by investors in general, so there’s more opportunity. So we find whether PEs are high or low, there’s always an opportunity for us to take advantage of. And Small Cap, every day – every day I get up and look for opportunity and if you look hard enough it’s always there.

Courtney: You can always find it, but going back to your point, I mean about PEs, the S&P’s at 17 times PE multiples you said, it seems like valuations are getting a little bit frothy there, whereas
Small Cap’s at a 13 times PE, that looks a little bit more attractive, especially for a value investor.

Mark Ashton: We’re finding now, the index may be at a higher PE than that, but we’re finding enough attractive valuations, we can build a portfolio that comes out significantly below that of the index, and below that of even the Value Index. So yeah, we see very attractive valuations. We think a good chunk of the market has been sold off; it’s just a ripple effect from energy, from interest rates, from macroeconomic influences, which don’t have as much impact really directly in Small Cap. And that for an active manager is great; companies are trading cheaper for the same fundamentals.

Jack McPherson: Yeah, and the way we see it at Aristotle is that we’re not buying the index, so we don’t really care what the index is valued at. We’re buying individual companies that we think are attractively valued. And I think there are lots of opportunities out there across a variety of industries. And that’s just our job is to go out and do that on a daily basis.

Courtney: Yeah. I want to dig in a little deeper with active management, particularly with Small Caps. I mean everybody knows across the board, the beta trade was so productive the past 5-7 years with the inflation of asset prices in QE, we’re certainly at a different point in time right now, but why specifically active management for Small Caps?

Jack McPherson: Well, I think it’s because of the inefficiency of the segment, there’s much less scrutiny from Wall Street in terms of the research coverage, the trading liquidity can create buying opportunities and I think it’s just a class that is really overlooked by a lot of investors, and that just creates more opportunity when there’s less scrutiny out there.

Jay Kaplan: There are some negatives to passive and Small Cap as well. We often tell investors when they own a Russell 2000; they don’t understand how much risk they’re often taking. And over time in the neighborhood of a third of the companies in the Russell have been unprofitable, you know, it’s plus or minus, but it’s around that all the time. So there is a lot of risk embedded in that and people really don’t focus on that, don’t understand it. An active manager can select stocks to help mitigate and try to control and manage risk a little bit better.

Reed Walters: Yeah. I think in the Small Cap space there’s, unlike a lot of large caps there’s a little more blow up potentially with an individual company name. And when you buy the index you buy all that blow up potential, or as an active manager can really look for quality companies with good balance sheets, good cash flow, low levels of debt. So I think active management, Small Cap, especially it’s a less efficient space, not as much endless coverage, so it’s … to me if you’re going to pursue active management, Small Cap is definitely one of the places to do it.

Jack McPherson: Right. And passive management is really an inefficient allocator of capital because the money flows in, buys anything, it doesn’t matter how expensive or cheap it is or how good a business or how bad a business it is. And so it’s our job to identify and really, you know, the good companies, not really look at the bad companies and allocate capital more efficiently.

Mark Ashton: Yeah. I would echo all the comments there and the same thing. They’re inefficient, you know, at our shop at Homestead Funds, we do a lot of research and the volatility or sometimes these blobs that happen are a great opportunity to add to positions rather than worry about. We’ve done a research compared to others. I would say, you know, do your own research, trust your research more than others and that’ll pay off in the long run.

Courtney: And you’re looking at a very long time horizon, correct?

Mark Ashton: Yes, in our case [inaudible] periods over five years, so we try to keep turnover low. And then our approach is very research oriented. There’s only three of us, we have no traders, we have no analyst, we’re just three PMs and you’re on the frontlines which can be difficult sometimes, but more often than not it’s a lot more fun and you deal directly with the managements of the companies we own and talk to them directly, ask questions directly, see … look in their eye and get the reaction from your questions and what their answers are.

Courtney: Yeah, the kind of corporate access you wouldn’t necessarily get in large cap, it certainly is a huge advantage there, what time horizon for you?

Jack McPherson: We’re similar actually, our average holding periods is over 6½ years. We actually have a quarter of our portfolio that we’ve owned for more than 10 years, so we truly do take a long term approach. You know, we’d never kid you that we have a crystal ball looking out 10 years when we buy something. But we think if we’re identifying the right businesses and the right opportunities you can wind up holding things for a long time. And it avoids really trying to react to that market volatility, trying to make market timing calls. It really comes down to identifying the good businesses. And when the market gives you the opportunity, take advantage of it.

Courtney: Yeah.

Reed Walters: Yeah, I would echo that as well. We’re long term focus, when we buy a company we want to see it move to a kind of achieve what our thesis is within somewhere between 6 and 18 months but we like to hold it as long as possible. In Small Cap really your biggest win is when you have something that graduates and becomes a mid cap and you have to sell it, you have to turn it back. And so that’s usually what you’re knocking up against with our types of portfolios.

Jay Kaplan: That’s kind of the mid cap idea is the holy grail but the reality is that a lot of companies never really get there. They get … if they’re really good they get taken over and they get taken away from you and that’s a blessing and a curse, you lose a great company but you made hopefully some good money when that happens. But what happens a lot is they stumble and the prices come down and that presents opportunities to trade and average down into positions, and sometimes as your position’s up, stocks get marked up, you can sell them, trim a little bit, and they may come back down again, when there’s news in Small Cap stocks they move a lot in a very short window. And it gives you an opportunity as an active manager to try and add some value, but being a little bit nimble during those times when there’s some disruption in individual stocks.

Jack McPherson: Yeah. I mean the M&A activity in our space, it’s like it’s been pretty good in the past year or so, over the last 18 months we’ve had 18 of our holdings acquired by other companies. And so you’re losing some companies that you have a lot of faith in, but you’ll take it, it’s a good problem to have and then you try to find the next one.

Mark Ashton: Yeah. I would really add just in terms of, there’s a great book called The Next Decade or The Next 100 Years by George Freeman, and I think it’s The Next Decade he talks about that in the long term things are actually more predictable than they are in the short term. So with a long … if you … I think the panel, we’re on the same boat in the sense that looking long term you can reduce your risk, increase your probability of success, and success in terms of better returns. Because if you’re investing with better managements, better balance sheets, better business opportunities, your volatility may be less or you are better educated to take advantage of the volatility, the ups and downs and then you actually lower the risk profile of your portfolio over time.

Courtney: Well, let’s take it in a little bit with volatility. I mean typically when we see more volatility, more chop in the market there’s more dispersion. It sounds like there’s more opportunities actually for you guys.

Mark Ashton: Absolutely.

Jay Kaplan: It’s a wonderful thing.

Reed Walters: Yea, yeah, it’s, you know, as a long term investor you tend not to see opportunities to sell a name and buy it back in a short period of time. There’s some much volatility recently that we sold a biotech name out that had about 130% run up last year, we had owned it for about three years. And it just got way too rich for us. The market sold off; there’s been political pressure on the healthcare side of things, pricing of drugs. And so there’s been a pretty good sized sell off in that space. And the same company’s down 35% in a matter of two or three weeks, with the same or improving fundamentals, and we actually bought it back. That’s unusual, but that’s the kind of volatility we’re seeing in the market now.

Jack McPherson: Right. And it can be frustrating when that happens to a name that you continue to own. But if you really understand the business, you really understand the opportunity, it maybe becomes an opportunity to add to the position and not really get scared out of it. And I think that’s the benefit of being a long term investor is that you really don’t have to try to make those market timing calls.

Jay Kaplan: You can often take advantage of the volatility to improve your average cost really. So over time if you have the fundamentals right but the market disagrees with you and the price gets interesting, that’s an opportunity to average down, create that better cost base. So when you’re ultimately right your profits can potentially be even higher.

Jack McPherson: And it’s also an opportunity to initiate new positions maybe in something that you like, but it was too expensive when you were first looking at it. So again, market volatility can be frustrating at times when it happens but it definitely creates opportunities if you’re a long term investor.

Courtney: Yeah, it seems like it would really be amplified for Small Caps versus if you were trying to do that with large caps, right.

Mark Ashton: Right. And also in Small Cap, in our research effort, we recently bought a stock back in 2015 and I had first call on a company in 2010 and kept an eye on it, understood the business or felt I did. And then finally something cracked or they had a bad quarter, bad report, people overreacted in the short term, but I go, this company I’ve followed for a long period of time, very sound fundamentally. Here’s our opportunity and we stepped up and bought it. So the other thing too is volatility goes up as well as down and I think a lot of times people forget that you do want volatility on the upside because that’s where the appreciation is and that’s what you’re really looking for.

Courtney: Reed, you mentioned healthcare being a political footfall. Jack, how does the election cycle play into, you know, when you’re looking at Small Caps from a top down perspective?

Jack McPherson: Well, we really do things from a bottom up approach when we’re picking our stocks. But you have to have a top down opinion about what’s going on. And I think the problem right now is the election cycle is creating a lot of uncertainty. And investors generally don’t like uncertainty. So I think that contributes to a little bit of the volatility that we’ve been talking about here today. And I think the other issue that investors are grappling with is depending on who wins this election there could be some really different approaches on how to deal with business and how to deal with the economic situation. And so again, that just creates uncertainty then investors really don’t know how to deal with and it creates that volatility. But as we’ve been saying, it can be frustrating from time to time. But it also can create opportunities, so I’m not sure how the election is going to turn out. But I think the economy will be fine in the long run.

Courtney: What are the biggest issues, I mean you hear so much about tax inversions, you hear about, you know, sort of populous desire to be insulated and limit trade outside the US. But you think of those as kind of large cap issues, how is that impacting Small Caps?

Jack McPherson: It really impacts the management of the companies and their ability to make investment in their businesses when there’s a lot of uncertainty as well. And so I think the large caps get a lot of the attention but it impacts Small Cap companies as well, just in their ability to manage their businesses on a day-to-day basis.

Reed Walters: would agree, I would … I’d even suggest that depending on the cycle, so let’s take the two frontrunners, you’ve got Hillary and Trump. If Hillary is elected it’s more of the status quo, it’s more of kind of what’s going on today which is global friendly, which is more large cap friendly. If Trump is put in place, right, he’s talking about slamming down borders. He’s talking about renegotiating trade agreements, which is going to hurt larger global companies. Small Caps tend not to be global companies. They tend to be a little more US centric, a little more US focused, their manufacturing, distribution sales are all maybe in the same borders. That could be a positive, could be a pro or a gain for Small Cap investing.

Courtney: And the strong dollar we had, that’s been a headwind for a lot of multinationals. A lot of Small Caps seem like they’d be insulated from that.

Jay Kaplan: Well, I’m not sure I would agree. When you think about Small Caps, if we think about real estate investment trusts and community banks, those are certainly US local businesses. But many of the companies that we’re invested in at Royce, manufacture globally, sell globally, and have actually had a little bit of a hiccup from currency problems. You know, I think that, you know, growth policies or the lack of growth policies, you know, resulting from the election is really what’s important. You know, we know what the rhetoric is today, the ultimate policies probably will be slightly different from the rhetoric it always is, but more growth is probably better for stocks in general.

Mark Ashton: Yeah. I was just going to add, what I try to do is tend to do a secondary or tertiary look at things. So if you back up like the last eight years for instance, it’s been a slow growth environment. But in any environment there’s things that are taking place that are fairly dramatic to the economy. And I would posture like that the Amazon effect is what’s gone on in ecommerce and whatnot; it’s one of the greatest revolutions that’s taking place in the last 10 years. And so looking at how that’s changing buying habits, what it means for mobile phones, what it means for research, what it means for advertising, what it means for distribution, that churn that’s taking place, you know, it can affect trucking companies to ditch digging companies or whatever. And so from our perspective, you know, a lot of people look at the economy as up and down, good, bad. I always say you should look at it this way, and take the positive and negative out of it and kind of strip some of the emotion and then just look where is opportunity, where is change taking place? And is there a compelling investment opportunity there and what’s the value it’s priced at? And work from there.

Courtney: So you’re really looking at long term secular trends and moving that into your investment thesis?

Mark Ashton: Right. And try to … use the short term to your advantage and use the long term to your advantage as well. I’m value long term, valuation short term.

Jack McPherson: And I think just to follow up on something that Jay was saying about Small Caps. We do have exposure to markets outside the US but to a much lesser degree than a lot of large cap multinational companies. And so while there’s individual companies that are dealing with the strong dollar right now, I think from an asset class perspective it’s one of the reasons why we think that the Small Cap sector is really … is really attractive because the growth dynamics can be better than they can be for some of those large cap companies. And I think the validation of that is the amount of M&A activity and large cap companies buying smaller cap companies to supplant their growth, they haven’t been able to do on an organic basis, partly because of a strong dollar.

Courtney: Yeah. Is that where we’re seeing the majority of M&A activity actually being generated from?

Jack McPherson: I’m not sure I’d say the majority of it but I’d say it’s pretty health, again at least in what we’ve seen in our portfolio. So I think it just … is just again a validation that the … that a lot of large cap companies are having a hard time growing.

Courtney: Any other big macro trends that you feel are impacting the Small Cap space, be it interest rates, currencies, Central Bank policy?

Jack McPherson: Well, I personally think that again a lot of the volatility in Small Cap, a lot of the lag that’s been taking place relative to large caps over the last two years if you will, is driven by that uncertainty and uncertainty about interest rates and what will you discount future earnings at. And investors again don’t like uncertainty. So when they’re looking to derisk or they are becoming more risk averse, they pull back on their Small Cap weighting and I think that that again is … can be frustrating when it’s happening. But for a long term investor it’s really creating a long term opportunity.

Reed Walters: I think there’s quite a few different trends. We mentioned healthcare earlier and that’s really a generational trend, right. We’ve got an aging population. We’ve got tremendous advancements in technology. So I think healthcare is really one of those sectors that long term should be a top performer and maybe now is a great time to add to the portfolio of these great discounts. Obviously energy has been devastating for most areas of the market. But the ripple effect in energy into industrials has been very difficult as well, so all the companies that are building machinery and drilling equipment and catering to that business has been very difficult. So there’s been quite a shift to the homebuilding side of the segment to personal consumption, to areas that just avoid the drilling aspect of it. But at some point it also creates an opportunity for the good quality companies that are able to withstand the storm, have a good balance sheet, have plenty of cash reserves; it just at some point creates a great buying opportunity.

Jay Kaplan: Because I do worry a little bit though about the great unwind of zero interest rates. You know, the market behavior, and Courtney, you said earlier, the beta trade that’s gone on for a couple of years, the rank speculation in parts of the Russell 2000, much of which I think was caused by zero interest rates. And you saw with the first uptake from The Fed that the market didn’t react very well, even though the market knew it was coming, and there will be more. And the market I think is going to take some time to get used to going back to what a normal used to be some day, because we’ve been abnormal for quite some time now.

Jack McPherson: And I think that’s another argument for active management over passive management as we said. When money flows into passive products, it indiscriminately buys, in a rising interest rate environment it’s incumbent upon us to identify companies that have good balance sheets. If the cost of capital is going up then it’s not going to be overly damaging to their profitability. And so, Jay’s right, it’s going to come to an end at some point, the low interest rate environment. And so you’d better have companies that can withstand a rising interest rate.
Mark Ashton Yeah. In terms of active management we’re looking for better quality companies, especially ones that are self-financing. If you can self-finance and the interest rate is [inaudible] it’s really what’s the business opportunity that’s going to drive how well that stock’s going to do. And that also gives the advantage of your competition if you can self-finance. And the cost of money and financing is going up, you’re maybe the one that’s making the acquisition of that company as well as the other way around.

Reed Walters: It’s interesting, if you look at the correlations between Small Cap and interest rates, they’re actually fairly highly correlated until recently, until the last couple of years. And there’s really a dislocation between where interest rates are and where the economy is because there’s financial tinkering going on. If interest rates truly do go up there typically is a response to improving economy. And who’s going to benefit from that? Small Caps are going to benefit from that from an improving economy. And if interest rates do go up, what sector is going to benefit from that? Typically financials benefit from bigger interest rates, they have better margins. And if you’re looking at a value tilt, that’s probably a good idea in Small Cap, being that the Small Cap Value Index is almost 45% of financials. So you know, if you’re deciding between growth and value right now, if interest rates truly do go up and it means something from an economic standpoint, I think that financials would do well, which tends to lead to a value tilt.

Jay Kaplan: But buying small community banks with that, right, with that thought in mind, hoping that someday we’ll get a steepening yield curve, which would be great for some of these companies. The Fed really, really, really wants inflation. We still haven’t had it. If we do, the yield curve can steepen and small community banks for example have a chance to do really well.

Courtney: Is the biggest boon, that you’re going to see just increased net interest margins for these smaller community banks and…

Jay Kaplan: It would be now because credit quality is pretty good now. It’s probably as good as it’s going to get. But better margins would be better profits.

Courtney: Because it’s definitely a different scenario than 2008 in terms of credit quality, right?

Reed Walters: Tier one ratios are completely different today.

Courtney: Yeah. Let’s take it into other sectors. I mean we’ve kind of touched on healthcare and what other sectors do you like?

Mark Ashton: Well, we’re pretty sector agnostic. So we’re kind of spoilt. But our philosophy is predictability, better quality. So we tend to be heavily invested in industrials and in consumer discretionary. And within that context we’ve found opportunity for … I’ve been at it for 17 years, so there’s always something. And then well, in terms of financials, because we’re looking for capital appreciation, a big section of the Russell financial is REITs and that’s kind of return of capital. So we tend to stay away from that. And then in terms of healthcare, which that oftentimes is binary outcomes. So if you’re waiting for a compound to be approved by the FDA that’s a little too risky for us. I think in 13 and in 15, people were looking for growth and in the short term that things builds up, people get excited, valuations go high. Our philosophy stays away from that. So we’re, in the short term we’re disadvantaged, in the long term I think we do okay. And then in technology, similar stuff, you have one product, kind of risky, but that isn’t to say that we don’t invest in those. I try to say we don’t look at the SIC code per se because we have a company we own, like it’s a polymer manufacturer and they produce probes for operations and things like that. Now, when you go in and do an operation, the color of the plastic changes, so you know it’s been used, if it’s been sterilized it goes back to its original color.
So I wouldn’t say like in banks, they’re like intermediary technology financial institutions. It’s a matter of how you put your perspective on it or not. And so I try to not fall into traditional convention but look at it differently. And in terms of sectors, I always say, “Well, in the Russell 2000” which is probably only 1780 real firms, there are the good ones and then there’s the bad ones and to the extent that you can be in the better ones rather than the worse ones, over time you’re going to do better. And so be careful about labels you put on then. And I also say you should also kind of strip the label out, what sector it’s in and just look at kind of what everybody on the panel has said, what are the fundamental characteristics of the finance, I mean is it cash flow positive? What’s the return? What does the balance sheet look like? And kind of use that as a starting point, as a base point, is that a good business or not? And then just pull it up from there.

Jack McPherson: I mean we’re looking around and we’re really finding opportunities across the board. We’re sector agnostic as well but … and we’re not biased, we’ll go just about anywhere
in terms of sectors. We’re going to avoid binary outcome situations in our strategy. But there’s really opportunity everywhere if you’re looking. And as a long term investor you don’t need to find a 100 new ideas a year, you only need to find a couple a handful. And so it just comes down to being focused and disciplined and being, you know, focusing on the business as opposed to what sector you’re looking at. And if the market gives you an opportunity in an area and you find a lot of ideas we’re not afraid to go overweight. If we cannot find ideas in a particular sector because they’re not attractive, we’re not afraid to avoid that area. It really is about buying good businesses and investing in good businesses.

Courtney: How concentrated are you guys?

Jack McPherson: We run roughly about a 100 names in the portfolio and position sizes can be anywhere from on the top end 2½% to something that maybe we’re starting out new with is 25 basis points working its way up. But it’s really trying to be … I call it, concentrated enough that it allows you successful ideas to add value but it’s also diversified enough to protect you in the event that something goes wrong.

Courtney: Reed, you mentioned healthcare earlier and we’re talking about binary outcomes, it seems like there’s a little bit more risk there but potentially more upside, is that fair in healthcare?

Reed Walters: Yeah. I mean you have to be choosy. And I think there are certain biotech type names that you would be careful of. And to be concentrated and to buy one name is a lot of risk. But to buy several and diversify is a smarter way to approach it. One of the companies we like focuses on a different aspect of that business and they’re actually the manufacturer of generic drugs. So they have a proprietary process. They supply the ingredients, so a company comes to them if they want to actually do the manufacture of generic drugs. It’s just a nice angle, a nice area of that market that doesn’t have the same kind of risk. They’re not trying to get things approved at that point. So there are areas of the market that you can play that are safer, better ways to diversify. But yeah, we’re finding opportunities really across the board. We like to be … I’m not sure if we’re sector agnostic or sector neutral or, you know, for us we like to have broad coverage across all sectors. We think that lowers your risk over time. And so we like to look at companies on a relative basis versus their peers. And there’s certainly certain areas that have been overrun. This year utilities have done well because there’s been a flight to quality, also interest rates have dropped which helps utilities. But that sector is very, very highly valued right now. So that’s one of the places I would shy away from as opposed to in consumer discretionary and technology and healthcare, there’s some interesting names in industrials that we’re starting to look into. So there’s opportunity there, there’s no shortage of it. And so we think the future’s bright for Small Cap.
Jay Kaplan Well, at the Royce Small Cap Value Fund, we’re trying to buy great businesses that are well financed at the right prices where the expectations are really low and they tend to come in sector clumps over time. We try to buy what’s on sale and companies tend to be on sale in sector groups. So today we have a pretty good size weighting in consumer discretionary, a fair amount of retail. A good size weighting in technology, but technology is very broadly defined so it’s not necessarily the one product high flying company. It could be a company that distributes computers for example, I mean very low tech tech, and industrials has also been a pretty big part of our portfolio for a little while now.

Courtney: Yeah. We talked about valuations a little bit and where to find good value, Jack, what about, you know, energy?

Jack McPherson: Well, obviously given the carnage that’s taken place in the sector over the last two years/year and a half, there should be a lot of opportunity. But given the precipitous drop in crude oil prices and the devastating effect that’s had on the balance sheets over that time period, you’d better be very, very careful. There will be companies that will survive. There will be companies that will prosper as commodity prices rebound but it really is about being careful right now and making sure you identify a good business with a good management team and a good
balance sheet.

Courtney: So selective opportunities within energy?

Jack McPherson: Selective, absolutely.

Reed Walters: Yeah. I think a lot of people want to time the bottom. But I’m not sure that that’s possible right now. There’s too many macro factors influencing that. And what we saw in the end of February, early in March was really a trading rally in energy. There wasn’t a fundamental shift. There wasn’t a change in supply or demand. There was actually an increase in supply with about the same demand. And so that’s not good for energy long term. And so we’ve seen that selloff a bit since then. But I agree, I think it’s just, it’s an area that you have to be careful. And strong balance sheets are … are the way to go right now.

Jay Kaplan: Yeah. Well, you almost need to be a book valued buyer today, because the companies I look at, if you look at the current level of energy prices, the earnings that come from that,
they really don’t support the stock prices and the valuations. So if you want to play long term, you need to find really good management teams, strong balance sheets and perhaps assets and try and buy at really good discounts to book value to hope that, you know, you have the patience and the time to be there if and when commodity prices go back up to a sustainable healthy level.

Jack McPherson: Right. I think, you know, crude prices should come back at some point, it’s a commodity product. It’s all about supply and demand. And supply is being impacted as a result of this; it may take some time to filter through. But trying to make that call, trying to pick the exact bottom in the commodity price, trying to pick when it’s going to go up and really save some of these companies, it’s not our job. Our job is to identify the businesses first and then factor in what the commodity price is right now and where it might be going.

Mark Ashton: Yeah. I would just say in energy, patience is the word, right, you just, you know, pick your quality and, you know, if you are investing both as somebody who is investing in the fund or the manager, patience, you just have to accept that. Eventually it will go back as commodity goes up and down, the question is when it’s going to take place. And you have to be able to weather perhaps two or three years before it bounces back, and we’ll see.

Reed Walters: It’s interesting, if you look historically, the types of energy stocks that do well in a bounce back when prices recover are going to be the highest risk, the highest beta stocks, which are probably the stocks that we’re not buying. So at some point there will be a shift, but those are also the companies that are most at risk. A lot of those previous bounce backs have been more of a V shape recovery, not a prolonged sustained recovery. And now what you’re seeing is, it’s not just that rigs have been taken offline but all the employees are gone, they’ve moved, they’ve moved out of the state, moved somewhere else. And to turn them back on is quite complicated. So it’s really a different environment than we’ve seen in the past. And I think investing in some of those higher risk high beta names right now creates not just a lot of risk in the market from a volatility standpoint but the [inaudible] might just go away, they might not be around in a week, a month, a year.

Jay Kaplan: That’s very true. But if you look really hard sometimes you can find companies that are classified as energy companies, maybe because a lot of their customers are energy companies and they trade like energy companies. But their businesses are only tangentially directly related to the commodity. So there’s an opportunity or two that I’ve found working within that energy category but you wouldn’t think of it as a traditional energy stock.

Jack McPherson: Yeah. And I think that’s right. There’s a lot of guilt by association companies right now where you’re being tagged with the energy brush and they’re really not, it’s really not as big of an impact as the share prices might suggest. So it goes back to what we’ve been saying from the beginning is it’s opportunity. And maybe frustrating if you own some of these things, but it’s definitely an opportunity to either add or to initiate new positions.

Mark Ashton:Yeah, [inaudible] Texas banks, not all banks are the same. And a lot of people think Texas is slipping into the Gulf of Mexico, that’s not the case, at least not recently. But they get brushed with the, you know, tarred with the same brush. But if you do you research then you can find out that some of them don’t have the same kind of exposure, the same kind of risk, but they’re being priced that they’re going out of business when in fact they aren’t. Or they have very strong franchises throughout the economy. And I believe Texas is sort of a net importer of labor and employees. I think there’s something like 10,000 people immigrate to Texas, so their market share take over the 49 states. And they have a very favorable tax code and it’s a very dynamic environment. And it’s not the same downturn in oil or the impact on that economy that it was 15 years ago when it last turned down.

Courtney: Yeah. And even if you look at Texas, which as you mentioned is an enormous state, West Texas is, from the oil perspective, doing so much better than East Texas. So even if you think about like those tangential businesses that you guys mentioned, you can even paint with a broad brush the state of Texas, so to your points.

Mark Ashton: Even Houston is doing very, very well despite its … I believe that that’s where it’s hardest hit, you know, cement is selling like crazy in Texas, people are still building there. It’s a much more diversified economy than people give it credit for.
Courtney: And just to widen the aperture a little bit, when we kicked off, Jay, you talked about, you know, that inflection from growth to value. And certainly we could, you know, deduct growth versus value from the sectors that you mentioned. But when it comes to Small Cap investing, you know, where just broadly is everybody, you know, kind of seeing that … that growth versus value play right now?

Jack McPherson: Well, I think you know, history would suggest that value oriented stocks outperform growth oriented stocks over long periods of time. But the last five, six, seven years, whatever it’s been, growth has been really leading the charts since the market bottomed in 2009. And so you would think over time, reversion to the mean would kick in. And as we were talking earlier, some of these banks that have been underperforming can start to outperform, financials is a big part of the value index. But there’s no reason why a lot of these money losing companies can continue to go up. You can’t go up forever if you’re losing money. You have to start making money at some point. So I think from a … looking for good opportunities, I think we’ve all discussed here, looking for good values, good businesses, good opportunities. I think that bodes well for our kind of businesses going forward where it’s not just rampant buying of growth stocks.

Jay Kaplan: Let me try and frame it another way. If you look at 2013, 2014 and the first half of 2015, if you took the Russell 2000 and divided it between the non-earners and the earners, the non-earners vastly outperformed. If you look at from the middle of 2015 through the end of 2015, complete opposite. So the invisible hand has come back to the market, the laws of economics have come back to the market. First quarter, same idea, is it long term sustainable? Nobody really knows, but it feels like there’s some rationality that’s come back. And we saw it in the performance of our funds at the Royce Funds; we had a very good first quarter, much different than maybe a couple of years ago. So things really do feel like they have changed.

Courtney: It feels like there’s a little more financial gravity these days?

Jay Kaplan: A little more rationality, a little more attention to risk, a little less speculation, a little more focus on fundamentals.

Reed Walters: Yeah. I think the dispersion between Small Cap growth and value this year, just in the first three months was almost 6% that the value outperformed, which is a huge reversion from what we’ve seen over the last few years. The way, you know, Tradewinds our approach is style agnostic. So we’re looking at value growth, wherever the opportunity is, it tends to be somewhat balanced. But in Small Cap we really specifically over long term feel better on the value side of things, have a value tilt to it. And we think that it’s better bang for the buck that growth has a lot more volatility without that much more return, is not quite as consistent. Maybe that hasn’t been right the last couple of years, but we really think that long term that is the right … the right way to approach it. And maybe there’s a turn this year that the first quarter represents that, whether it’s sustainable or not, nobody knows.

Jack McPherson: And I think we’re always looking for good businesses at attractive prices. And so good businesses should be able to grow, so you know, the definition of growth is going to change depending on who you’re talking to. But I think we’re all looking for companies that can grow their shareholder value. But we’re going to be very disciplined about what we pay for that.

Mark Ashton: Yeah, I would echo those, I mean whether it’s growth or its value, it’s got to be good news going forward that the stocks are going to go up. And then much of the fluctuation of volatility is based on, I think an investor group that is just so short term in focus that as long as your investors are patient, you’re patient and you’ve picked better quality good businesses, you’ll outlast them and at some point they’ll probably come and help you at some juncture and lift those valuations.

Courtney: And you know, we’ve really talked about the bottom up stock picking process. What about, you know, for people who are thinking about allocating into Small Cap funds, what about the top down process, be it from a portfolio management perspective or risk management perspective? You know, I’d love to hear everybody’s thoughts on how they manage that.

Jay Kaplan: Well, even if you’re a bottoms up stock picker, which I am, it’s important to have a view of the world around you, a view of the economy, a view of the marketplaces that your companies compete in. And at the moment my view is it’s kind of not so great. I think the economy continues to limp along and growth is very hard to come by. So that’s number one. Number two, risk is important, one of the ways we really think about risk is companies that are financially strong, generate free cash flows, self-financing, don’t need the capital markets, and by the way, right now, the capital markets really aren’t functioning very well. The debt market’s not usually functional, the equity market’s not so functional, the cost of capital’s going up. So that is another way to control risk, by controlling the financials of the businesses that you invest in. And because over the long term, Small Caps have done well, investors should, who have equity exposure should always have a part of that in Small Caps to get that long term return, and if they can try to do it in a way where risk is a little bit lower than that of the average, all the better.

Reed Walters: Yeah. I mean we also bottom up fundamental as well, but we have a top down balance or overlay to that because if you spend so much time focused with a microscope, that you sort of miss the world around you. And there’s so many influences that you need to take into consideration, just because something’s cheap doesn’t mean you should buy it. There’s a lot of other factors, we want it to grow, we want to buy it cheap, but we want it to grow. And if there’s a lot of headwinds preventing that from happening, then typically we want to avoid that. So yeah, I think it’s important to have a balance between the two.

Jack McPherson: At Aristotle we’re doing things from a bottom up approach as well. But you have to factor in that the top down issues into your company specific analysis, you’re not trying to make a bold forecast on crude prices or interest rates and then build a portfolio around that. But you’re going to put some scenarios into your company specific analysis based off various levels of interest rates and crude oil and the US dollar or whatever it might be into that company specific analysis and then build your portfolio that way.

Mark Ashton: Yeah. I would agree with everything that was said. And I would go back to what I said, in the long term it’s more predictable than it is in the short term. So I think Small Caps, at least from people who speak to me think it’s more risky. I actually think that with good research, like everybody on the panel is doing, you tilt the balance in your favor. You’re probably taking less risk and you may take actually less risk than large caps because you know your companies more intimately than you would if it’s large cap. You tilt it in that favor on the longer term; I can’t see why you wouldn’t even want to put a larger percentage of your money in well managed companies, well managed funds that orient that way. And you’re actually reducing your risk and increasing your return, especially if you’re looking at a 10, 15, 20 year timeframe. I mean the whole point is to end that 20 year period with a lot more money than you started with and personally do better than the indexes.

Reed Walters: Yeah, I mean I agree, that’s what I said earlier a little bit, was the consistency in Small Cap. You’d be surprised that not just that Small Cap outperforms over a long period of time, but it does it through consistency, not by having home run years. If you look at how many years Small Cap actually plots in the bottom of all asset classes, it’s very rarely. It’s really, it’s a very consistent theme and active management I think makes it even more consistent by choosing companies that are generating positive earnings, good cash flows, low debt, that are quality companies, no blow up potential and strong earners.

Jack McPherson: And I think the evidence is indisputable, that Smalls Caps generate outsized returns over long periods of the time. But the key is long periods of time, trying to make those market, short term market clauses very dangerous. And that’s where you add your risk if you’re trying to get in and get out. And you miss time, that you can really hurt yourself. So stay focused on the long term, keep exposed to the Small Cap segment of the market and identify good active managers that can add alpha above and beyond that.

Courtney: And Mark, you know, you really honed in on company management, you know, walk us through that a little bit more.
Mark Ashton: Well, I guess, in looking at a manager, given our [inaudible] is a very long term holding period, the management’s going to make a difference. So in Small Cap, what we basically try to do is match up a manager with good skill sets, often times are one of the best opportunities when you have a management that has been successful previously at another entity or in the same industry or similar circumstance and you match that up with a good set of assets and a good opportunity. There’s a lot of geniuses in the world, I’m not a genius but I have noticed that some people do something very, very well. And if humans can repeat something, there’s, as the Brits call it, operational gearing or a skill factor. And if you let those managements do their work and repeat themselves, they’ll get larger and you’ll get that increase in the margin and scalability, profitability that builds your valuation and that’s usually the sign of a very successful company over time. So one of the things we also do is that we would ask questions, and what’s [inaudible], what is the opportunity that we see in the stock or the company, then ask the management, how did they view that opportunity, how are they going to go about it? What’s their strategy for executing, does it make sense? Is it consistent? And if they have a record of having done something similar before, that tends to improve the odds that you’re going to be successful with that investment.

Courtney: So you’re trying to find a match up between the value proposition that you’ve identified and the ability of management to execute that?

Mark Ashton: Correct.

Courtney: Which with, you know, less sell side coverage the onus is more on you as individual stock pickers to ascertain whether that’s possible.

Jack McPherson: Yeah. I mean management is important in any business but in Small Caps in particularly because they tend to be more narrowly focused on a lot of their large cap counterparts. So having a management team that is really focused on creating value for shareholders as opposed to building something just to get bigger for the sake of getting bigger, and so they’re the ones that are going to set the strategy. They’re going to be the ones that hire the people to execute their strategy. And ultimately they’re the ones that are going to dictate the kind of returns that we can get as investors.

Reed Walters: Yeah. I would echo everything you’ve said. And even a red flag for us is management turnover. So if we see an executive leave, even if we see a sales team, a marketing team from a company leave, that represents some concern for us, why is that happening? What’s going on? Because what we’re looking for is a company that’s executing well in a lot of places. It’s at the executive level also at manufacturing, at distribution, sales, all those levels should be working well. And if you’ve got everything working in sync, you’re going to have a great company that’s going to perform well long term. But typically that tends to break down at the executive level first. And you see it in turnover. You see that in kind of conflict. And so that tends to be one of the red flags that immediately zeros us in to dig deeper.

Jay Kaplan: Everything you’ve heard is true. But I would argue that sometimes the business can often trump the people. So sometimes I’d almost rather have the better business with the okay people than the okay business with the genius people. But overlaying all of that, I think it’s important to keep in mind that valuation matters too. And so with all of that, if you pay the wrong price for a stock, your prospects for great profit might not be that good, but if you pay the right price, over time you really do increase your odds of success.

Jack McPherson: Right. And I think Jay’s right. You can have … you really want to have a good business to begin with. And sometimes management change is bad, but sometimes it can be good because you might have a good business with a management team that hasn’t been able to execute. And so a management change can be a catalyst to unlock that value that’s in the business, that’s in the good business.

Courtney: So key man risk maybe something that’s a little bit more amplified in Small Caps but it can also be an opportunity. And, Jay, to your point, sometimes the business is more important anyway.

Jay Kaplan: Sometimes. And you know, sometimes, you know we look for founders and CEOs that are getting near retirement and sometimes a succession plan is internal, sometimes a succession plan is a headhunter, sometimes a succession plan is a sale in M&A. So all kinds of things can happen in the world of Small Caps which is why research is so important and hands on is so important and why this is so much more labor intensive than just investing in an index.

Mark Ashton: Yeah. Just to go back, if I were asked the question slightly differently or to answer it better is that we do start with trying to understand the business, like is it a good business? Is it a bad business? Is it very competitive? Are there special factors or aspects of the business that lead to success or failure? That’s the first order of ascertaining whether or not you are interested in it or not. I was at a company yesterday and I’d done some previous work on it and I go, “I don’t think this is a very good business but I’ll give it the benefit of the doubt, ask some questions.” And then I go, “This is a situation where…” One guy [inaudible] says, “When a good management meets a bad business it’s usually the latter that wins out.” So I would agree with that. So that’s the first step in the process and then you, you know, work from there. But I would say, you know, be a skeptic first, do your own research, you know, follow your heart or your research. Because in our case I think we all have good research staff with experience. And our research is probably better than what you’re getting from the street or from the outside. And then finally just be patient and let it play out.

Reed Walters: But I like what Jay said too, you’ve got to buy it at the right price, right? That’s got to be value or you could hold that stock for a long time, longer than you want.

Courtney: A critical point.

Jack McPherson: You can either hold it a long time or you can wait to buy it for a long time, when the valuation comes your way and it adds…

Courtney: You said you were waiting for five years, right.

Jack McPherson: I’ve waited five years, six years sometimes, waiting for that valuation to match up with the opportunity of what, yeah, establish whether there’s a value there first and that’s the whole process I think we all go through. And then at what point do you think the valuation makes it compelling of the two, and step in or add or in the reverse, if it gets to be too expensive you leave and go elsewhere.

Reed Walter: The problem is, if you own … if you wait and it’s in your portfolio then you have opportunity loss. It’s taking up the spot for something else that may be more attractively priced and have a greater upside opportunity.

Courtney: So all things that you have to be weighing all the time. Before I let you guys go I’d love to get your thoughts on the outlook for Small Caps, you know, where do you see them through the end of 2016 and beyond, Jay, your thoughts?

Jay Kaplan: I’ll start. I think 2016 will probably continue to be a little bit choppy, a little bit scary. We’re going to hear more about The Fed as the year goes on. The dollar’s moving around in surprising ways. The economy remains not so great. The election is still up in the air. But with that said, I feel pretty good about the prospects for owning a portfolio of really well financed businesses at the right price, which is what we’re doing at the Royce Small Cap Value Fund.

Courtney: Reed?

Reed Walters: I mean I would echo that, I think there’s a lot of volatility in store for us and there’s so many factors that can influence the direction. But on average we’re looking at an area of the market that’s growing at 10-14%, the valuations as I mentioned earlier, PE ratios in the range of maybe 13/14, collecting a dividend yield 1½-2% on top of that. That’s a nice combination. And I think long term, this year Small Cap will outperform large cap and probably the value side of it will outperform growth.

Jack McPherson: Yeah. And I think it’s really difficult right now to say. I think the fundamental situation is okay and so there’s opportunity for companies to go higher, but there’s so many external factors about the election, about interest rates, all the stuff we’ve been talking about. So you can envision a scenario where the market’s down a little. But you can envision a scenario where the market’s up a little bit. And it’s really difficult to tell. And which is why we try not to make that forecast. But I think we believe that if you look out two to three to four years that you’re going to make an outsized return relative to large caps, and that’s really the focus.

Mark Ashton: Yeah, I would agree with everything that’s said. I would just add that, you know, choppiness and volatility is also opportunity. So if it’s going to be choppy throughout the year, I’ve got some cash, if things come my way, valuation comes my way, I’m happy.

Courtney: So you have some dry powder waiting to bounce?
Mark Ashton: Right.

Courtney: Okay. And then I want to go back to something you said about dividends, I mean are you actively looking for dividend payers at this point?

Reed Walters: Well, we look for great companies and in some cases they’ll be dividend payers, in cases they’re not. If we’re on the fence between two companies we’ll take the one that pays dividends. I enjoy being paid while I’m waiting for a company to turnaround and for the market to turnaround. So if there’s the opportunity to collect, in Small Cap it depends, you know, it’s not quite the dividend payers as some of the large caps are. But still if you can get close to 2%, that’s a nice dividend, you know, especially relative to the 10 year treasury right now.

Courtney: Not even at 2%, that’s right.

Jay Kaplan: We have two dividend focused funds actually, Royce Total Return and Royce Dividend Value Fund. And we don’t invest looking for gigantic dividends. We’re actually really investing for total return by companies that pay a dividend and we think that a dividend paying company is one marker of good capital allocation. We think it’s shareholder friendly and we think it shows that managements are thinking about their owners. So we like that and we think the market really doesn’t reward that, so we think you kind of get it for free. And it helps, we think, to temper volatility along the way. You can put some money in your pocket as you go and history has shown that our Total Return Fund has been very low in volatility relative to most of its competitors, so dividends are a good thing.

Jack McPherson: Yeah. I mean it’s all about the capital allocation decision. And if there’s not a good place to invest in the business then I’d rather see them pay it out in a dividend. We’re not necessarily looking for that but it really comes down to understanding what management’s focus is. And if there’s not a good opportunity then pay it back to the shareholders.

Courtney: Yeah. With so much about share buybacks across the board, is that happening a lot when you talk about management decisions in Small Caps, is that?

Mark Ashton: Well, I like to say the only reason you should really buyback your stock is if you’re going to grow a lot in the subsequent years because otherwise you just, you know, a lot of companies issue restricted stock, they buy it back in. I’d rather be paid that in a dividend rather than the other way around. So in a case where a company is going to grow substantially and you’re outgrowing whatever you’re buying back, that’s okay. But if you’re just buying back to minimize dilution or you don’t have anything better to do with the money, pay us either … special dividends is something that is welcome in certain cases. But for the most part, I’d rather see the cash or what we really want is reinvestment in the business and opportunity for it to get larger.

Reed Walters: Yeah, I’d say generally, Small Cap companies are reinvesting in the business. And they’re looking for growth. They’re expending capital in a way that wouldn’t allow them as much leeway to buyback shares like Apple has a huge cash reserve. And Small Cap companies typically just don’t have that. So you don’t see it … there are buybacks but it’s not as prolific as would be in the large cap space, especially over the last five years.

Courtney: Well, this has been fascinating, but before I let everyone go I’d love to get everyone’s final takeaways on Small Caps right now.

Mark Ashton: Every day is a good day and a sunny day in Small Cap.

Jack McPherson: And I think as we’ve said there’s really a great long term opportunity in Small Caps and I think there’s a really great opportunity to be an active manager in Small Caps.

Reed Walters: Yeah. I think Small Cap has a permanent place in a portfolio. I think it has value, it’s got a little correlating factor to it. It’s a growth area of the market but also I think the timing is right, I think Small Cap has underperformed and is attractively valued.

Courtney: Alright, gentlemen, thank you. And we’re going to continue this conversation about Small Cap investing. Follow us on our social media, on LinkedIn, Twitter and Instagram. From our studios in New York I’m Courtney Woodworth.