MASTERCLASS: Small Caps

MASTERCLASS: Small Caps – December 2021

Jenna Dagenhart: Hello and welcome to this Asset TV small cap masterclass. Joining us to share some of the big year to date winners, a comparison of value versus growth and where they're eyeing opportunities in 2022, we have Brandon Nelson, senior vice president and senior portfolio manager at Calamos and Miles Lewis, portfolio manager and principal at Royce Investment Partners. Looking back at history, we can see that small caps and large caps tend to take turns leading the market. Large caps will lead for a few years, then small caps lead for a few years. Brandon, where are we in that back and forth process?

Brandon Nelson: Yeah, that's a great question. Yeah. And your spot on. If you look back at a 100 years or so of data, you'll see that they do take turns. Large cap was leading for about nine and a half years and we think that switched over to small caps last fall, beginning in early September. And we think we're 15 months or so into a new regime where small caps are going to sustain as a leadership asset class. And importantly, when they do have that leadership role, they tend to stay in that role for about seven years on average. So it could be a lot of open runway here for multiple years of leadership. It's never a straight line. There's always ebbs and flows, but I think it could be the right time to own small caps.

Jenna Dagenhart: Yeah. Small cap value recently saw it's lowest valuation versus small cap growth since the dot-com bubble. Miles, could you weigh in on the small cap value versus small cap growth debate? I guess kind of similar to the ebb and flow between large cap and small cap as well?

Miles Lewis: Yeah, sure Jenna. Brandon, I apologize for everything I'm about to say. Look, similar to what Brandon said on small verse large, we know that small cap value over long periods of time outperforms small cap growth, but that hasn't been the case last decade or so. And there's kind of a lot of reasons. I think two important ones would just be first, there are some really fantastic, wonderful companies within the small cap growth space that deserve to have gotten the valuations they've gotten. And the other one is interest rates. I mean, it's hard to ignore the impact of interest rates given that growth stocks are really kind of a long duration asset.

Miles Lewis: So why do we think that's going to change? Or I think some structural factors that are happening just in the economy broadly speaking, that weren't present in the last cycle. So the CapEx spending, labor, housing, which has been strong and we think is going to continue to be strong, which was a drag in the last cycle. Onshoring. There's lots and lots of different things that are kind of structurally different this time around and yet the narrative is kind of that the same asset class that has really done incredibly well is going to continue to do well, even though some fundamentals are shifting.

Miles Lewis: If you look at the market side of it, you pointed out Jenna, the valuations. I mean, valuation spreads between growth and value and the small cap space are about as wide as they've ever been and wider than they were in the dot-com bubble to the detrimental value that is. So that's an important one. Relative performance matters a lot too. If you look at the long term returns of value versus growth, small cap value is well below long term averages and small cap growth is well above. So to the extent there's any mean reversion there, that would play a role. So those are few of the factors that we think are kind of us up for a regime change in the shift of value.

Jenna Dagenhart: Brandon, I want to turn it over to you here. Small cap valuers outperform small cap growth so far this year. Is small cap value likely to continue to outperform small cap growth going forward? And also given your portfolio tends to be growthier than both the small cap growth benchmark and the small cap growth peer group. I would think small cap value outperforming would be a big headwind for you. How have you been able to outperform this year, despite that headwind?

Brandon Nelson: Yeah, so I think the outlook for small cap value and small cap growth, I think looks favorable for both sort of sub segments. If you look back since the Russell Indexes were put together in the late 70s, it's 45 years of data. Small cap value, like Miles just mentioned, has tended to outperform. Most of that has taken place in the first two thirds of that 45 year period. The last decade or so, small cap growth has been all performing small cap value. And when I look at that chart of small growth versus small cap value, I don't necessarily think small cap value is going to maintain or take over that leadership role that it had in the first 20, 25 years of that time period.

Brandon Nelson: It looks to me like small cap growth could sustain the leadership. It's definitely pulled back this year relative to small cap value. Small values beating small growth this year by over 2000 basis points. That's meaningful. But who's to say this decade trend of small growth beating small value can't continue for another decade? I just don't know if anyone's got that kind of visibility to know so. And then to your question about how we've been able to perform well in the face of small value, beating small growth by so much, it's all come down to stock picking. We've been able to find small cap growth stock specific situations that were so positive that they were able to overcome that headwind of value being more embraced than growth. And so there've been a variety of stocks in our portfolio that have performed well in a variety of sectors, technology, healthcare, consumer discretionary, industrials, financials.

Brandon Nelson: We've had winners in all sorts of different pockets and it's been from the sort of bottom up strength that we've found in a variety of places. And so that's how we've been able to perform well. And that's really where we spend the bulk of our time is trying to find these special situations where you're not dependent on macro tailwinds or headwinds to all perform. You can find bottom up situations that create your own tailwinds and therefore you should be able to outperform in any environment. And this is a great example of it this year.

Jenna Dagenhart: To follow up on that, these environments can be good ones for active management. Would you say, Miles, is critical for effective long term investing in small caps? Why?

Miles Lewis: Well, I think the data shows pretty clearly that active is where you want to be if you're in small caps versus passive. I mean, it's just a much less efficient market and there's more opportunities to exploit those inefficiencies for small cap managers. And I think there's a couple structural reasons for that, right? On our side, on the buy side, we can't have an army of 100 analyst going out there and looking at every small cap company because that would require a lot of assets. And if we had that many assets, we wouldn't be able to outperform on a relative basis. Similar dynamic exists on the sell side. There's just not the economics for investment banks to have all those analysts given relatively low investment banking and capital markets fees that they get.

Miles Lewis:  So we think that because of that and the fact that there's just fewer people looking at these stocks, there's more opportunities for folks that are doing the fundamental research to exploit the inefficiencies and that favors active management. Active management also tends to do better from an excess return perspective and single digit markets, which kind of makes sense because that favors stock selection over big markets that are going up and to the right and really have a phenomenon where a rising tide is lifting all boats.

Jenna Dagenhart: Brandon, I know you just touched on stock selection, is there anything you'd like to add about active management?

Brandon Nelson: Yeah, I think what Miles said, I largely agree with. I think there's a lot of dead weight in the indexes. And if you can find a savvy active manager that knows what they're doing and has a repeatable and proven process, I think you can definitely outperform consistently. And that's the business we're in.

Jenna Dagenhart: Miles, a similar dynamic exist between small cap as a whole and large caps. Relative valuation said a 20 year lows relative to large cap. How are you interpreting the recent small cap outperformance?

Miles Lewis: Yeah. So it kind of goes back to some of the things Brandon said earlier, in long run, small caps win. They historically trade at a slight premium to large caps. Today, to your point, Jenna, they're trading at multi decade lows on a relative basis and more than two standard deviations below average. And so we think that that is kind of a favorable backdrop for small caps over the coming kind of five to 10 years valuation is a notoriously difficult signal to use in the short run, but it's pretty powerful predictor of more long term returns. And I think that there's also just a lot of parallels between now and kind of the last time we saw a small cap underperform so significantly, which was in the late '90s and early 2000s. You've got this huge concentration of market value within the mega cap tech companies or the NASDAQ.

Miles Lewis: So the NASDAQ, for example, has a 15 trillion valuation. The entire Russell 2000 is three trillion. And the Russell 2000 value is about 1.5 trillion. So capital has flowed very much towards those larger companies and we think over time that results in valuation multiples that get a little bit elevated and it becomes harder and harder for these large companies to grow into those multiples over time. I mean, just the sheer math, right? They're very large companies. It's harder for them to sustain that earnings growth and so they're more susceptible to multiple compression over time.

Jenna Dagenhart: Brandon, how do small cap valuations look versus large cap valuations?

Brandon Nelson: Yeah. They're inexpensive and they're.... There's a variety of ways to look at it. And in almost any metric you look at, they look cheap and we're oscillating, I'd say between the bottom quintile and maybe the second quintile of where that relationship normally trades of small cap valuation versus large cap. And the data shows that when you are in those two quintiles of valuation where smalls are much less expensive than large, the go forward performance of small caps tends to be better for the asset class over large caps. And the batting average is not a 100%, but it's well over 50%. And in a market that's seen valuation expand in a variety of ways in a lot of asset classes, here's a pocket of the investment world that still looks cheap.

Brandon Nelson:  So I think it's a really interesting time and I think, back to your first question, Jenna, about these multi-year runs of small caps being in a leadership role and then large caps being in a leadership role, when small caps are in that leadership role, not surprisingly, when they're peaking and getting ready to hand the baton off to the large cap world to lead, valuations tend to get into that top quintile of evaluation. Right now, we're in the bottom or the second from the bottom. So we think we have multiple years in front of us of valuation expansion. And so it's, again, it's not going to happen in a straight line, but the deck seems stacked in the favor of small cap as an asset class.

Miles Lewis: Hey Jenna, I'd like to just piggyback on something Brandon said. I mean, I think from a fundamental point of view or the economy, Royce's research shows that when nominal GDP growth is greater than 5%, small caps tend to outperform large caps. And the current estimates for '22 are 7.5% and I think for '23, they're about 5%. So from a fundamental perspective, there's another kind of supporting argument in favor of small caps.

Brandon Nelson: See Miles? We agree on quite a few things.

Jenna Dagenhart: Yeah. Who would've thought? I do want to point out those small cap stocks tend to be less liquid, thus all else equal winning within the small cap asset class can be easier when working with the smaller base of assets. Brandon, could you elaborate on that point?

Brandon Nelson: Yeah. You still have to pick the right stocks no matter what sort of asset base you're managing, but it's all else being equal. It is easier to manage a smaller asset base than a larger asset base. And having that lower asset base on a relative basis, which is the situation we're in, it gives us the ability to be more nimble. We can get to our optimal weights quicker than our competition whether we're ramping up a new position or winding down an existing position, we can get there faster if we have a lower asset base. And so we're a relatively undiscovered manager. I've been in the business over 25 years and we've performed very well, but we've been sort of underutilized by the world, again, on a relative basis.

Brandon Nelson: And so I like the asset class as we've discussed and I like our specific positioning because of that lower asset base, because it, again, it gives us that nimbleness. We can traffic in the smallest of small cap stocks and a lot of our competition just refuses to even look there because it just doesn't make sense. They can't ramp up a position in an efficient manner or if they do ramp it up, they'll own too big a percentage of the company and that invites additional problems. And so it just get us more flexibility. And again, you have to pick the right stocks. Just having that flexibility isn't the end all, but it does open up a part of the universe that some of our competition just can't traffic in.

Jenna Dagenhart: Miles, anything you'd like to add about liquidity?

Miles Lewis: Yeah. Again, I agree with everything Brandon said. We like to be look liquidity provider. So in addition to having a relatively smaller asset base, which enables us to get in and out of positions more quickly and use that to our advantage, we have a long term view here at Royce so we can be liquidity providers if a stock is selling off because there's concerns about a secondary offering from the private equity owner or something like that. We're happy to step in and take that because in the next six months, the issue may not get resolved, but over the next three to five years, we know it will be. And so we can participate in those discounted valuations that result from the liquidity discounts.

Jenna Dagenhart: And Miles, you emphasize high quality and dividends. How does this area compare to small caps as a whole in single digit return periods?

Miles Lewis: Yeah. So, I mean, I guess the backdrop would be that high quality and dividend payers outperform over time within the asset class and they do so with less risk. Like a lot of the things we've mentioned already in this discussion, that has not been the case recently. And as a result of that, high quality and dividend payers are incredibly attractively valued relative to their low quality and non-dividend paying counterparts. And so what that means for a strategy like total return, which is the primary one that I'm involved with here at Royce is that we tend to do much better in single digit return environments. That's when we generate most of our excess returns. And there's a couple reasons for that. I think it goes back to stock selection, which we talked about earlier, much more important in a more muted environment.

Miles Lewis: And then the second reason is the fact that dividends are a bigger proportion of your total return. So just hypothetically, if you have an 8% total return in a year and 2% of that's coming from dividends, that's a quarter of your return and that's much more impactful than it is in a 20 to 30% environment. So what we like to say for total return is that we give you your absolute returns at a time when we cannot give you your relative returns, but we give you your relative returns at a time when you need them most, which is when absolute returns tend to be low. And that's important because you may be in danger of not meeting your return requirements for the assets that you're managing.

Jenna Dagenhart:  Brandon, you say you look for fundamental momentum. What does that mean?

Brandon Nelson: Yeah, it's really two things. Number one, it's companies with sustainable growth, something sustaining growth for multiple quarters, multiple years. And then secondarily, not only operating their business as well to sustain that growth, but also having the market savvy to manage expectations well. A lot of management teams, especially in the small cap world can be clumsy at that second part, the managing of expectations, but the market really eats that up. They love it when a company can consistently show that growth, but also show that ability to meet and exceed expectations.

Brandon Nelson: They tend to reward stocks of companies that can do that consistently and when a company is maybe new to the public markets and it's just starting out and that pattern is just beginning of them beating and raising, maybe it's only trading at two or three times sales, but by the time they're five or six quarters into that pattern, the valuation may have expanded to 10, 12 times sales. It's something that can really trigger evaluation expansion. When a company can do both of those things, grow fast and exceed expectations, that's when the magic happens and that's when the valuation tends to expand. So we spend our time trying to find situations in all sectors of the economy that have those characteristics.

Jenna Dagenhart: There's a perception that tech disruption is bad news for small caps. Well, true, in some cases, of course. Other areas such as P&C insurers and banks have historically been immune from these effects. Miles, could you elaborate on this for us?

Miles Lewis: Yeah, Jenna, I mean, I think you hit the nail on the head. I mean, there is this perception that small caps are more at risk and the reality is that some of them are. I mean, particularly in the value space, when we run our screens, we see companies that look very cheap, attractive returns on capital, a lot of cash flow, but we know that just with a cursory glance at the business that those returns are not sustainable going forward. So we move on to very quickly. The FinTech angle, I think is a little bit more perception than reality. And you touched on insurance and banks and I think that's important. The FinTech is really kind of targeting mostly consumer financial services. So think about buy now pay later, direct lending. And that's a relatively commoditized space.

Miles Lewis: So who plays in that space and the traditional financial services space? It's the large companies that have massive amounts of scale and the ability to have low cost structures because that's what's needed in a commoditized industry. So think Wells Fargo, JP Morgan, Geico, Progressive, those kind of companies. On the other end of the spectrum, the companies that we're looking at, A, they have almost no exposure whatsoever to consumer because they've either seated that to the large cap companies that I just mentioned or they're just really focused on their bread and butter, which is small commercial markets. So think small and middle market companies. And there, it's much more difficult to underwrite or extend credit based on an algorithm or a robot of some sort because there's just a dearth of information, the accounting is opaque, it's not consistent from company to company. And so there's lots of little nuances that make it very difficult for those things to be automated and ultimately that helps to insulate these companies from some of this pressure.

Miles Lewis: The quiches that I like to use is Applebee's, right? So if Applebee's has hundreds or thousands of locations around the country as do many other chain restaurants. That's a very easy thing for an insurance company to underwrite. They've got decades and decades of data and they can very easily figure out how to price that policy using technology. And a FinTech company could theoretically do the same thing. On the other side of the spectrum in the companies that we traffic in, they may be ensuring a bar that has ax throwing and a mechanical bull and you're mixing in alcohol consumption. So that's not something you really want to outsource to an algorithm. You want to have some manual underwriting involved there. And so we think that's just kind of an example anecdotally of how these companies are more well insulated.

Jenna Dagenhart:  Brandon, any misperceptions in the small cap space that you would like to address?

Brandon Nelson: No, I think the reality is the cost of being wrong is higher in small caps and the reward for being right is higher in small caps. And that is, I don't know, it's not really a misperception. I think most people know that that's the case, but it creates just tremendous opportunities. If you know what you're doing and you know what drives stock prices and you know where to look for stocks that have those characteristics, there can just be huge opportunities. So I don't necessarily think there's misperceptions, I just think there are huge opportunities if you know what you're doing and you have a robust process.

Jenna Dagenhart: And speaking of that process, you've mentioned that you and your team are good at finding big winners, but also good at cutting losses quickly as a method of damage control. Do you have any evidence of this that you could share with us? Any examples?

Brandon Nelson:  Yeah. No, that is when you cut through what we do and if I had a 30 second elevator pitch to give you, that's what we do. We're good at finding big winners in staying with those companies. And then inevitably, like everybody, we come across losing situations, but how we deal with it is a big competitive advantage. We cut those losses quickly and we're able to move on and not dwell on it, not double and triple down the exposure in losing situations. I think that's a big mistake people make. The biggest mistake they make though is they sell their winners too soon. And we stick with those companies as long as they're checking the boxes and showing that fundamental momentum that I touched on earlier, we'll stay with it. And as far as the evidence of us actually doing what we say we do, the first place you should look is the attribution analysis of our portfolio in any given time period. If I'm right about our ability to find big winners and do damage control on the losers, there should be a disproportionate number of winning stocks in the portfolio relative to losers.

Brandon Nelson:  And I just checked through month end, through the end of November and we have 15 stocks year to date that have added at least 50 basis points of relative performance versus the Russell 2000 growth. And we have two stocks that have cost us at least 50 basis points of relative underperformance. And those two stocks were both in the 60s in terms of what they cost us in basis points. And nine of those 15 that were at least 50 basis point positive contributors were contributing at least 100 basis points. So again, very lopsided. This year is a case in point, but last year was the same way. And if you look back at the many, many years I've been a portfolio manager, it's the same theme. You just get just different sort of variations of that theme. So that's what the numbers should show and that is what they show.

Jenna Dagenhart: Well, thanks for those examples there. Now, does this approach tend to be a more tax efficient, would you say?

Brandon Nelson: Yeah, it tends to be more tax efficient and it makes total sense, right? Based on what I just said, you're riding those winners, you're deferring the gains and you're realizing the losses quickly. And so that inherently creates some tax efficiency where you're deferring gains and realizing losses. In addition to that, I'm also just as the portfolio manager, just very aware, on a year round basis, aware of the tax lots and knowing when lots are turning long term versus being short term, being sensitive to wash sales, just sort of the basic blocking and tackling that goes with optimizing tax efficiency. And it's never at the expensive performance, but there are plenty of situations where just by having that increased awareness and just doing the extra work, you can have your tax efficiency improved and we definitely do that on the portfolios I manage.

Jenna Dagenhart: And going back to some of those points about cutting losses quickly, how important is sell discipline?

Brandon Nelson: Oh, it's huge. Like I said before, the cost of being wrong in small caps, it's above average. And so a sell discipline is very important and finding those big winners and staying with them is critical. But I just think, and I'm repeating myself, but too many people too many times, I think investors make the mistake of digging in and adding exposure to losing situations and you don't want to sell a loser because you've essentially locked in that loss forever and sort of admitted defeat. And nobody wants to do that. They'd rather hope it gets back to even, that investment. And a lot of the times, it's very unlikely that that's going to happen in many cases. So having that sell discipline and recognizing when the thesis hasn't played out the way you expected, the timing isn't right, the best way to deal with it is just get out of the way. You can always come back to it later and that's our approach.

Brandon Nelson: And so it turns out, just as more evidence, you didn't ask for evidence of the importance of the sell discipline, but we've looked at this very carefully and it turns out that stocks we sell from our portfolios do tend to persist as losers in the following six months, 12 months, 24 months. And I'm talking on a relative basis and I'm not talking by just 10 or 15 basis points. It's meaningful underperformance. So our sell discipline, in other words, saves the mutual fund investors and the separate account clients a lot of lost performance. We're preserving performance. It's really a risk control, that's sell discipline. So it's hugely value added, it's hugely important. And I think it's more important in the small cap asset class than perhaps any asset class out there.

Jenna Dagenhart: And as one of our many behavior role biases, we tend to hold on to losers and sell the winners. That's just what we do, even if it doesn't always make sense.

Brandon Nelson: Yeah. It's the biggest mistake people make. It's called the disposition effect. A lot of white papers have been written about it and we have our whole investment process, it's designed to exploit that and do the exact opposite. Sell the losers, ride the winners. It's the name of the game. Easier said than done, by the way.

Jenna Dagenhart: Miles, how do you do damage control?

Miles Lewis: So we kind of think about position sizing as a risk management tool as well. So there's a lot of similarities, I'd say, with what Brandon just said. We're probably more guilty of selling our winners too early as value investors, but on the front end of the process, we spend a hugely disproportionate amount of our time focusing on the business models and understanding the risks and we do what's called pre-mortem. So we try to figure out why we're going to be wrong on a stock X anti before we even make the investments so that if and when those things begin to play out in real time, we've thought about them in advance and we can act accordingly. So that's one way that we do it and we have a similar discipline where if the thesis changes for whatever reason, we have no problem selling when the stock is down 10, 15%. And in hindsight, that often goes on to be the right decision.

Miles Lewis: The other way that we think about it is a little bit different from Brandon. Our biggest positions tend to be the ones where we think we have the least or the lowest probability rather of losing money, as opposed to the greatest probability of making money. So it turns out quite often that downside risk is limited, but our upside is pretty substantial, but we really tend to focus more on the downside risk. And that's, part of it is a credit background that I have, part of it is the low volatility nature of the total return portfolio that we manage. And part of it is just kind of focusing on risk as a general theme and using that as a way to size positions.

Jenna Dagenhart: Turning to earnings, Miles, what was the overall mood of management teams reporting earnings in the third quarter of 2021? What are they saying about earnings growth?

Miles Lewis: Yeah. So look, I would say that the overall tone was very positive with probably lots of asterisks behind that. The demand is robust. Backlogs are building. I'd say more often than not companies complained that they couldn't fulfill customer demand, they couldn't get their hands on the inventory or the parts or the supplies they needed to deliver. And so that kind of sets up 2022 very, very well, as well as 23. And then the other thing that I think is interesting is we've had a lot of companies take a lot of pricing, and sometimes that happens real time and they're able to preserve margins very quickly. Other times, it happens with a lag.

Miles Lewis:  And for those companies where the pricing is coming in with a lag and it'll begin to flow through the income statement next year and beyond, I think that creates an interesting dynamic because if the demand environment remains robust, which it seems to be, you're going to have a lot of top line growth from a volume perspective in addition to pricing. So those two things should mean positive operating leverage, which is the most traditional way of getting margin expansion as you leverage your fixed asset based. And if we were to see some of these supply chain issues or some of the inflationary issues that are probably more temporary in nature begin to stabilize or even roll over a little bit, that would be on top of the operating leverage I just mentioned. And I think that would be a pretty powerful recipe for margin expansion and earnings growth in '22 and beyond.

Jenna Dagenhart: Miles, many of the companies you hold are currently cautiously optimistic about economic growth in 2022 for keeping an eye on supply chain issues, as you mentioned, labor shortages, wage inflation and greater clarity about China. Do you think these issues are all manageable and could some prove to be more transitory than others?

Miles Lewis: Yeah, I think some will be transitory, some might be a little more enduring. So going back to the theme of kind of listening to earnings calls last quarter, there were a few topics that just jumped out at us. Supply chain being the obvious one, labor shortages is another big one. Wage inflation, which is related to labor shortages, another big one. And then just overall inflation. Our companies tend to be a little more domestically oriented so we didn't hear a ton about China, but obviously people are keeping an eye on that. And then in terms of the issues that'll be transitory versus more enduring, I just alluded to it a little bit, but I think that some of the supply chain issues are going to ultimately prove to be a little bit more transitory. We're already seeing some anecdotal evidence of that.

Miles Lewis: So to kind of use a real world example, there's a company that we own called Minerals Technologies, it's a specialty chemicals company. They supply into foundries who in turn make parts for tier one auto OEM suppliers. And those tier one auto OEM suppliers told the foundries they expect capacity levels to be back to 2019 levels sometime in 2022. And that's what our company, Minerals Technology is hearing from their customers. And so that suggests that if the worst is not behind us, the bottom is really close. And so these supply chain issues should start to abate. Obviously, there's this news right now of a new variant. We don't really know how that's going to play out. That as the potential to delay that if we see lockdowns in different countries around the world, but overall, these issues should prove transitory.

Miles Lewis: On the flip side, labor is something that I think seems a little bit more persistent. So I read a statistic recently that said, on the shortage side, of the 4.5 million people that are unemployed since 2020, early 2020, 64% of those people have permanently left the workforce. They're not coming back. So it's hard to replace them or it's hard to find a way to attract them back into the labor force. So that's going to be an issue for some time. The other topic that is in the news, but probably not getting a ton of attention is unions. Union participation has been declining in the United States for decades and it ticked up in 2020. And it probably, when the data comes out, it will have probably ticked up again in 2021. You are starting to see unions being formed, right? There are the baristas at Starbucks in Buffalo, New York. There are the warehouse work down in Alabama for Amazon that are coming back to the table and trying to form a union again.

Miles Lewis: So that's sort of a shift, I think, in the labor market. And then the unions themselves are probably appropriately so flexing their muscles right now. They know that labor shortages are a big deal at a time when demand is booming. So it's a perfect time for them to exercise that force and negotiate better pay, better benefits for their constituents. And those are things that'll ultimately prove from a cost perspective to be sticky.

Jenna Dagenhart: Brandon, I know you're more from of a bottom up researcher, but we also can't ignore inflation, labor shortages, supply chain disruptions, and you name it. How are you monitoring some of these macro issues that Miles just mentioned?

Brandon Nelson: Yeah, I agree with what Miles said and that was definitely a theme during this last earning season. It seemed like just about every company mentioned, all of those things. Inevitably, it'll normalize. We don't know the details on the timing, but yeah, it's put a premium on finding companies that can pass along those disruptions to their cost structure in the form of higher prices. And so you're seeing a lot of semiconductor companies, for instance, where pricing tends to fall just about every year. Call it three to 10%, you're talking about those companies are now talking about increases in prices, which is very unusual.

Brandon Nelson: Or, we own a few stocks in the transportation logistics world and their costs are rising as well, but they're able to pass along those cost upticks in the form of higher prices. So it's the hand we've been dealt as a world here and some companies are able to navigate it very well and still show strong growth and strong margin expansion. And those are the ones that we're naturally gravitating toward. And so there's opportunities. Where there's disruption, there's always opportunities being created. And that's, I think back to your, a different question about active management, I think this is where an active manager can really add value and help manage portfolios through these very unusual times.

Jenna Dagenhart: And we expect that interest rates will start to rise again. It's more a matter of when, at this point pending any major market surprises. Miles, why have rate hikes historically been good news for small cap value investors?

Miles Lewis: So Jenna, it's actually not necessarily rate hikes, but the 10 year yield. So somewhat counterintuitively when the 10 year yield is rising, small caps tend to outperform large caps by a pretty significant margin and the batting average there is, is pretty high. I suspect that somewhat correlated with economic growth. We don't know when or why the 10 year yield is going to rise. I certainly have no idea. I think there's lots of logical arguments that it should be higher. You've got CPI running at 6%. Even if you think inflation is going to settle in at 2% or so later next year and into '23, that's still a negative real return on the 10 year. We do have a lot more confidence in the Fed raising rates at some point, because that happens just about every cycle, probably every cycle.

Miles Lewis:                  37:07                And that's a little bit less of an indicator, but it does stand a reasonably a good economic growth. The Fed takes its foot off the gas in terms of asset purchases. And we have inflation that you should see the longer end of the curve rise and that would be good for small caps, which is again, somewhat counterintuitive. I think a lot of people in the market think rising rates are bad for small caps because perhaps the cost of capital goes up and small caps are viewed as being more dependent on the capital markets. But the reality is the data shows that the opposite is true.

Jenna Dagenhart: And given this environment, Brandon, what's your outlook for small caps moving forward?

Brandon Nelson: Yeah, we're very upbeat for a lot of the same reasons we've already discussed, just feel like it's their time. I think a lot of people don't really understand that small caps do tend to win and people have forgotten that. Large caps have been performing so well for so long that they assume that's normal. Truth is, the long, long term tells you that's not normal and it's more the exception than the rule. And so I think from a high level, the asset class is really poised to sort of play catch with the underperformance that it's seen in the last decade plus. And so that's very high level, but as far as our focus and then there's the bottom up where we spend all of our time, more of the micro and more of the stock specific analysis, we're finding opportunities all over the place in all sorts of different sectors.

Brandon Nelson: The big three are technology, healthcare and consumer discretionary. But from that bottom up standpoint, I can tell you there's just really no end to the opportunities that we're seeing. And we're finding just so many stocks that are meeting our criteria. We've got way more buy ideas than sell ideas. And it's just a very fruitful environment, I guess, on a lot of different levels. So we're pretty upbeat. It's probably very similar to the message I had last time I was on this program, but it continues and we see a lot of ways to win.

Jenna Dagenhart:  And Miles, how is your portfolio positioned for ongoing inflation and whatever 2022 might hold?

Miles Lewis: Yeah, so I'd say, first and foremost, we construct the portfolio from the bottom up. We're not building it with a specific view on an inflation. It's really a function of where we see the best risk rewards in the market, on a stock by stock basis. And sometimes themes or industries will kind of bubble up from that. But that being said, the total return portfolio that we predominantly work on, I believe is very well positioned for inflation. Brandon touched on one thing a second ago and that's pricing power. So now, total return has a huge bias towards high quality companies and a hallmark of a high quality business is the ability to take price, which is particularly important in an inflationary backdrop. The second reason is our financials exposure. So we have a significant exposure to banks and P&C insurance companies specifically.

Miles Lewis:  Again, that's not because we have a view on inflation or rates. It's because that's where we see the best risk rewards from a valuation perspective. And historically those are two areas that have done very well in an inflationary environment. And I guess the last thing I would say is the commodity space. So if you think commodities are going to continue to run and ultimately that will lead to investment in the commodity patch, we think that we can benefit from that. We do not own commodity producers directly because they do not meet our business model criteria from a quality perspective, but the small cap industrials and materials, there are just a plethora of companies that either directly or indirectly sell into that supply chain and will benefit from that investment, should it happen. So we think that's another way that we can win if we see a sustained inflationary environment.

Jenna Dagenhart: Brandon, you mentioned earlier, it's been a good year. Before we ask you about 2022, could you elaborate on some of your year to date big winners for 2021?

Brandon Nelson: Yeah. Happy to. Yeah, like I said before, we had a number of big winners and they've come from a variety of places. I think sometimes that there's this misperception that small cap growth investors only traffic in technology or only traffic in biotech. We traffic all over the place and we're finding big winners all over the place, but one name that's been an outsized performer to the upside is a company called SiTime. They've only been public for a couple of years. They're a semiconductor company. They're in a real niche that relates to timing aspects of semiconductors. And that's got end markets that include 5G infrastructure, cell phones, data centers, electric vehicles and SiTime's got a couple hundred million of revenue. The niche they're in is about eight billion in revenue opportunity and it's probably going to be 10 plus billion and a couple years.

Brandon Nelson: So they're a small company gaining a lot of market share at a rapid rate and have a lot of open-endedness to what they're doing. And by the way, they're also really good at managing expectations. That's sort of part two of fundamental momentum and something I described earlier that something that we look for. So that's stocks that had a big run this year. It's been a big wait. A couple others I'll just quickly mention. Electric vehicles have been a big focus for investors this year. We own a smaller company called Aspen Aerogels. They make thermal barriers that surround the batteries within an electric vehicle. They've got a couple big OEM contracts, one domestic, one international. They haven't named who they are, but they're talking to all the other manufacturers. And I think it's going to become part of the necessary material in any electric vehicle, regardless of who's producing it.

Brandon Nelson:  So it's a way to bet on electric vehicles without having to pick a winner within the electric vehicle space. It's just you're making a bet that electric vehicles are going to be adopted by the world and it seems like that's a pretty high probability of happening. It's just a matter of what the trajectory looks like. So that's an interesting one. It's been a big winner year to date, but I think it's got a very promising outlook going forward.

Jenna Dagenhart: Miles, which cyclical areas within industrials, tech, discretionary, financials inspire the most confidence in you?

Miles Lewis: Ah. I mean, I really like them all. I would say I'm a little bit more cautious on discretionary. I think you got to be very selective there. Just, I feel that way generally speaking, but I think one of the reasons I'm cautious there is that historically this has been, think about retail as an example, hyper-competitive industry with low barriers to entry. And as a result, companies had to be very promotional to sell their products. And that meant lower gross margins. That's not happening right now and they're a beneficiary of supply chain constraints. They can't replenish inventory, there is no inventory, so they don't have to mark down sweaters and t-shirts and things like that. And as a result, gross margins are really, really expanding pretty dramatically. And that has a huge impact on the earnings power of these companies. I think as these supply chain issues abate and inventories get rebuilt, that's probably something that's going to be a headwind for these.

Miles Lewis: So I'm a little bit cautious as a general statement there, but I think there's select opportunities. Tech, we've seen some opportunity where the market is kind of rotated. When it rotates towards value, it will throw the baby out with the bath water and we'll find some attractive value tech companies there and we'll add to those. So we like a lot of that right now. We're very constructive on industrials. We believe that there is a new CapEx cycle coming. There has been a long period of under investment in the United States. The labor issues that we just talked about ultimately mean more capital investment. It's not just automation. It's replacing that boiler that keeps going out and has to be repaired by a human being and that human being is now a lot more expensive. So the company will say well, let's just replace the boiler. There's infrastructure spending, there's onshoring and the stocks are not expensive so we think industrials look interesting.

Miles Lewis: And on the financial side, we really like both banks and P&C insurance. So they're completely unrelated and we like them for different reasons. On the bank side, this is just a structurally different industry than it was going into the financial crisis in '06 and '07. It's got more capital, less risk and we don't think any of that is reflected in the market. You've got on a fundamental side, loan growth picking up. We think net interest margins, which are basically at all time lows are about to start expanding simply because you're going to have earning asset mix shift where you've got this huge amount of liquidity from deposits on their balance sheet that they've been parking at the Fed earning, almost nothing. They're going to begin to deploy that into loans at 4% so that's very creative to their margins.

Miles Lewis: We think that that happens irrespective of what happens with rates. Though clearly, a steeper yield curve or even higher Fed funds would, would help them. And then on the P&C insurance side, we talked about this last time I was on your program so I won't bore your listeners to death it again, but just to summarize, I mean, it's a hard pricing market which is going to lead to a multi-year period of expanding margins, accelerating earnings and book value growth. And against that incredibly powerful fundamental backdrop is a group of stocks that has dramatically lagged the market. Many of them trade at single digit multiples and below tangible book value, so from a risk reward perspective, that is highly asymmetrical and that's one of the things that we look for. They also tend to be pretty defensive in down market. So there's kind of elements of both defense and offense there. So I kind of named them all, but we're excited about the prospects. Much like Brandon said, we're finding lots and lots of opportunity right now.

Jenna Dagenhart: Lovely optimism. And Brandon, are there any areas where you're particularly bullish heading into 2022?

Brandon Nelson: Yeah. It's a variety of places. There's no dominant theme. I've mentioned, I think a few of them up to this point, but those secular growth areas tend to be where we continue to the most opportunities and that's technology, healthcare and consumer discretionary specifically. And then we'll find a few one-offs in industrials, in financials and sometimes materials and even in energy. So it's a diversified portfolio. So we go wherever they opportunities take us from a bottom up standpoint and we're very open minded and just seeing a broad opportunity set right now. So that's actually ideal.

Jenna Dagenhart: Tying together everything we've been talking about today Miles, how should financial advisors be talking to their clients about investing in some small caps?

Miles Lewis: Yeah. I mean, look, we've hit on a lot of the major points, right? I agree with Brandon, I think small caps as an asset class are poised for a good run. I think that we've had an environment where the market has kind of risen in unison and usually those environments are not followed by hugely up markets again in the subsequent years. So I think stock picking and active management becomes even more important in the next few years. And I do think that value is poised for a great run, but people can certainly disagree on that. And so I think there's lots of opportunities for the financial advisors watching within small caps, which as we've discussed, tends to be an asset class that that is historically been underallocated to.

Jenna Dagenhart: Brandon, any key takeaways for advisors watching?

Brandon Nelson: Nothing they probably don't already know. Fine. I think in small cap, active management can be very value added. And I think there's a lot of good small cap managers out there and they should spend some time studying the universe of managers and go with proven managers that have repeatable processes. That's my advice.

Jenna Dagenhart: Typically follow up on that, Brandon, do you think there's the risk that financial advisors clients are under exposed to small caps?

Brandon Nelson:  I do. As I've said, the small caps do tend to win and we could be entering a period here where large caps in an absolute basis sort of flat line. Nobody knows for sure how these absolute returns could play out, but what if large caps put up -3 to +3% returns for each of the next three, four years and small caps put up eight to 10 plus percent returns over the next three to five years? That's going to be painful for an advisor that doesn't have that exposure. They're craving that appreciation and they need to find it somewhere. And if they're under-exposed in what could be a leading asset class where it's in the early stages of a multi-year run, that's going to be painful. They can either position for it now as it's still in the first or second inning or they can wait until it's more mature and by then they're scrambling and they've already missed some of the easy money in that positioning.

Brandon Nelson: So I do think it's a risk. I think they should be inching their way more and more into small caps. And I think there'll be a payoff for that if they do so. And it probably won't be each and every week, each and every month, but I think, again, the deck, I think is stacked in your favor if you're tilted that way.

Miles Lewis: Yeah. Jenna, I would just add to that. I mean, I think I have some empathy for the advisors, right? I mean, their clients do not know about graphite electrode makers and specialty insurance companies. They know about Tesla and Google and Apple and they know that they've been right to own those companies for a very long period of time. So there's just this sort of psychological barrier that I think you have to overcome to get your clients to do that. And I think the way you do that is using lots and lots of data. Right? And I think Brandon and I have presented pretty compelling evidence that in the long run, small caps win and that hasn't been the case lately. And so I think advisors can lean on the data and worry less about the fact that these investments are things that their clients may not have heard of. And that helps to make the argument in favor of small caps.

Jenna Dagenhart: Miles, any final thoughts on your end before we wrap up this discussion?

Miles Lewis: No. I'm good Jenna. Thank you so much for having me on today.

Jenna Dagenhart: Yeah. Well, great to have you and Brandon, thank you as well.

Miles Lewis: Yep. Thanks for having me.

Jenna Dagenhart: And thank you for watching this Asset TV small cap masterclass. I was joined by Brandon Nelson, senior vice president and senior portfolio manager at Calamos and Miles Lewis, portfolio manager and principal at Royce Investment Partners. I'm Jenna Dagenhart with Asset TV.

Calamos Timpani Small Cap Growth Fund (CTSIX)

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

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The principal risks of investing in the Calamos Timpani Small Cap Growth Fund include: equity securities risk consisting of market prices declining in general, growth stock risk consisting of potential increased volatility due to securities trading at higher multiples, and portfolio selection risk. The Fund invests in small capitalization companies, which are often more volatile and less liquid than investments in larger companies. As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries.

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