MASTERCLASS: Small Caps Investing

Jenna Dagenhart: Hello and welcome to this Asset TV Small Caps Masterclass. We'll cover what makes this part of the market unique, some of the dominant sectors in this space, and why investors should consider allocating to small caps. Joining us now to share some of the characteristics they look for. We have Joe Gubler, Quantitative Portfolio Manager at Causeway Capital, and Ryan Thomes, Portfolio Manager at Hotchkis and Wiley. Joe, starting with you. Why should investors be thinking about allocating to small caps stocks right now?

Joe Gubler: Yeah, I mean, my view would be, if you can, you should always have an allocation to this area. It's an inefficient asset class. There are lots of stocks to look at across a wide range of countries, a lot of mispricing that you can potentially profit from. And also, it tends to have a pretty good growth background. These are smaller names. And so, you are kind of getting growth as part of the package, regardless of which individual stocks you pick.

Joe Gubler: In terms of right now, I would say, there's a couple ways you could look at that. One is that, I think there's still a fair amount of disruption. If you think through the pandemic and then through what's happened with Russia and Ukraine this year, and then the looming threat of inflation and rising rates, what I see when I look at this asset class right now, she's at very high level of disruption, where a lot of stocks, investors, aren't quite sure what to make of them. They're having trouble figuring out what these stocks are worth, what they should be paying for growth, which kinds of value stocks they want to buy or don't want to buy.

Joe Gubler: So, I think, we're kind of in that clean up on aisle three phase of the market right now. There's been a lot happening. I don't think it's all been sorted out yet. So, it's a good time to be an active manager in an asset class like this. Another thing, maybe this is a little more off the beaten path, but one concern in large cap stocks recently, particularly in China and U.S. is just sort of regulation, right? You have some very large growth stocks that become focuses of attention for regulators, particularly in the internet and commerce space. I would say that small cap stocks have always sort of had to deal with kind of flying under the radar a little bit on regulation. Regulation is not designed to help them.

Joe Gubler: And so, sometimes, they find it difficult to navigate regulatory issues in the same way that larger cap stocks do. But at the current moment, I feel they're not really the focus of those regulatory efforts. So, it's sort of business as usual for small cap stocks, maybe not so much for certain areas of the large cap space. And sort of related to that, I think the pandemic and the trade wars that preceded them, and some things that have happened in the interim, supply chain complications have maybe pushed globalization back a little bit. I think we were on a multi decade run of increasing globalization, increasingly tight in its supply chains.

Joe Gubler: And sometimes again, that would mean that a bigger company could kind of succeed in a winner take all battle for the ability to supply product. That may be changing that. It may be necessary to have more suppliers that are alternative sources of something that are a domestic supplier in any given country. Some countries are going to want to make sure that they've got their own domestic supply of certain resources and certain items. And that may also play to the benefit of smaller stocks.

Jenna Dagenhart:  Building off of that, Ryan, what are some of the benefits of investing in small cap stocks relative to large caps?

Ryan Thomes: I think there's two things that come to mind that really stand out and Joe hit on a couple of these already. I guess, three, that I would really differentiate small from large. The three being, the large opportunity set, the inefficiency of the asset class, and then, the third would be that they're generally simpler businesses than large cap. So, if you think about each of the three, the large opportunity set, we invest in basically any U.S. stock between a hundred million and 5 billion in market cap. And that represents somewhere on any given day between, call it 2,500 and 3,000 potential securities that we can invest in.

Ryan Thomes: So, if you have a large cap strategy that can invest in, let's say, the opposite of anything larger than 5 billion, that would represent a universe of something less than a thousand potential ideas. So, the small cap universe from that perspective is call it two and a half to three times as large in terms of the number of possible opportunities. And so, we definitely view that as a positive, right? There's more to pick from.

Ryan Thomes:  The second element would be the inefficiency of the asset class that Joe alluded to already. When you think about some mega cap, especially in the tech area, Facebook, PayPal, Salesforce, Netflix, and Nvidia, they have more than 50 Wall Street analysts covering them actively. And so, if you take an average of that large cap universe, there's an average of 17, 18, 19 analysts that cover that group. So, there's very little that these large cap companies that can do that's going to just be overlooked by the market. That's not to say you can't add value in large cap. You can, but you need to do that by taking a view that's different from what consensus view is, and then being correct with that view, of course.

Ryan Thomes: That's something you can do in small cap as well, but you have the additional opportunity of just finding overlooked ideas. So, in small cap, instead of having that 17, 18, 19 analysts covering it, the average is five. And about 15% of the universe has zero cell set coverage. I think those numbers, as stark as they might be, still kind of understate how much more inefficient the small cap market is. Because if you think about it, the best and most experienced Wall Street analysts are more likely to cover the apples of the world. They make a better living doing so because those are the kind of names that are more widely held. And so, the demand for that research is greater.

Ryan Thomes: And so, while the average small cap company has five analysts covering it, you get a lot more junior analysts, you get a lot, more analysts that are newer to the business. And so, if you factor that, and I think that inefficiency is even greater than what those numbers suggest. The other thing that I'd mention is, even within small cap, the lack of coverage becomes more and more pervasive as you go down in cap spectrum. So, call it names under a billion in market cap. The coverage is even thinner there than it is in sort of the larger portion of the small cap market. We're typically overweight that sub segment of the market, the smallest cohort of small cap, typically one and a half to two times the benchmark weight.

Ryan Thomes:  And that's simply because it's such an inefficient part of the market. There are many underfollowed opportunities there. And I think that not only gives us an edge in generating performance because there's so much underfollowed opportunities there. But it also, in many cases, helps our clients kind of fill a void in a part of the market that they would otherwise have because many of our peers aren't really investing in that part of the market, which is why we like it. So, we think that's a real core competency for us is sort of that smallest sub segment of the small cap market.

Ryan Thomes:  So again, the large opportunity set, the inefficiency of the asset class. The third thing I mentioned was the simpler businesses say, this is less important than the former two, but most large cap companies have multiple business lines. They have a far-reaching global footprint. GE in its current form is kind of the poster child for large cap conglomerate. They have a very large aviation business, very large medical device business, very large power business, very large renewables business. We own GE in our large cap portfolio, but it took a lot of work from multiple industry analysts to do some of the parts analysis to come up with a reasonable valuation would be.

Ryan Thomes:  You get a lot less of that in small cap. Most companies have, one or very few material business lines. They tend to be less global. And so, our investment team is segmented at the industry level. The average person has been covering their industry for over a decade. And so, we can kind of leverage that experience and tap into that body of knowledge that they've accumulated over time to really efficiently research these smaller businesses. And it takes less time to do the research on them than it would for a large cap, for example. So, that allows us the ability to create a highly diversified portfolio.

Jenna Dagenhart: Joe, I've seen you nodding your head. Anything that you would like to add on the advantages that small cap stocks offer versus large caps?

Joe Gubler: I think we've covered a lot of it. One other thing that's maybe worth mentioning is that, when you think of the indexes that track these various small cap areas. So, for us, we do an international small cap strategy and the appropriate index for us is MSCI ACWI Ex-U.S. small cap index, and it's a very flat index. So, the thing about small cap stocks is you don't get this sort of FANG-like phenomenon that you get in large caps where, I think in MSCI USA, the top 10 stocks or if you're look at the S&P 500, you'd find something similar to top 10 stocks. It would be around 30% of the weight in the index. You have some very large BMS at the top that really dominate the index.

Joe Gubler:  In our ACWI Ex-U.S. small cap index that we sort of grade our performance against the top 10 stocks would add up to about 2% of the weight of the index. And so, what it really means is it's a stock picker's paradise. You're going to be judged really on your ability to actively pick the right stocks and not so much on, "Did you hold these, these giant FANG stocks that are disproportionately influencing the way that market moves?

Jenna Dagenhart:  And what about some of the drawbacks, Ryan?

Ryan Thomes: I would say, I mentioned the large universe or the large opportunity set a positive, but it's also a challenge, right? It's a good thing to have a lot of names to pick from, but it also means that's a lot of information to sift through a lot of research prioritization to do, and that can be a real challenge. There's more fish in the ocean than there are in the pond by my house, but that doesn't mean I'm going to catch more fish there necessarily, right? So, we have a number of tools to kind of address that challenge. We have models that we've developed, which are really designed to kind help narrow that unwieldy universe to something that's more manageable, and hopefully, more attractive for our analysts than that starting opportunity set. So that's kind of our solution to that challenge.

Ryan Thomes: Other drawbacks or challenges, I'd say, the most obvious one would be trading liquidity. Trading liquidity in small caps is considerably lighter than it is for large caps, which is a big risk that needs to be addressed. It needs to be addressed for any investor, because if some unforeseen circumstances arise, if our investment thesis turns out to be wrong, we want to be able to exit that position without moving the price against us. So, we manage that in a couple different ways. First, we do a thorough liquidity assessment prior to taking a position in the first place. So that's, I think, probably the most important thing we do.

Ryan Thomes: Other things that we do is we have a highly diversified portfolio. So, any one position is going to be pretty limited, so that helps manage our liquidity. And then, I think, another thing we do that I would critique some of our peers on is we limit assets to a responsible level. If you get assets to kind of bloat, that means you're taking large positions. You're going to represent a large percentage of the ownership of the company. You're going to represent a large percentage of the average daily volume. So, making sure that you limit your AUM, I think is an important way to sort of managed liquidity risk.

Ryan Thomes: The other thing I guess, in terms of drawbacks or challenges, I would say, and this is a little more controversial, but I would say business quality. There are good and not so good businesses in both large cap and small cap. There really aren't any, let's say Microsoft's in small cap where you have a very captive customer base, outstanding balance sheet managed for the benefit of shareholders and a real competitive lasting advantage. There are good businesses in small cap though. It just takes some work to find them. But this, I think is one of the big drawbacks of say, passive small cap investing. I think if you went passive, you would own a lot of companies that you wouldn't necessarily want to own. So, I think in terms of, I would view that as a drawback, but not so much for an active investor, more so, in terms of passive small cap investing.

Jenna Dagenhart: And I know Ryan, you just talked about liquidity risk. But Joe turning to you, how would you compare the risk of small cap stocks to the risk of large cap stocks? And has this changed over time?

Joe Gubler: Yeah, I mean, just one point really quick on liquidity. I agree that's something you have to watch very carefully. Our universe of stocks is basically derived from that ACWI Ex-U.S. small cap index, which has about 4,300 names in it, but we apply a minimum liquidity threshold on the stocks in that universe. And so, that ends up narrowing us down to about 3,000 names once you're done ensuring that, again, you can have that sort of orderly entry and exit to the position, but that still is a huge amount of stocks that you can look at from there.

Joe Gubler:  And in terms of, from my perspective, we manage this portfolio primarily in a quantitative fashion. And in quantitative investing, breadth is on your side. The, the more, the larger, the universe of stocks that you can look at, the more ability you have to take signals that you think should work on average and apply them across that very large universe to get consistent return from your investment. So, we view the breadth as a very positive thing from that perspective. It's one of the things we really like about it.

Joe Gubler:  From a risk perspective, I think, one thing that's interesting is that there's no doubt about it. That if you look at the individual stock volatilities of stocks in the small cap space, they are higher than what you're generally going to see in large cap stocks. To some extent emerging markets, even in the large cap space is comparable in terms of individual stock volatility, but generally, small cap is going to be way up at the high end of the spectrum. What's interesting though, is that the correlation of stocks to each other in the small cap space is actually very low compared to what you see in the large cap area. And part of that is that when you're looking at large cap stocks, you're often looking at sort of, again, global companies. They're responding to sort of the same macro trends, the same information, and there's a tendency for them to move more closely together based on that.

Joe Gubler:  Small cap stocks tend to be more, as Ryan said, single line businesses. They tend to be more domestically focused in terms of their revenue streams. And so, they're much more idiosyncratic in terms of what they respond to and what drives their stock prices. And what that means, when you think about the way risk works, the risk of a portfolio is ultimately a combination of the risk of the inputs. So how volatile are those individual stocks that we're putting in the portfolio, but also how correlated are the stocks that we're putting together in that portfolio? And so, because the average correlation of stocks in small cap is very low, even though they have high individual volatilities, you can typically put together a portfolio of small cap stocks that has very, very restrained, overall risk characteristics.

Joe Gubler:   And that's what we want to be able to do as investors is take stocks and benefit from assembling them into a portfolio and making a product out of that portfolio that's better than the individual stocks that we're putting into it. How has that changed over time? I haven't seen a huge shift in that. I think that the underlying drivers that have caused those high single stock volatilities, and also the drivers that have caused the interest stock correlations to be low, those are still in place. If anything, to some extent right now, we're seeing even more attractive pair wise stock correlations within the small cap space.

Jenna Dagenhart:  Ryan, how do you find the asset class today, say relative to history or relative to other parts of the U.S. equity market?

Ryan Thomes: Pretty attractive. And that's not something I say just because that's where I invest. And I think we're all guilty of being perennial bulls in our own asset classes. But just for some perspective, the last I looked, the total U.S. equity market, so the Russell 3000 was trading at something like 18 times forward PE. It's 20-year average is 17 times. So, pretty close, a little bit richer than what it's at least 20-year average is. So, not richly valued, but certainly not on sale either. But there's a big, if you kind of look under the hood from there, there are some big variations. So, there's a large gap between value and growth and also between large and small. So, basically, the more you move across the size and style spectrum towards growth and towards mega caps, valuations become quite elevated relative to history.

Ryan Thomes:   And so, as you move towards value and towards small caps, valuations look quite attractive relative to history. So, again at 18 times today versus it's 20-year median of 17 times, the Russell 1000 growth is something like 24, 25 times forward earnings, where it's average is 19 times. So, it's a pretty healthy premium to what its 20-year average is. And then conversely, the Russell 2000 value index trades at, it's less than 15 times. I want to say it's close to 14 times earnings and it's 20-year average is close to 20 or 21 times. So, large growth training at about a 25% premium to its historical average and small value training at a 30% discount to its historical average. So, the combination of those two things I think, would lead to concluding that small value is producing a pretty good entry point in today's market.

Ryan Thomes:  And so, you kind of think about why that disparity exists. And in our view, it probably shouldn't, at least not to that extent. If you look back over very long periods, we're talking 50 years, 100 years, small value has been the best performing equity asset class by a pretty large magnitude over the last 10 to 20 years, that's reversed in a pretty big way. So, large growth has definitely been in favor of the last decade plus. So, over the last 20 years, the annualized returns for the 1000 growth were about 10% annualized. And for the 2000 value were about 8% annualized. So, that two percentage points ends up being a very big deal when you annualize that over a 20-year period. So, the difference between the two indexes on accumulative basis is closer to 200%.

Ryan Thomes:  And so, that's what's really caused that big disparity between the two. So, this is not something that we see that would be able to continue indefinitely, and we've already observed a reversion towards more normal valuation relationships in the last couple years. And we would be very much of the mindset that's something that we think is more likely to continue than not.

Joe Gubler:   Yeah, I mean, just to jump onto that, we use value in a meaningful way within our strategy. It's probably the single most important decision-making input. And one of the things that we've seen, I hate to disappoint the viewers, probably the best time to get into small cap value at least in the international space that we look at would have been late in 2020 or early in 2021. Value's been doing very well across the asset class since that time. But the good news is, I think, there's still a lot of potential for value in the small cap space. When you look at, Ryan was talking about sort of disparities between value and growth. We see a lot of that in the international space as well, where if you were to look at the ACWI Ex U.S. small cap growth index versus the value index, at one point, it traded at about 100% premiums to value not too long ago.

Joe Gubler: You've seen that come back. It's more like 70% premium now. That's still very high compared to history. If you were to look at things on a book value basis, growth was trading at about a 200% premium to value before things started to correct. So, there's lots and lots of potential for that adjustment to continue. We also look at value dispersion. And I would say, again, depending what measure evaluation you look at, you're well above one standard deviation. In some cases, approaching two standard deviations, which means, 90 plus percent of the time valuations differentials between the two sections of the market have not been this stretched. So, it started to come back in, but I would suspect that there's still a lot of room to move.

Jenna Dagenhart: And to spend a lot of the benefits that we've discussed so far today, investors still tend to under allocate to small caps, Joe. Why do you think this section of the market is often overlooked?

Joe Gubler:  Well, I think, so if you were to look at a very broad index, say IPIMI, which really would cover all stocks in all countries across the world, across the market cap, spectrum. Small cap stocks are about 15% of the capitalization weight of that overall kind of mega worldwide index. And so, I think, sometimes people think, depending on the organization, depending on your resources, you may look at that and say, "Okay, I'm not really giving up much of the market capital of the universe by not being present here." But I think that overlook is that, we talked about the number of stocks that are available to invest in here, and the numbers are huge. Small cap stocks represent about 65% of the numbers in that sort of broad, worldwide index that we're talking about.

Joe Gubler:  And so, again, that should be interesting to investors. The fact that there's so many stocks to choose from, so many different chances for stocks to be mispriced or inefficiently priced. I think again, sometimes the potential, the thought of risk might scare some investors off, but as we discussed a properly constructed portfolio in the small cap space, really shouldn't be substantially riskier than any large cap portfolio because of those correlation benefits that you can pick up. And so, those are some of the hurdles, but I think, investors are starting to take a closer look at small cap. We see increasingly that clients that we talk to realize it should be part of their allocation. So, I think that's going to more and more over time become kind of an outlier position to not have a dedicated small cap allocation.

Jenna Dagenhart:  And I'm glad you bring up risk. And I want to spend a little bit more time there. Ryan, how do you manage risk and how does this differ from large cap?

Ryan Thomes:  Yeah. When we're looking at the portfolio, I think there's sort of two camps that we classify risk and we have the stock level risk, and then we have the portfolio level risk. And so, at the stock level we use, I kind of alluded to these proprietary models that we designed to help kind of narrow that universe, that big universe that we're looking at. Embedded within those models are a number of features that we hope steer us away from some riskier businesses, particularly those with a lot of financial leverage. So, we also have a very diversified portfolio. So, the idiosyncratic or stock specific risk is pretty contained.

Ryan Thomes:  The most important, I think, stock level risk control that we have is something we refer to as our fundamental risk ratings. And so, when our industry analyst is doing a review on the names under their coverage, they provide a rating on one through five, one being good, five being bad on three different pillars. And those pillars are balance sheet quality, business quality and governance. And so, those scores help us really distinguish better businesses from worse businesses. And then obviously influence waiting decisions for companies that are trading at similar valuations.

Ryan Thomes: At the portfolio level, in the portfolio construction phase, we have, again, a few mechanisms in place that really help us manage risk. And this kind of gets to a lot of what Joe talked about. You can have a very diversified portfolio that holds a lot of securities, but if, for example, they all had bad balance sheets, that's a big risk. That's a correlated risk that these names would be exposed to. And so, that's the kind of thing you're trying to avoid. So, we have a few things in place to help manage that.

Ryan Thomes: We obviously view the sector and industry ways and how that compares to our benchmark. We look at factor exposures and this would get to the financial leverage example I gave. If for example, the factor exposure told us that we had a lot of a positive risk exposure to financial leverage that would surprise us and we would want to understand why that is. We wouldn't expect that. We would expect the opposite, perhaps it's because we have an overweight in financials or something like that. But that's something that we do just to make sure we're not taking any unintended risks.

Ryan Thomes: We also look at, and I mentioned this before, but we do a liquidity analysis, trading liquidity. We want to make sure we're not investing in any names where we would be concerned about exiting them. And so, we have a number of different things in place to help us manage that I alluded to already. And then, the last thing that we've been doing is sort of a supplemental ESG test. And this is also a component of the fundamental risk ratings that I mentioned earlier where any material ESG factors would be represented in the scores that come out of that fundamental risk rating system.

Ryan Thomes:  But we also look at it through using a third-party tool and just look at anything that scores poorly. We want to understand why. We deserve the right to disagree with this third party's opinion, but it is something we want to understand and consider their perspective. So, those are some of the most important ways I think we manage risk. And so, in terms of how that differs from large cap, most of those apply to large cap as well. I think the liquidity one is the one that would really stand out as being unique or more unique at least to the small cap market.

Jenna Dagenhart:  And Joe, you build your own risk model for the small cap asset class. That sounds like a lot of work considering that vendor supplied models are available. Why is this important to you and your firm?

Joe Gubler: Yeah. So just to step back and give you a little bit of sense of how we do risk management. We've got a quantitative expected return model that looks at stocks across a number of dimensions. So, we're very interested in valuation, in growth, in price momentum, and in quality. Those are sort of the four categories that we will look at a stock on to decide whether it's attractive and really whether we like it or not ends up being a combination of those four bottom up areas. And then also, we do look at top down information. We want to understand, again, our strategy is in almost 50 countries in that ACWI Ex-U.S. small cap universe.

Joe Gubler: And so, we need to understand the macroeconomic backdrop in those countries. We need to understand whether stocks in those countries are overvalued or undervalued, where the asset flows might be going, so that top down expected return information also enters into the assessment. So, you can think of that as sort of the, what can we get from investing in these stocks? And then of course, the flip side of it is what are the risk elements of these stocks? And that's where the risk model comes in. It's similar conceptually to what you might see from some of the third-party vendors. It cares about sectors and countries and currencies. It's got style factors like value, growth, momentum, volatility, cyclicality.

Joe Gubler: But where we find it advantageous to build our own model is that, it's estimated over the specific universe of stocks that we're interested in, which means it's better able to capture exactly what are the co-movements and correlations and idiosyncrasies of that universe. If we decide we need a new factor to manage risk that's not in that vendor supplied model, we can add it in. I think a lot of people were in the position during COVID of saying, "Wow, here's a new risk factor that is not in anybody's models, but we need to have a better ability to understand how to manage this." And we just have complete transparency on how the model works. So, it is, it is more work to do. It's something we've been doing for decades. We think it's well worth the effort we put into it.

Joe Gubler: And so then, what happens with those risk models is that we care about portfolio level risk. We want to know are we getting the best possible expected return for the lowest possible level of risk in this portfolio? When we reward expected return and penalized risk in the portfolio construction process, it pushes us towards a portfolio that's diversified across countries, diversified across sectors that holds a sufficient number of stocks that are uncorrelated to each other to make sure that we get that ideal level of risk for the amount of return that we're going to be rewarded with.

Jenna Dagenhart: And turning to different sectors and regions, Joe, what are the dominant sectors in the international small cap asset class? And how does this differ from what we see in large caps?

Joe Gubler: Yeah. I mean, one thing that I've found interesting is that, whether you look at sectors or countries, the asset class composition is a bit different. Maybe not quite what people would expect. So, one really notable thing is that financials don't play the same outsized role as a sector in the small cap space, at least in international small cap, compared to what you'd expect in large cap. Generally, in large cap space, financials are going to be 20 plus percent of the weight of any index that you might look at. In small cap, it's closer to 10%.

Joe Gubler:  What you see moving up is industrials. Industrials is a huge segment numerically and by weight within our investable universe. And so, that actually ends up being the largest sector by weight. Materials is a bit more important here than it is in large cap and also real estate, which is fairly small in most large cap indexes is appreciable weight here. It's sort of 10% weight in this index. When you look at the country level, you see some interesting things too. Again, we're investing in, non-US developed markets as well as emerging markets.

Joe Gubler:  And one of the things that you see is that if I were to look at the ACWI Ex-U.S. index, which is sort of the large cap equivalent of ours, Japan, UK, Canada are the largest constituents. That's also true for this small cap index. Although Japan sees its weight become even larger, it's still the largest country, but it kind of bumps that up to an even higher level. But what starts to surprise people, I think is that countries like China, which are very dominant in the large cap, ACWI and ACWI Ex-U.S. index in China is about close to 9% of that ACWI Ex-U.S. large cap index. It's not even the largest emerging markets country by weight in the universe that we're looking at. You've got Taiwan and South Korea. Well, well above China in terms of weight in that index. And I think China's down at number 10 or 12 as far as its importance there.

Joe Gubler: So, it's an interesting thing. There are investors who are worried about exposure to China and do I have too much and what can I do about that? To some sense, investing in small cap, it gets all the benefits that Ryan and I were talking about, but also potentially kind of diversifies your country mix a little bit more compared to large cap investing.

Jenna Dagenhart:  And Ryan, what are your thoughts on financials? I know that's one sector that you're interested in right now.

Ryan Thomes: Yeah. So, financials in the U.S. small cap value index is by far the biggest weight. And we actually have an overweight to that even. So, it is an area that we've been pretty attracted to. We, generally, at Hotchkis and Wiley value companies based on a normal earnings framework. Which means, that we're trying to figure out what a company should earn in sort of a mid-cycle equilibrium type environment. And so, using that framework, banks are still trading at a considerable discount to the rest of the market. So, from there, we're pretty attracted to that part of the market. They're also attractive based on their current earnings, which in many cases are actually pretty close to what our normal earnings estimates are.

Ryan Thomes:  I think the reason that valuation opportunity is available to us is that there's a general concern in the market about financials and about banks in particular, because there's some concerns that a recession might be coming in the near termed and banks have generally lagged in economic downturns or late in economic cycles. And so, there's sort of this reticence to invest in that part of the market. We're more than a decade now removed from the great financial crisis, but I think that experience is still fresh in a lot of investors' minds and many just want to avoid any repeat of that kind of experience if we do enter a slowdown or a recession.

Ryan Thomes: Our view is that this time around, there's a lot fewer excesses in the financial system compared to 2007, 2008. If you look at loan growth, which is one good proxy of how tight or loose lending standards are, it's been pretty modest recently, whereas it was incredibly rapid leading up to the financial crisis in '07, '08. And the bigger reason is, essentially all banks today hold considerably more capital on their balance sheets than what they did prior to the financial crisis. So, that provides them the ability to absorb credit losses without raising equity and diluting shareholders, which is what happened in the financial crisis.

Ryan Thomes: The other benefit I think that banks provide today is they're a nice offset to other sectors that are very negatively exposed to inflation and higher interest rates. So, higher rate poses challenge to just about every other sector, but banks actually get a boost from net interest income when rates rise and thus generate increased earnings from that. That's disproportionately true for smaller banks actually, because a larger portion of their earnings come from net interest income where larger banks tend to have other businesses that aren't as rate sensitive, like payment processing or asset management businesses or investment banking, for example.

Ryan Thomes:  So, the exposure to smaller regional banks, I think, provides some nice offsets to other areas of the market that might be more negatively exposed to rising rates, which, many people believe are inevitable moving forward. I think, finally, the other thing, and this is a much more, I guess, longer term potential benefit is the consolidation of the industry. So, there's been a lot of consolidation over the last decade, but there's still nearly 5,000 banks in the U.S., which is kind of a remarkable number, not all public, but there's still 5,000. I think it's 4,800 FDIC banks in the United States. And there can be an opportunity for prudent M&A activity to take place, which could really result in substantial cost savings. So, that's not something we necessarily count on, but it is something we've benefited from in the past and could continue to benefit from going forward.

Jenna Dagenhart: You're also pretty overweight energy, Ryan, what's your outlook there?

Ryan Thomes: Energy is a very interesting story. And it has been for the last five, six, maybe even longer than that. There are 11 gig sectors, right? Energy being one of them. So, energy was the worst performing of all of the small cap sectors. I'm using the Russell 2000 here in 2017. It was the worst performer in 2018. It was the worst performer in 2019. And then, the pandemic hit, which is terrible for energy. And there was a huge demand shock like we've never seen in the past. So, energy in 2020 was also the worst performing sector. So, that's a four-year period where it was just getting crossed relative to the rest of the market. So, if you took that four-year period cumulatively, the energy sector was down 70% cumulatively while the overall index was up 50%. That's a huge magnitude.

Ryan Thomes:  I mean, if you have a stock, that's down 70%, it has to get return more than 200% just to get back to where it started. So, to have a whole sector down that much is pretty remarkable. And so, we view that as potentially creating some very rare opportunities for us from a valuation perspective. Meanwhile, what had gone on in some of those years, and this is for a variety of reasons that are probably beyond the scope of this discussion, but E&P companies, the exploration and production companies, which are those that are doing the searching and actually extracting oil from the ground, they had reduced their CapEx dramatically. In other words, they stopped or at least dramatically reduced the amount of investment that they were putting into new exploration projects.

Ryan Thomes: So, our view at the time, and I'm talking after, let's say, the big selloff post COVID was that, this would very likely lead to a supply shortage once demand reverted back towards pre-pandemic levels. And I think there's sort of this misnomer out there that these are the kind of things that can be corrected quickly and that just isn't the case. You have to hire geologists to help find oil. You have to hire people, you have to buy equipment. So, the amount of time that it takes from deciding to invest in these projects to you and I putting gas in our car is measured in years, not measured in months, not measured in days, it's not turning the spigots on. So, we thought there would be this big challenge in meeting that demand once that demand kind of grew back to pre-pandemic levels.

Ryan Thomes: The other thing that we certainly didn't have the foresight to predict that Russia would invade Ukraine and that NATO would impose sanctions that would create this additional supply shock, but we did certainly acknowledge that supply shocks in energy markets are always a risk. You think about where oil is produced in the world, and we're talking the Middle East, Africa, Venezuela, Russia, they're all big producers of oil. And they're not exactly hallmarks of geopolitical stability. And so, their conflict in those regions is reasonably frequent. And so, the risk of a supply shock is always kind of there.

Ryan Thomes:  So, again, we didn't predict this whole thing with Russia was going to happen, but it did sort of accelerate or exacerbate our viewpoint by creating an even further shortage of supply. So, where does that kind of leave us today? Well, the big rise in oil prices that came sort of following all these events really benefited energy companies in a big way. So, over the last year and a half or so, it's been by far the best performing sector in small cap and large cap too. But in small cap, the sector itself is up something like 175%, and the index is about flat. So, I'm using some pretty rough numbers here, but I'm not too far off.

Ryan Thomes:  And so, that's a pretty big reversal. These companies have been able to generate a tremendous amount of cash flow in the last year and a half, and many have used it to pay down debt and improve their balance sheets. So, that's really derisk the sector in a big way. So, which we view as a major positive. The other thing is, because they are still attractively valued, they can also use that cash to repurchase shares, which is an accretive use of capital, so long as they're still undervalued. We've also observed some M&A activity among companies that operate and call it similar or adjacent geographies, because there's the ability to take some costs out there and some value add that they can obtain through M&A activity so long as it's done prudently.

Ryan Thomes:  And then finally, the last option that companies can use this cash flow for is to increase their CapEx and invest in some of these new projects that they have been delaying, which at current oil prices are hugely economic. And so, we're kind of at this situation now where the management of these companies are faced with several options, all of which could be very good for shareholders. So, we're still pretty excited about the prospects of energy.

Jenna Dagenhart: Now, Joe, what are some of the characteristics that you look for when selecting stocks?

Joe Gubler:  Well, again, we sort of look at a number of different dimensions at once. And so, value is a very important part of that, generally, the single most important piece of decision making for stocks that we look at. But we really also want to see stocks that are seeing good earnings, momentum, good evolution of the earnings and sales and cashflow trend over the next several months. We want to see stocks that we think have good long-term growth characteristics and potential. Whether you like it or not, momentum works in this asset class.

Joe Gubler:  And so, as a component of a broader overall view of a stock, we view it as a signal of positive sentiment. We actually have a very kind of interesting variation on momentum that we use here in the small cap strategy, where in addition to looking at an individual stock and its momentum over three, six, nine, 12-month time periods, we identify a company as sort of a focal company. And then, we create relationships between that company and other companies in terms of these are suppliers or customers or competitors, or peers who are related in some relevant way. And what we found is that, when you establish those relationships, you can not only look at the momentum of the stock that you're focused on, but you can look at sort of the aggregate average momentum of all of these stocks that are related to the focal company. And that tells you something about whether there's potential outperformance on the horizon for your stock.

Joe Gubler:  And then, beyond momentum, we also look at what I would describe as a quality category of factors. We sort of have competitive strength and balance sheet quality. And within competitive strength, we're looking at things like profitability, sustainability of that profitability margins, but also what's the structure of the industry that you're in. Is it attractive or not? What is your sort of position within that industry in terms of market share? Is that sustainable. And again, all of those things need to then come together. In addition to that top down information that I mentioned before, macroeconomic information about the country that you operate in high level information about whether your country is cheap and seeing good growth and seeing good momentum. All of these different dimensions get unified into a single expected return assessment for every stock.

Joe Gubler: And we think what happens there is that you get a really good balance between different types of characteristics. And one thing that's nice for us is that we're always going to have a cheap portfolio. This portfolio is always cheaper than the ACWI Ex-U.S. small cap index for as long as I've been managing it, that's always been true. But it also has really attractive growth and momentum and quality characteristics relative to that index. And the reason that's important is that, it's very hard as an investor to decide what style is going to succeed in the next time period. There are times when, we talked about value underperforming.

Joe Gubler: When it underperforms for long enough and the stress gets large enough, you have to suspect that eventually that's going to turn, but things can overshoot and you just never know exactly what is going to be the trigger for the market, preferring one style over another. So, we're very confident and comfortable being spread across a number of different, attractive investment characteristics in this portfolio at a given point in time.

Joe Gubler: The other thing that comes into play for us is our firm has a group of quantitative professionals. I'm a portfolio manager that leads a team, that manages this strategy along with some other quantitative co-portfolio managers. But we also have a very large group of fundamental investors at Causeway who look at things from a different perspective. They look at stocks in terms of, "I'm going to talk to management, I'm going to tour the facilities. I'm going to do channel checks and understand everything I can about the structure of the industry that they're operating in." And so, we're not shy about going to our fundamental colleagues when we have a stock that we're looking at and saying, "Look, do you know something about this stock that would be useful to us?"

Joe Gubler: And a lot of times it's about idiosyncratic information. It's things that you might not expect a quantitative process to pick up on. Is there litigation? Is there regulatory risk? Is there something going on politically that might disrupt the ability of that quantitative model to get traction? And so, I think we end up with kind of the best of both world scenario. We're in an asset class that's very large in terms of the number of stocks that it covers. We need the breadth and the repeatability and the consistency of a quantitative process to scour that space and find all these good opportunities. But we also have the ability to have our fundamental colleagues chime in and say," Hey, there may be something about the stock that you don't know that may change your view of whether this is a good investment to make."

Joe Gubler:  Now, does that imply that every stock in the portfolio looks great on value and growth and momentum and quality simultaneously? It has perfect top down macro and valuation scores? No, but you'd be surprised at how often you can find stocks that line up on all of those measures or five or six out of the seven measures that we're talking about. And that's very appealing. You can't always do that in a more efficient asset class. Sometimes, in the large cap space, you have to decide, "Am I buying a growth stock or am I buying a value stock?" I think a lot of times here, because small cap stocks sort of are growth stocks in a lot of cases. You can get both. You don't always have to choose.

Jenna Dagenhart:  And Ryan, is there anything else you'd like to add about value and why you're bullish on value right now?

Ryan Thomes:  We talked about, I think, the biggest advantage, and that's just that it's trading at a big discount relative to history, relative to other asset classes, like large growth in particular, which is trading at a premium. So, I think that's the biggest advantage that small cap and value has in terms of if you're looking at the prospects of it today. Another thing that I think is important that could work in value's favor, at least relative to growth would be the arising rates. So, inflation is obviously getting a lot of attention out there today, as it should. The FED has signaled a willingness to raise rates from here, which warrant some consideration as investors. And higher rates, I think, are unequivocally bad for equities, right? It increases company's cost of capital and makes fixed income, alternative investments, more attractive to investors.

Ryan Thomes:  But I think higher rates are a lot less bad for value portfolios, value equities value indices, relative to growth for a couple of main reasons. The first, I sort of alluded to already, which is financial. So, financial is sort of the one segment of the market, which has the potential to benefit from horizon interest rates and financials generally represent a much larger portion of valued portfolios and indexes relative to growth portfolios and indexes. So, that's one important facet.

Ryan Thomes: The other one, which is a bit less obvious is that, value securities tend to be shorter duration securities than what their growth equity counterparts would be. And so, what I mean by that is if you think about this in terms of bonds, you have a short duration bond pays cash to investors sooner than a long duration bond. But value stocks in general, pay cash to shareholders sooner than what a typical growth stock would. And so, one simple proxy you can use for that would be free cash flow yields. And in small value, you can find a lot of opportunities where you get pretty attractive cash flow yields.

Ryan Thomes: Like, an energy is the real standout. You can get cash flow yields in the high teens today, which is pretty remarkable. But in general, the value part of the market I think is offering free cash flow yields today that are significantly higher than for growth. So, in growth, you get free cash flow yields that are a lot lower, in some cases negative. And that means that the bulk or the entirety of the intrinsic value of a growth stock is really derived from something that's far into the future, which means it's a long duration security. And so, that would imply that it's something that's going to be hurt more by higher rates.

Joe Gubler:  Yeah. I mean, not to mention just as a, you're talking about that competition for yields, these value-oriented stocks just tend to have higher yields. They're going to pay dividends. They're going to be returning cash flow to shareholders. So, at the margin, that's more competitive against a rising coupon in the fixed income space. One thing that we also like in the current environment is that we have significant allocation to emerging markets in this portfolio. It's a part of that ACWI Ex-U.S. small cap index. A lot of our peers tend to stay a little bit more away from emerging markets historically. It's one of our core competencies. We have a standalone all cap emerging market strategy at Causeway that I run with some other portfolio managers. We're very comfortable and familiar with the space.

Joe Gubler:  And one thing that people may find again in an inflationary environment where a lot of these emerging markets economies have a certain amount of commodity export sensitivity. That's going to add a little bit of resilience for some of those markets in the face of inflation that you're not necessarily going to see in some other markets. So, it's another area of interest there. And look, I think, people are inclined to look at the world and say, "Hey, you've got a bunch of, you've got all these different central banks and aren't they all going to move separately and do their own thing?

Joe Gubler: But when you look at a lot of these economies, particularly in the emerging markets, what the big central banks are doing in terms of rates, if they're moving up from a currency perspective, from the perspective of wanting to make sure that your currency doesn't take a hit from being out of sync with where the big central banks are, there is pressure, right? So, I think there's going to be pressure generally worldwide for rates to increase. Obviously, there are going to be idiosyncrasies, individual economies depending on how hot or cold the individual economy is running. But I think central banks everywhere are going to have to be sort of much more careful about where they set rates and where that puts them on a sort of globally competitive perspective.

Jenna Dagenhart:  And as we wrap up this discussion, I want to ask if there's anything you'd like to leave the viewers with, any final points? And Joe, on the note of EM, a lot of investors have become accustomed to thinking of Brazil and Russia. Well, at least until recently India and China, as the most important of the emerging market countries, but this isn't necessarily the case in international small caps. Could you elaborate on that for us?

Joe Gubler: Yeah. We talked a little bit before about how the country composition is very different. I always kind of found it amusing that Russia was in the sort of the BRICS acronym, because it's never really been a huge weight in emerging markets compared to some of the other countries. Taiwan has always been bigger within recent memory. Korea has been bigger. But the people's perspective about emerging markets is that it's Brazil, Russia, India, China. And again, one thing I think to keep in mind, particularly in this small cap universe is that Taiwan is way up there. It is the largest of the emerging markets by weight in that index, and Korea and India are higher up than China.

Joe Gubler: So, that's a very different kind of configuration. And Russia is tiny in this asset class. So yeah, what people think of in terms of emerging markets, I think it's pretty different. Your emerging markets, small cap universe, and the opportunity set is quite a different thing than what you get from a large cap EM perspective,

Jenna Dagenhart: Ryan, any final thoughts on your end? Anything that you'd like to leave our viewers with when it comes to what small cap investing is and is not?

Ryan Thomes: I think one thing that comes to mind is the risk part of it. And Joe went through quite a few things on this, about the volatility of the asset class and tools you can use to help manage that. But I think there is sort of this, there's two trains of thought here. I think they're usually perceived right or wrong as, as one of the riskier parts in the market. And I think that could be true depending on what your perspective is. So, if your perspective is volatility, then yes, small caps are going to be pretty risky. Some of the most renowned investors out there, the Warren Buffetts out of the world, they, I think, view risk very differently, right?

Ryan Thomes: And so, they take the general view that if you're a truly long-term investor, you should be more worried about protecting your purchasing power over the long period. And so, if you have $100 today and you're going to invest it at 3%, which I think is what the 10-year treasury is at about right now, you're going to have 130 some dollars in the future. But if inflation exceeds 3%, that means you've lost purchasing power.

Ryan Thomes: And so, I think Buffet's view, he would prefer long term returns in the high single digits or low double digits. And to achieve that, is willing to endure some of that volatility or accept some of that volatility in a way to protect that long-term purchasing power, because you can invest in very safe assets and you get a guaranteed return, but you almost get a guarantee of a loss of purchasing power. And so, I think, if you're a very long-term investor, I think, if you take the perspective that, that's your ultimate goal, I think you would view risk differently and maybe be a lot more amenable to the small cap asset class.

Ryan Thomes: So, I think what I would leave people with is, small value has been the best performing equity asset class over time, and its inefficiency, I think, creates a lot of opportunities for active managers. And then, it trades right now at a pretty attractive valuation relative to its own history and relative to other parts of the equity market. And so, it's also less exposed, I think, to the effects of higher interest rates than what some other parts of the equity market are. So, I think we're pretty excited about the prospects for small cap value.

Joe Gubler:  Yeah. And let me just sort of put a finer point on something Ryan was saying before. We've talked a lot about why people should be in the small cap asset class. What's interesting about it? But particularly if there's any asset class where you want to be active, where you don't want to settle for what the index has to offer, this is that asset class for a lot of the reasons that we've covered. The amount of dispersion in the opportunity set, the inefficiencies. But I'll just throw another thing out. From a risk perspective, it's very hard for indexes to track this asset class without a fair amount of tracking error, which is basically how much volatility you're going to have around the target of actually delivering the returns of that market.

Joe Gubler: And so, as an investor, when you think about allocating capital, one of the things that you'll look at is how much tracking error am I taking on? How much active risk am I taking on by doing this? Even passive alternatives in the international small cap space have three and a half, four percent tracking error, which is really, getting up towards the amount of tracking error that you get from an active strategy in the first place. So, given all those inefficiencies, given the opportunities, and given the fact that from a risk for tracking error perspective, you can't really do too much better anyway. To me, this is an asset class where you want to be active. You want to be here and you want to be active.

Jenna Dagenhart: Well, I wish we had time for more, but we better leave it there. Joe, Ryan, thank you both so much for joining us.

Joe Gubler: Thank you.

Ryan Thomes:  My pleasure. Thanks for having us.

Jenna Dagenhart: And thank you for watching the Small Caps Masterclass. Once again, I was joined by Joe Gubler, Quantitative Portfolio Manager at Causeway Capital and Ryan Thomes, Portfolio Manager at Hotchkis and Wiley. I'm Jenna Dagenhart with Asset TV.