MASTERCLASS: Liability Driven Investing - October 2019
October 7, 2019
Sue Lee: Welcome to Asset TV, I'm Susannah Lee. Small caps stocks are starting the year strong, rebounding from 2018's steep losses. The Russell 2000 Index, which tracks small caps stocks, is delivering double-digit returns so far this year beating the benchmark S&P 500's gains. Small caps performance is also a good indicator for investor appetite for debt.
Sue Lee: Where are we in the cycle? Joining us now to give their insights are Joe Gubler, Quantitative Portfolio Manager at Causeway Capital Management, along with Jay Kaplan, Portfolio Manager at Royce & Associates. Sue Lee: 00:47 What a stunning turnaround in January for the markets, especially the small caps leading the way. Jay, let me start with you. With small caps so strong in the early part of this year, is it time for a pullback right now?
Jay Kaplan: Well, you never want to predict a pullback, but let's think about where we've come from. 2018 was shaping up to be a perfectly fine year until we got to the end of August, and from the end of August to the end of the year the Russell was down around 22%, 20% of that in December. We really had a small cap bear market in the span of a month. From Christmas Eve till now, the Russell's up about ... A lot. It's made up most of those gains.
Jay Kaplan: Year to date we're up at about 16 and change as we speak today. That's a lot of performance for the months of January and some of February. Could you argue that we've had a pretty good year's worth of performance so far? Three weeks into February? Probably. Should we expect that the rest of the year will continue on the same upward path? I'm not sure that that's the case. Could there be a pause? Of course there could.
Sue Lee: How about you Joe? Small cap stocks sold off sharply at the end of 2018, but that was after years of underperformance, right?
Joe Gubler: Yeah, you do have some pent-up underperformance, particularly for EM small cap stocks, which really started struggling much earlier in the year in 2018. If you were to look at EM small cap stocks just for the fourth quarter, they were down 7 or 8%, but they had already been struggling earlier in the year. Jay mentioned the case of U.S. stocks, they were humming along quite fine through the beginning of the year and then took a really big hammering at the end of the year.
Joe Gubler: EM stocks, small cap stocks sort of drifted down steadily throughout the year, but if you're still looking at ... Whether you look at EM or IFAs, small cap stocks, you're looking at stocks that are down 18, 20% as a market for the year, and they haven't bounced back in quite the same way that U.S. stocks have. You've seen international small cap stocks come back 8 or 9%. So far this year it ... I looked at the numbers, it might be different by now, could be much more performance today.
Joe Gubler: What you've seen is that they've retraced a little over half of what they lost last year. Whereas U.S. small cap stocks, depending on the index that you look at, were only down about 10% all of last year and they've been up. We look at the MSCI U.S. Index, it's up about 18% year to date. I think across that spectrum you do have to look at that big reversal and say, "That look, 8, 9, 10% for a one month and change period is a lot of performance." You could see this kind of cool off and consolidate for a while.
Sue Lee: Jay, Wall Street is expecting a nearly 3% decline in small cap earnings in the first quarter. What are the headwinds for small cap earnings for Q1 and the remainder of this year?
Jay Kaplan: The earnings picture is a little tricky. There are a lot of things going on, some of which are maybe obvious, some not so much. One of the easy things to think about would be taxes. If you are an EPS buyer of stocks, and at Royce we're not really EPS buyers. We think about cap rates and operating income. If you're looking at EPS, which includes taxes, in 2018 many companies had gigantic benefits from tax decreases. You're not gonna have those again in '19, so that's a bit of a headwind. There is, although you don't see it in the headlines, there's inflation in the system, and we can talk about that if you want some more, but companies are seeing inflation in their supply chains. There's some pressure on margins. That's also a bit of a headwind for earnings.
Jay Kaplan:I think if you put those two things together, the earnings growth rates are going to be slower than they've been in the past couple of years.
Sue Lee: Joe, what are your thoughts on Q1 earnings?
Joe Gubler: Yeah, I think the challenge for international small caps is that there's so much uncertainty. There are a number of things that would need to be resolved in order to clearly answer that question, so we've got ... The UK's the second-largest country in the international small cap index. We've got a big Brexit decision point March 29th, so where earnings go from there partly depends on what the political process does. We also have ... One thing that's interesting about international small cap stocks is that they do have less external international revenue exposure than their larger cap counterparts, but there's still a fair amount of foreign international revenue exposure, non-domestic revenue exposure for a lot of these names.
Joe Gubler: The stocks that Jay looks at in the U.S., small cap stocks are like 80% U.S. domestic revenue exposure on average. The numbers are smaller as you go into the international small cap space, and therefore a lot of what we're seeing about trade and trade tensions and resolution of issues that could affect supply chains that companies use around the world ... For me, it's more of an earnings uncertainty issue in the small cap space, and I think that's what has people kind of trying to figure out what's coming next.
Jay Kaplan: Joe raises an interesting point about international exposure in U.S. small companies. While it's true that people think there's not a lot, if you sort of slice and dice a little bit and banks, which is a big part of small cap ... Small banks don't do a lot of business overseas, so that's true. Utilities, REITs, those are mostly domestic businesses, but within the materials companies and the industrial companies in the U.S., they really are global businesses, so there is a fair amount of global exposure even within U.S. small caps.
Sue Lee:With these domestic companies for you, is recession or inflation, which you mentioned earlier, a bigger concern?
Jay Kaplan: I think right now it's inflation. I think if we were talking in December when the market had its pain and the yield curve looked like it was about to invert, I think the world had some worries about recession. We seemed to have gotten over that. The Fed is on pause right now, that's a good thing I guess because they didn't want to cause a recession. I think now inflation, which nobody's talking about really and I'm a contrarian, so I try to think about the things that people aren't talking about or thinking about that aren't so obvious.
Jay Kaplan:I think inflation could be looming. We talked about supply chain pressure, number one. Number two, think about employment. Most Americans who want to work are pretty much working. We're basically at full employment, but there really hasn't been any pressure on wages yet, so my sense is that's going to be inevitable.
Jay Kaplan: If there's supply chain pressure and then we get wage pressure, the next step after that is to start to see some headline inflation. You're seeing it. The consumer products companies are starting to raise prices. On the tape today, Hershey's ... Poor Hershey's just announced that the price of chocolate is going up, so your Hershey Kisses are going up. We're gonna start to see in households, we're gonna see inflation now. I think that's a bigger risk, but it's one of those risks that's kind of off the radar.
Sue Lee: Do you see a recession in the looming?
Jay Kaplan: I would say in the U.S., I can't find any evidence of a recession right now. That means we're probably at least a good six months in the clear.
Sue Lee: Joe, let's go overseas internationally. Sentiment toward Europe's growth is not particularly strong, but European small cap stocks have delivered some strong performance, currently offer a large discount over U.S. equities, right?
Joe Gubler: Sure.
Sue Lee: Aside from exposure to international stocks being important, how important is top-down information in building an international small cap portfolio?
Joe Gubler: Well, it's interesting. One of the things we were just talking about, inflation kind of ends up having an impact on a lot of topdown issues for us as well. What does inflation look like? What do relative interest rates look like across countries? How does that then affect exchange rates? We're investing locally in these names, and so we do have aspects of our top-down model that are looking at currency to try to understand which way that might move. We do look at things like leading economic indicators, current count surplus and deficit dynamics to get an understanding of really just which countries may offer kind of a macro economic headwind to stocks that operate there or a tailwind.
Joe Gubler: Having said that, 90% of our decision-making process is based on bottom-up stock level information. I see the top-down information as being important, there's sort of a guardrail there, but really, especially in the small cap space where our universe is 4400 stocks ... I'm a quantitative investor. This is a quantitatively-driven process. We love breadth. The larger the universe that we can choose from, the larger number of countries they're distributed across, that works really well for us. That's why you see 90% of that decision-making weight being bottomup.
Sue Lee: Tell me why you think there's advantages to the quantitative approach.
Joe Gubler: Well, I think one of the things that is interesting about an asset class like international small cap is that it is in a lot of ways a growth asset class. My firm sort of has a history in value investing and even within our quantitative process, value is the single-most important factor that we use. In a growth asset class, EM or international small cap, people come there for growth rates. They're excited about the growth opportunities that those stocks present.
Joe Gubler: What we've found is that we always want value to play the largest role in what we do quantitatively, but we want that to be supplemented by information about near-term earnings momentum. Price momentum as it bears on sentiment. We use ... We think quality factors are extremely important in this context. Quantitatively, we can take all of those sort of disparate pieces of information and blend them together into a unified view for each of those stocks, and that's worked pretty well for us.
Sue Lee: Jay, with the current global backdrop, a U.S. allocation is one of the easiest to create a compelling narrative for. What are your thoughts regarding finding opportunities here in small caps?
Jay Kaplan: There are many opportunities. There were a lot of opportunities in December, but now they're up 16% from New Year's. There are probably fewer today and the areas where there are opportunities if you're a value investor are in the more cyclical areas. Places like banking, trucking, some old tech technology are some of the areas where we're looking for value.
Sue Lee: Joe, aside from Brexit uncertainty, what challenges have posed a ... Posed to the relatively larger index stocks do you think that the small caps in Europe are shielded from?
Joe Gubler: Well, look, I think there is still ... There's a shift. There's more domestic revenue exposure for small cap stocks in general than for large cap stocks. That means that a lot of the stocks that you're looking at, the main concern for them is gonna be, what is that domestic economy doing? Not as much about trade relationships and barriers that might be erected, but I think Jay made a good point. When you drill down into sectors, it can vary a lot. There will be certain sectors where that's true, but when we look at technology, when we look at energy, there are areas where that is still gonna come into play.
Joe Gubler: Uncertainty about trade ... We have a lot of exposure to Taiwan. There are a number of outsourced design and manufacturing firms, component manufacturers, all through that supply chain spectrum in Taiwan that ... I think part of the reason you saw a lot of these names sell off was that in addition to all the other concerns that people had, people started to wonder, is it possible these supply chains get rerouted away from sort of the China/ Taiwan nexus. It doesn't mean that that's the base case. The likelihood is that after a lot of saber rattling something gets sorted out, but when you go into a risk opt environment like we had in the fourth quarter, investors have this tendency to say, "Look, that's a complication. I don't like it."
Joe Gubler: There are a number of things that investors are quite happy to run away from, and you can see that they did that. One ... I'm a quan guy, so I'm gonna throw out some stats. I looked at ... I was going through my client reviews and just astounded by the number of stocks that were down huge magnitudes in the small cap space in the fourth quarter. I realized that if you went back through all of 2018, some of these stocks have been kind of silently suffering a long time through there.
Joe Gubler: There are 4500 stocks in the ACWI U.S. Small Cap Index. For 2018, 600 of them were down 50% or more, which is an astounding number. 50% down for a stock is ... I mean, that's armageddon. You're basically saying there's something horribly wrong with that stock. That can happen from time to time if you find out that a stock's management team is horrible or they do a terrible merger or you find out that they've been manipulating earnings. That's not what was going on here. You don't get to 600 names in one year that way. What you're seeing is an expression of a risk-off mentality.
Joe Gubler:You can take those numbers further. There were a thousand stocks out of 4500 that were down 40% or more, and there 1700 stocks that were down 30% or more. There was an extremely big risk-off effect on these stocks and that's why we've seen things sort of pivot and go so aggressively in the opposite direction this year. The psyche, the mentality changed very quickly and we were talking about this off-camera. A lot of it unfortunately is just the Fed pivots to a different position. The market mood changes very dramatically. Those stocks are not that different today than they were in the middle of December. Sue Lee: 14:50 Did you go bargain hunting?
Joe Gubler: We did, yeah, and that's one of the advantages of being a value investor, right? When people lose their mind you sharpen your pencil and you figure out what to buy. We have a portfolio that as of the end of December, it's a little different now because of the rally, but as of the end of December it traded at 7.9 times forward earnings, which is incredibly cheap in the small cap space. Now, the index was trading at about 13 times, and now after the rally we traded at about eight and a half times forward earnings. You can build these incredibly cheap portfolios in the international small cap space.
Joe Gubler: A lot of that is due to the fact that EM small cap stocks believe it or not actually trade at a lower multiple than EM large cap stocks do. You hardly ever see this in small cap, right? This where the growth is. You often see higher multiples. EM small cap stocks have been punished for years. They're very cheap. That's one of the reasons why we have a meaningful overweight to EM stocks in our portfolio.
Jay Kaplan: Way cheaper than here.
Joe Gubler: They're very cheap.
Jay Kaplan: Way cheaper than here.
Sue Lee: Here, though, aside from Brexit, are headlines regarding trade disputes also a factor for you, though, for domestic stocks?
Jay Kaplan: Oh, sure. Well, I mean, it's ... Number one, it's just the noise of the day and it gets back to saber rattling and at some point there will be some clearing of the dust and some clearing of the smoke. We don't know what it will be, but there will be trade again and things will eventually be fine. Back to the point about China and spending in China, you can see that in the small cap technology stocks that we trade in capital spending for capital equipment in technology has come to a grinding halt really, and a lot of that equipment goes to China. Trade wars are definitely a big deal, but at some point things will calm down.
Sue Lee: Do you have anything further to that on
Joe Gubler: No, I agree with that. I think the ... What you end up with at a time like this is there are a lot of investors who don't care for that uncertainty. Again, we have stocks in the portfolio that trade at three and a half, four times forward earnings because of that, the fact that there's a large investor clientele who does not want to deal with the uncertainty that is present there. There is a point ... We're value investors ... There's a point at which we're gonna be willing to take on the risk.
Sue Lee: Why not access international stocks passively?
Joe Gubler: Yeah, this is an interesting question. Something that we only became more aware of once we got into the space, but I think a big part of it is that you really will struggle to find a small cap passive proxy that doesn't have 3, 4, 5% tracking error to the index, at which point you're talking about tracking error levels ... Level of relative risks to the index that look a lot like what ... Especially in our case of what a quantitative active manager would do. Add to that the fact that this is an inefficient asset class. In most asset classes your median manager struggles to deliver alpha. That's not true in the small cap space.
Joe Gubler: Most managers larger than 50% share of the managers produce positive alpha after fees. That shows you something about the inefficiency of the asset class. There are a number of reasons for that. Borrow costs are extremely high, which means it's hard for sort of long-short arb investors to quickly squeeze out inefficiencies. There are 45 countries to cover. There are 4500 stocks to cover. As I mentioned, that breadth works to our advantage from a quant perspective. Really at the end of it, despite all those things you would struggle to find a passive international small cap proxy that doesn't have a lot of tracking error anyway. You might as well get some alpha with that tracking error.
Sue Lee: You mentioned Europe and Taiwan. Anywhere else in the world you're finding opportunities for small caps?
Joe Gubler: Geographically, yeah, we do like Taiwan. We have a modest overweight to China. We ... EM as a group, we do have about an 8% overweight compared to the index in EM stocks overall. We have ... In the Euro area we're underweight pretty substantially. We're not finding a lot in Germany, France, Spain. Some of that weight is going into some of the Scandinavian countries, so Norway and Sweden. We are, I should point out, modestly underweight the UK. The UK's a big constituent in the international index, around 13 or 14%. We're about 50 basis points underweight there, so we still have a lot of exposure to it on an absolute basis, but we're not seeing enough compelling value there that we want to be overweight the UK.
Sue Lee: Jay, domestically are small cap stocks in general insulated from all the international unrest or headlines?
Jay Kaplan: If you want to oversimplify in general, in general they are, and people use that as a reason to buy them when times get tough overseas. You have to pick your spots and we talked about this a little bit. If you're a bank in a small town in New Jersey, where I live, you don't do a lot of international business, right? You're financing the auto body shop and some home mortgages, so whatever happens in the UK for Brexit doesn't mean a thing. If you're running an electric utility in Wisconsin, it doesn't really matter. If you're a REIT that buys office buildings in Milwaukee, that doesn't matter at all. If you're in the middle of the country and you're making pumps and valves that you sell all over the world, well, of course that matters.
Jay Kaplan: I think ... I'd like to come back to a point about active-passive I think which we didn't really get to hit on in the U.S. and when we think about small caps in the U.S. and the Russell 2000, that's a very interesting index. It's an index where a third of the companies are entirely unprofitable. There's a lot of risk embedded in that, so folks when they're looking at U.S. small caps and active versus passive, if they're taking a passive position in the Russell, a third of what they own doesn't make a nickel, may never make a nickel.
Jay Kaplan: A lot of it is biotech. A lot of it is internet and software that makes no money. Companies that are very dependent on the capital markets and their next capital raise to be successful. In the environment we just came from, any company could have raised money. You saw in December, no companies could raise money, so sometimes there's a whole level of risk involved that people I think just don't consider.
Sue Lee: Speaking of ... You spoke about value earlier, value in small cap space has struggled for many years.
Jay Kaplan: Greatly.
Sue Lee: How attractive is a value opportunity compared to history for domestic small caps?
Jay Kaplan: I would tell you it's very attractive, but we could have had the same conversation probably once a year for the last five years. Small cap value has been out of favor. This year so far to date, small cap value has almost caught up to small cap growth, so that's a post in the right direction I guess. When you look at valuations, small cap value stocks are way less expensive. The earnings power is way better better. They actually have earnings. As interest rates go up, and part of my contrarian idea is that interest rates will again start to go up because if we're not gonna have a recession, the economy is good, rates will tend to go up. As rates go up, the discount rate that we use on companies that don't earn to value those assets will make those assets worth less, so those stocks will not perform as
Joe Gubler: Did you say worthless or worth less?
Jay Kaplan: I did ... You could take it either way. The companies that are steady earners generate a lot of free cash flow in an environment where interest rates are no longer zero over a nice three- to fiveyear holding period should do just fine. I think that the environment is pretty well primed for a small cap value hopefully to raise its head up again. We'll see, though.
Sue Lee: Joe, has the strong rally coupled with downward earnings revisions made small caps expensive again in a short period of time? Taken into light the Russell 2000 is now trading at nearly 20 times forward earnings?
Joe Gubler: Yeah, I mean, this is something that we were alluding to before. International small cap stocks trade at about 13 times forward earnings. They're not incredibly expensive and in fact when the EM portion, as I said, the small cap stocks there actually trade more cheaply than the large cap stocks do, which is often an unusual situation to find yourself in. I would just reiterate what Jay was saying about interest rates because that is an inexorable weight on growth stocks. When you do start to see a normalization there, that is just math. I'm a physics guy. I respect the math
Jay Kaplan: I was a math guy.
Joe Gubler: Yeah, so
Jay Kaplan: Thinking about math.
Joe Gubler: The math is going to cause a lot of pressure for these growth stocks and we're gonna be well-positioned to see that. Now again, same on our side. We've been saying this for a while. We have a portfolio that trades at eight and half times forward earnings. It's traded very cheap for quite some time. Value has kind of flirted with a rally here and there but never really sustained one. I think there's a lot of ... There's definitely a lot of pent-up pressure there for value stocks.
Sue Lee: Joe, small cap companies tend to be businesses with long-term goals. Yes?
Jay Kaplan: Sure.
Sue Lee: The U.S. growth is currently late in the cycle as you've mentioned. How much more can we expect positive performance from small caps? Is there much in the way of valuation cushion if conditions deteriorate?
Jay Kaplan: I think in small caps as a whole, there is very little valuation cushion at 22 times earnings or so for the Russell 2000, which by the way, when people quote PEs on the Russell 2000 they don't quote the non-earners.
Joe Gubler: Right, exactly.
Jay Kaplan: We're gonna ignore those and the rest sell for 22 times. Is there a lot of cushion? No, but have valuations really come down much from where they were in the summer? Not so much. If you thought stocks were a little expensive in the summer, which I kind of thought they were, as a whole they remain sort of expensive today. Margin of safety, maybe not so much, but if you're a stock picker, like we are at Royce, and you're forming around in cyclical areas, there are stocks that maybe aren't as cheap as Joe's EM stocks, but there are stocks that sell at 10, 11, 12 times earnings that are really good companies that should do perfectly well.
Sue Lee: Joe, in the areas that you cover, when do you see the next slowdown in the economic growth happening? How are you preparing your client for it?
Joe Gubler: I'm gonna for a second dodge that extremely difficult question and reiterate something that Jay said because we're stock pickers. If the Russell's at 22 times forward earnings or small cap stocks internationally are at 13 or 14 times in aggregate, that's less what we're concerned about and we're more concerned about, what's the value dispersion within that asset class? If I look at the cheapest stocks versus the most expensive stocks, we're not gonna buy the most expensive ones. That's not what we do with as much value weight as we have in our process. We looked at these numbers at the end of December, so they've maybe moved a little bit from there, but not by too much.
Joe Gubler: If you look at value dispersion by basically saying, "Let's look at our risk model's value factor", so we build our own proprietary risk models, sort of borrow type models, but tailored to our processes. We can take the value factor in that model. We can segregate stocks into the cheapest and most expensive quintiles and then we can look at how they're trading on a PE or an earnings yield basis and look at the difference between those two groups of stocks. What we actually find in small cap right now is that we are cheaper ... That value dispersion is higher right now than it has been at 88% of the times throughout history. That's a pretty ... From a stock picker's perspective and the amount of value dispersion you see there, that's a pretty attractive environment.
Sue Lee: Now your global economic outlook and how you're preparing your clients for it.
Joe Gubler: Well, I tell you ... I tell you one thing that we do is we attempt to build a portfolio that is very balanced from a country exposure perspective, from a sector exposure perspective, from an individual stock perspective. We have active weight constraints at the country and sector level, plus or minus 5% relative to the index. Plus or minus 2% at the individual stock level. A lot of that is designed to say we're also balanced on value versus growth versus momentum. A lot of that is designed to say it's very difficult to figure out which style or which economic regime is gonna take precedence next year or next quarter. We want to build a portfolio that is ready for a large range of conditions.
Joe Gubler I'm sort of sidestepping that question by saying, "We don't build the portfolio in such a way that we're gonna put a 10, 12% overweight in the UK and hope that things work out or that we're gonna demassively underweight some country and then deal with the consequences of being wrong." The country that we like least right now is Japan. It's nearly ... I think it's a 4% underweight, so it's nearly at our maximum level of underweight. We like to talk about make or break bets. None of those positions that we put in the portfolio are make or break bets. They will erode our performance a little bit if we're wrong, but we'll live to fight another day.
Sue Lee: Moving over to debts, Jay, shares of debt-laden companies have led the share for small caps to outperform so far in 2019. How much does an expected pause in the Fed's rate hike support a further run for small caps?
Jay Kaplan: That's a good question. I think that the Fed's pause was probably the consummate cause of the rapid inflection that we had Christmas. In December there were no junk bonds ... No junk bond deals done in the month of December, so that part of the capital market completely seized up. Historically if you look, junk bond ... When junk bonds do well, small caps in general do well. Over time, small cap stocks have gotten more leveraged.
Jay Kaplan: By the way, at Royce, we don't use companies that have a lot of leverage. We're kind of anti-leverage, so when times get tough as they did in December, we did okay because we're not doing a lot of leverage. Even within small caps, leverage has gone up. A lot of that leverage has been in the bank markets, so a lot of those ... A lot of that borrowing is floating rate. If the Fed unpauses and short-term rates start to go up again, that's not great for leverage small cap companies and they'll take it on the chin. The leverage companies did not do well in December.
Sue Lee: For the companies ... I know you're not investing in those, but the ones that are leveraged, will they find it more difficult to make payments on their borrowings as the economic growth and corporate earnings taper off?
Jay Kaplan: Well, sure. If you get to recessions, highly-leveraged companies generally do not do very well. Number one, because they have trouble paying. Number two, things get much more expensive when they have to try to refinance their way out of trouble. Yeah, so ... We have found that over the long term you have portfolios that are much less volatile in small caps if you avoid a lot of leverage. They can make a lot of money in leveraged companies when things go your way. There was no question about that, but that cuts both ways and we'd rather have lower volatility along the way.
Sue Lee: Joe, should investors be concerned that small caps are seen as more sensitive to debt since they often secure financing through bank loans with adjustable rates than fixed rate bonds?
Joe Gubler: Yeah, one of the reasons we have a quality component to the model, quality sort of subsumes earnings quality and financial strength. Obviously a degree of leverage and indebtedness is a factor in there. One of the things that we're seeking to do with the quality aspect of the model is to make sure that we're dealing with companies that have ... Not only are cheap on earnings but have real cash flow to back up those earnings. What that means is that they are less dependent on debt financing because it's a difficulty for smaller cap stocks.
Joe Gubler: They are going to ... If they need debt financing they're gonna see higher rates and unfortunately when they really need that financing, those markets can all but close up to them. That is a danger. I would say the effect of the quality component of our alpha model is to also to tend to push us a little bit away from the most leveraged, most indebted companies because they can be problematic.
Sue Lee: Can they be the most profitable, though?
Joe Gubler: As Jay said, I think there can be spurts of time when they're gonna do well
Sue Lee: Make a lot of money
Joe Gubler: But we are very sensitive to the level of risk that we're putting in the portfolio, and it's all about risk adjusted return. We use our risk model to assess how much return we think a stock can add, how much risk will it add for that increment of return, and the process is guided towards the stocks that do the best job of giving us high risk adjusted return. What you'll find is that a lot of times those names ... The amount of incremental risk that they add just isn't worth the amount of incremental return.
Sue Lee: Jay, with credit spreads narrowing and small cap stocks climbing, what does that signal for investor appetite right now? What does that say?
Jay Kaplan: Oh, I think investor appetite for small cap stocks is really, really strong. You can see that in the market actions so far this year. One of the things I would point folks to is think about asset allocation and think about how at least I believe and I think at Royce we believe that every equity investor should always have an allocation of small cap stocks. There should always be an appetite, and in times like December when maybe allocations get a little out of wack because different asset classes perform differently, that's the time to reallocate and move money in and move money around to go back to your target allocation.
Jay Kaplan: Cute market timing often doesn't work, so people who try to be cute and got panicked out of the market in December probably missed January and lost a lot of money had they just sort of hung tough. There's plenty of investor appetite right now, but who knows what tomorrow's gonna bring?
Sue Lee: 33:42 Joe, do you think investors are more risk averse now when it comes to debt appetite?
Joe Gubler: I think it changes quickly. I think if you had asked me on December 24th, I would have said, "Yes". If you asked today, that has certainly subsided a bit. I did want to make a point about asset allocation. One of the things that we often cite to clients is that if you look at the universe of international small cap stocks or actually international stocks broadly, including small cap and large cap, if you look at the ACWI IMI or the ACWI XUS, IMI indices, in the neighborhood of 85% of the names of the actual number of stocks are small cap stocks, right?
Joe Gubler: As investors, we have this perspective towards this 15% of the names that are large caps, but all ... The variety, the interesting opportunities, all these different business models, all these segments of the economy are represented by this other 80-plus percent of stocks that are small cap names. When you talk about wanting to have an allocation to small cap, that's one of the reasons that there are so many names there that are interesting.
Joe Gubler: Another thing that we have found, at least for international small cap stocks, that index is actually less volatile than you might think. It's less volatile than the EM large cap index. Of late it's had volatility on par with the IFA index of developed market stocks, and the reason that's the case is that it is certainly true that your average small cap stock is highly volatile.
Joe Gubler: The median volatility of stocks is very high, but another virtue they have is that their pairwise correlation, the amount to which these stocks tend to move together as a unit, is very low. Within a given index, and I'm sure this is true in the U.S. as well, even though the individual stocks are volatile, you can build a portfolio that actually has pretty modest volatility characteristics and then has the additional virtue of having on top of that low volatility, low correlation with the large cap equity indices. There's no doubt that most investors don't have enough of an allocation in small cap stocks given the benefits they can provide for the portfolio.
Sue Lee: Jay, within domestic small caps, what sectors do you find attractive?
Jay Kaplan: I've done a lot of work these past couple of years in banks, small banks, community banks, going back to really when Trump was elected, very small banks were very out of favor then. Large banks had worked, mid-sized banks had worked, even the bigger small banks, if you can say bigger small, the bigger small banks worked, but the really little banks had been left behind. We've done a lot of those.
Jay Kaplan: After Trump got elected, they did very, very well. Now they've come back in a lot. When you saw the yield curve almost invert, that's really bad for main street banks who lend in a spread business, right? They raise deposits and they lend money and as short term rates went up, the cost of deposits went up. The rate at which they were putting out loans didn't really go up so much, so margins got compressed, but credit quality is as good as it's ever been. Losses are very low because economies are good.
Jay Kaplan: Now that the Fed has paused, the cost of deposits has stopped going up, so spreads and margins have stopped coming down, and if the economy grows, credit should still be good. The yield curve ought to steepen, so profitability should get better and these stocks, the multiples should start to go back up again. You can get wonderful banks all over America 10 times earnings today with great dividends, by the way.
Sue Lee: What about technology in your sector? Or your asset class?
Jay Kaplan: Oh, we've been doing a lot in technology. I would sort of call out two different areas of technology. We're not gonna mention any names, but one area would sort of be the arms merchants, so distributors valuated resellers. If you run a company, you're buying a lot of computers, a lot of printers, a lot of tablets, a lot of software, a lot of software licenses.
Jay Kaplan: You're buying those all from a distributor and things have gotten so complicated in areas like cyber and cloud that most buyers, particularly when you get into mid-sized companies, smallersized companies, small governments, school districts, they don't have the wherewithal, the knowledge anymore to implement everything they need to. Not only are they buying hardware and software from these vendors, these vendors are providing services to help them choose and implement the right hardware, software, and strategies.
Jay Kaplan: There are a few companies that are growing very, very nicely that are product agnostic because they'll sell all of the products and those businesses are pretty good. They're great cash flow businesses, have very nice dividends. You can find a few of those in the small cap world. That's one area of tech.
Jay Kaplan: In a totally different area of tech, we're doing a lot of work in semi cap equipment, so the equipment that's used to make semiconductors. A lot of those tools go to China, and as we talked about tariffs and things being on hold, the Chinese have stopped spending for the moment. Those companies are in hopefully what's only maybe a six- or nine-month deep recession.
Jay Kaplan: We'll see, but if they come out of it in 2020, some of those companies are very inexpensive and they have ... Some of them have tools that are on every single chip that gets manufactured. Is manufactured by some component of some of the companies I own. Some of the companies help to make electricity be okay. It's very particular. Some make gas okay the way it needs to be to go inside a chamber. There are a lot of companies that make the tools that make chips that we like a lot.
Sue Lee: Joe, any areas where you are covering you find interesting right now?
Joe Gubler: Yeah, I mean, just to follow up on IT, we're modestly underweight IT across our investible universe, but it is split into some components where there's sections of that we find interesting. The hardware and equipment manufacturers we find more interesting than software and services, but still with an IT, that nets out to close to zero active weight. What we're liking right now, energy is one of our largest overweights in the portfolio. There was ... If you think the sell-off in energy stocks in the large cap space was brutal, you look at some of these small cap energy names. They ... It's easy to find names that were down 50% during that fourth quarter.
Joe Gubler: We also ... We like financials. Our ... A lot of what we're finding that's interesting is insurance companies, so a lot of that financials overweight is driven on the insurance side. Consumer staples were modestly overweight, but again, if you dig in there and you look at the kinds of names, if you split consumer staples out, food, beverage, and tobacco, there are particularly some beverage names that we find attractive. Within that particular segment we are overweight compared to the index.
Joe Gubler: Yeah, it's kind of interesting. We are ... You will find exposure to certain cyclical sectors, obviously energy and financials, but there are some areas where there's some seams and value opportunities have been created. There are a number of ... If you had asked me two years ago, I would have said, "Most food, beverage, and tobacco companies were overpriced." They've had a brutal sell-off since about the middle of 2016. We're finding some of those names attractive again.
Sue Lee: What are you avoiding?
Joe Gubler: Well, communication services is a big underweight for us. Some of these things are less surprising. Consumer discretionary, you get some of these areas that are very exciting to investors who are sort of looking at the growth story and maybe sometimes looking at the growth story without sort of a proper perspective on what can happen to interest rates going forward and, how sustainable are these growth rates in the long term? How much should I be paying for a dollar of exciting earnings compared to a dollar of boring earnings? We looked at this in the EM space for a long time and after the financial crisis investors got very risk averse and they only wanted to buy defensive emerging market stocks.
Joe Gubler: They got to the point where they were paying a hundred percent premium for earnings from defensive stocks compared to cyclical stocks. That ... You get to a point where that doesn't make sense. Defensiveness is a nice property and I'd be willing to pay a little bit extra to get it because they hold up well in downturns, I just don't think you should ever be paying a hundred percent premium for the same dollar of earnings because it comes from an exciting cyclical source versus a ... I'm sorry, because it comes from a defensive source versus a cyclical source.
Jay Kaplan: When you pay too much they're not defensive anymore.
Joe Gubler: Right, that's right. Yeah, that-
Jay Kaplan: You turn them into something else.
Joe Gubler: That's exactly right, and I think that's the mistake that investors make is that this may not hold up well in a downturn if it's one of the things that's massively overpriced.
Sue Lee: Jay, small cap stocks as we mentioned just blasted into this New Year so strong, but if history is any guide, and it's not, right? If it is ...
Jay Kaplan: It kind of is.
Sue Lee: In the previous five best starts to a year, small caps have suffered weaker than average performance in the following three months and squeezed out a 1.2% gain for the rest of the year. What makes this year any different?
Jay Kaplan: I don't know if this year is any different, but let me toss back a different fun fact about small cap stocks. Before last year, there were ... In the 40-some years they've been tracking the Russell 2000, I think there have been 11 down years for the Russell. In 10 of those 11 you had an up year following the down year, and a pretty strong up year. If you look at history, that's gonna bode pretty well for 2019, but by the same token, along the lines of your question, we've had a lot of that already.
Jay Kaplan: Predicting three months, we kind of think more about three to five years, so I couldn't really tell you what's gonna happen in three months. Hopefully we'll make money in three to five years, but I feel pretty good in saying if history is any indication and if history isn't going to repeat itself, '19 could be a profitable year. Will we hold the gains of 16%? We have so far. I don't know, but if I could close the year now, go home and come back in January and put my 16% of my pocket I would probably choose to do that.
Sue Lee: Joe, your take?
Joe Gubler: I mean, we're only up 8 or 9% year to date, so I'm staying at the table
Jay Kaplan: That's not bad.
Joe Gubler: No, it's not bad.
Jay Kaplan: That's not bad.
Joe Gubler: We haven't really retraced what we've lost last year, right? Last year we lost closer to 18% in the international small cap stocks. There still could be some distance to go in that rebound, but I take a similar view to Jay. I'm not that concerned about what's gonna happen over the next three to six months. What I like as I said before is I like how much value dispersion I see within the small cap space right now, and I know that if I am committed to this approach and we grit our teeth through the times where there may be investors who don't agree with us, that is eventually gonna pay off. It always has.
Joe Gubler: The wonderful thing about value is that it's just a mistake investors can't help making over and over. The investor psychology is just tuned to at certain points in the cycle or for other reasons based on what's going on in headlines to too aggressively sort of sell off certain kinds of stocks. I just don't think investors are capable of fixing that behavioral error, which means Jay and I are always gonna have an opportunity to exploit it.
Sue Lee: Will it be value or growth stocks that beat the small cap world?
Joe Gubler: If I
Jay Kaplan: That's tough.
Joe Gubler: I honestly think going forward, I would put better odds on the value stocks outperforming than the growth stocks based on that dispersion that we see, based on the fact that we are pretty late in an economic cycle and I think a lot of these growth stocks will have difficulty as we go through there. They'll have difficulty with rising interest rates as we stated. There's just a number of things.
Joe Gubler: Look, people use the terminology priced for perfection for a reason. You have stocks that are priced a certain way and if everything that people assume is gonna go right for them does go right, they're gonna be fine. We buy stocks that people are almost assuming the opposite of. They're assuming everything's already gone badly. These things are terrible. Often you just need a little bit of a lifting of the clouds and those stocks can do quite well. I feel good about being tilted towards the value side within the small cap space.
Sue Lee: Jay, agree?
Jay Kaplan: Well, I have to agree because I'm talking my book, right? I do agree. If you look over the long term over the Evanson data that everybody's looked at forever, small cap value wins over time and small cap value has had a dreadful cycle really since the Great Recession. It's really been caused by free money. The zero cost of debt capital has really thrown the markets completely out of wack. That has not ended yet.
Jay Kaplan: We started to see some signs of life actually really beginning for me in the middle of 2017. I started to see some signs of life with value sort of picking its head up a little bit. In December, we did okay and value has almost caught up to growth in the Russell so far this year. Value has not hung in there that closely in quite some time, so maybe that's a harbinger of pretty good things to come.
Joe Gubler: I do think the fourth quarter freakout is sort of a preview of what more growth-oriented investors are gonna have to grapple with as interest rates really do rise. I mean, eventually the Fed ... I don't know if you want to use the word "capitulated", but I will. We have a market that doesn't know how to work without the training wheels of Fed support. Eventually I do believe interest rates will normalize. There's a lot of investments out there and a lot of investors who just aren't prepared for that reality.
Sue Lee: We saw with stocks overseas, and there are a lot of uncertainties internationally. Are those uncertainties priced in?
Joe Gubler: I think in a lot of cases they are. Like I said, this is why we can build portfolios that are that cheap to trade at eight times forward earnings because stocks have really been punished for those uncertainties. Look, there's always ... This is a problemistic game, so there is some outcome that could occur that could be much worse than what's priced in, but I tend to think right now that the market's probably priced in something worse than the base case scenario.
Jay Kaplan: Yeah, yeah. Joe made a good point before, and I lot of what value investors really, really do is just about expectations, right? We try to buy stocks where expectations are really low and where the price and the multiple is even lower than the expectations. In those scenarios, most of the time you have two ways to win, right? If a company exceeds the expectations that the market has for its performance and its earnings go up, the stock will naturally go up because earnings are better. If that also happens, you get a re-rating so that really low multiple that you paid for the stock is gonna be a better and higher multiple.
Jay Kaplan: You have two ways to win when you invest in value stocks, so it's all about expectations and valuations and I think it requires patience. It requires patience from portfolio managers to put together portfolios where people basically think you're nuts for buying the stocks that you buy. Investors have to have patience to ride through the cycles and understand that if they hang in there over time, value generally wins.
Sue Lee: Last question for the both of you, starting with you, Jay. What differentiates your approach to that of other managers?
Jay Kaplan: Well, I think one of the key things that we do at Royce is to invest in really good companies that have very strong balance sheets, earn really good returns on capital, and we pay the right price for them. That's helped us have very good performance with low volatility over time.
Sue Lee: Joe?
Joe Gubler: Yeah, I mean, one of the things ... We've been talking a lot about value, but our quantitative process uses value, growth, and momentum, blends those together in the process. Yes, we have a cheap portfolio right now, it also has better near-term earnings, momentum in the benchmark. It has more positive momentum in the benchmark. That's a favorable outcome that we can get from that quantitative process. One of the things that we do that's interesting is, how much weight a stock gets to value or growth or momentum in that process is contextual.
Joe Gubler: We have a contextual approach where we try to understand, who's the marginal buyer for that stock? What do they care about? What are they screaming for? What kind of stocks are they researching? Even if value might get 35, 40% of our weight, typically there's certain types of stocks where we're willing to downgrade that because those investors don't care what we think about that stock. Their ... Our opinion from a value perspective is not as important. Now, we would never go to a zero evaluate, but we can navigate some of those challenges a little better by doing that.
Joe Gubler: The final I think we have that helps us a lot is our firm is composed of both fundamental and quantitative investors. I have fundamental colleagues who manage around $40 billion in developed market value stocks. When I'm confused about a stock or when I'm not sure I know everything I need to know about the stock from a quantitative perspective, which happens by the way. It can happen all the time. Their quantitative models can be fooled by stocks that have litigation or regulatory risks or some change going on in the industry that the model can't see. I have recourse. I can go talk to my fundamental colleagues. They can set me straight on a stock where they think the model might be getting it wrong and we can avoid some of the pitfalls that a pure quantitative investor might fall prey to.
Sue Lee: Great. Thank you both for sharing your thoughts with us today.
Joe Gubler: Thank you.
Jay Kaplan: Thank you.
Sue Lee: Thank you for watching. Our experts today were Joe Gubler, Quantitative Portfolio Manager at Causeway Capital Management, along with Jay Kaplan, Portfolio Manager at Royce & Associates. From our studios in New York, I'm Susannah Lee. This has been Asset TV's Small Caps Masterclass.