MASTERCLASS: Small Caps - March 2020

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  • 56 mins 32 secs
Companies with smaller market capitalizations can present unique investment opportunities in domestic and international markets. The strategies for this segment of the market require tailored metrics and models to manage and evaluate the health of small cap investments. The investment outlook for small caps is examined at the beginning of a new decade with consideration to bottom-up approaches. 

In this panel discussion, 3 experts evaluate the investment landscape for the small caps:

  • Ryan Myers, Quantitative Senior Research Analyst & Strategist, Causeway Capital Management
  • Rayna Lesser Hannaway, Portfolio Manager & Analyst, CFA, Polen Capital
  • Victor Cunningham, CFA, Portfolio Manager, Third Avenue Small Cap Value Fund, Third Avenue Management



Remy Blaire: Welcome to Asset TV. This is your Small Cap Masterclass. The broader US equity markets posted record highs heading into the second half of the first quarter of 2020. The bull rally is extending its run and small caps did not see a January effect as the new decade got underway. From valuations to leverage ratios, the masterclass works for the investment landscape at the beginning of the new year. Today, I'm joined by Rayna Lesser Hannaway, Portfolio Manager and Analyst at Polen Capital, Ryan Myers, Quantitative Senior Research Analyst and Strategist at Causeway Capital, Victor Cunningham, Portfolio Manager at Third Avenue Management.

Remy Blaire: Thank you so much for joining me for the Small Cap Masterclass. Now, if we look back at the decade before this, we know that we saw a lot of unexpected behavior in terms of the markets. But when we look at the decade ahead, we know there's plenty of uncertainty up ahead. So, this is a small Caps masterclass, so Rayna, starting out with you, can you tell me, given what we seen in terms of monetary policy and small caps, this rotation towards companies that are more cyclical and have less manageable levels of financial leverage. Do you consider this to be late cycle behavior?

Rayna Lesser: So your question is about the risk sentiment in the market. And we would agree that we saw a gravitation towards riskier assets in 2019, but it's really hard to say whether this is late cycle behavior or not. What we've observed over long periods of time is that investors often fluctuate between wanting to own riskier assets and wanting to own more defensive assets. And so, it's really hard to predict what's next and we don't try to pull in capital. What we focus on is owning the best the companies that we can find in a concentrated portfolio and holding them for 5-10 years and enjoying the compounding that they can generate.

Rayna Lesser: The foundation of this is really focusing on companies that have strong cash flow generation, really strong capital stewardship, and focusing on companies that are well positioned to deliver shareholder value, no matter what's happening in the economic cycle or in the capital cycle. A big piece of this is focusing on companies that can self-fund their own growth. Because what we've found is that when you own companies that are generating a lot of cash and they can self on their own growth, they're often in a great position to drive their competitive advantage and make great investments for their business, even when everyone else is struggling. Whereas the companies that can't self-fund their growth and they're more reliant on external capital, they can really struggle when risk tolerance drops.

Remy Blaire: Rayna, you brought up a lot of key points there. And I know that you'll be elaborating on some of those points later on this masterclass. So, I do want to move on over to you, Ryan. The strategy over at Causeway focuses on common stocks of companies with small market caps that are located in the developing as well as emerging markets outside of the US. So, can you tell me a little bit about some of the performance that you saw in terms of international small cap companies?

Ryan Myers: Yeah, absolutely. So, as the case in the US, international small caps have a very long track record of outperforming their larger peers. However, the track record has been a little less consistent in the last few years, and it's mostly driven by emerging markets small caps underperforming. And this is a pretty rare occurrence, so we've only seen ... They've underperformed basically for four calendar years in a row as well as the first month and a half of 2020. There were some country-specific factors going on, but it is a rare occurrence. I mean, the last time we saw this was really the late 1990s. And if you take a step back and look at international both emerging and developed, the track record still stands, though. Over the last 5, 10, 20 years, international small caps have outperformed their larger caps by a pretty big margin.

Remy Blaire: And now, Vic, moving on over to you. You're a Portfolio Manager of small cap value fund over at Third Avenue. So, can you tell me a little bit about the long-term capital appreciation by investing in equity securities of small cap companies in the US that are mispriced by the market. What exactly does that mean?

Victor Cunningham: Great question. Our firm was founded by Marty Whitman. And he had a differentiated approach to securities analysis in what he calls was a balanced approach. And a balanced approach meant that the income statement was only part of the equation, and you really need to focus on the capital accumulation of the business over time. So, we were looking at the income statement terms of what the operations is done, but also looking at how that capital was invested and how the company was financed. Because we want conservative finance companies, we want track record of allocating capital over time. So, marrying those through really shows up more on the balance sheet than on the income statement.

Victor Cunningham: So we spend a lot of time looking at the capital account as opposed to looking at the earnings statement when we're assessing securities. So that kind of lends itself to a differentiate portfolio. If you look at the active share across our three product platforms, we're close to 100% because we grade differently than many others and we see value. There is complicated situation maybe aren't as evident in companies, maybe just looking at pure earnings.

Remy Blaire: And before we take a look at the investment landscape, since this is a small cap masterclass, I would like to get your definition of small cap in terms of market capitalization. What is the range at your respective firms starting out with you Vic.

Victor Cunningham: Our wheelhouse is to 300 to 3 billion on initial investment. So, as it gets close to 3 billion, we're generally not going to put money to work in those types of securities. So, we want to buy smaller and we spend a lot more time in this sub-billion dollar range than others.

Remy Blaire: And Rayna, what is the definition over at Polen capital?

Rayna Lesser: For new positions, we focus on companies between 500 million and 3 billion and cap and then we look to trim or sell them between 6 and 9 billion in cap.

Remy Blaire: And Ryan, what about at Causeway?

Ryan Myers: We don't have a strict market cap cut off. We define it more by the universe and we use the MSCI ACWI Ex-U.S small cap benchmark as the universe, but generally, it's companies under a billion dollars in market cap.

Remy Blaire: And now that we've laid the groundwork, we can delve into these small cap approach at your respective firms. So, Rayna, starting out with you, can you tell me a little bit about the metrics that you focus on over at Polen Capital?

Rayna Lesser: Sure, if you think about the distinguishing characteristics in our portfolio, the things that really stand out most relative to our benchmark, the Russell 2000 growth, is the fact that all of our companies are profitable and they all have high returns on invested capital. If you look at our benchmark, what you'll find is that over 40% of the companies are losing money, and that the index in aggregate has negative returns on invested capital. And so that's really a proof point to our focus, high quality strategy.

Rayna Lesser: On top of that, you mentioned balance sheets. That's something that we think about a lot. We really want to make sure that all of the companies that we invest in have management teams that are very intentional and deliberate in how they manage their capital structures. As I mentioned before, if a company is too reliant on external capital for growth, it can lead to tough times when that funding dries up, and we don't want any of our companies to be in that position.

Remy Blaire: And while we're talking about approach, I think it's also important to talk about process. I understand that over at Polen, you do have your secret sauce, which comes together in your management team. So, can you tell us the importance of culture as well as management team?

Rayna Lesser: Sure, when I think about culture, it really is a key ingredient to drive successful long-term compounding. When you think about it, a company's culture leaves in its employees, in its partnerships in the customer experience that the company can drive. And when all of those things are in alignment, a company is really in a great position to maximize the value it can deliver for all of its stakeholders. This is something that we think a lot about at Polen Capital where we have a very strong culture. And it's something that stood out to me from the very first time I encountered Polen, when I went down to the office in Boca for my first interview.

Rayna Lesser: Immediately, when I walked in, one of my now colleagues took me over to what we call the Why Wall, and it has pictures of many of Polen's clients. I was blown away because it was clear that this kind of client-first culture is something that everyone at Polen lives and embraces. And it's something that I am now very, very proud of, as are all my colleagues. And so, as we're looking at different companies, we get really excited when we find employees that share those feelings.

Remy Blaire: I think you really drove the point home about how important it is to have quality management. Now, Ryan, I want to move over to you. I understand that you focus on a multi-factor quant model when it comes to your approach. So, can you tell us about the different categories? And when you're approaching macroeconomics as well as countries, how you aggregate these characteristics?

Ryan Myers: Yeah, absolutely. So, from a bottom-up stock specific characteristic perspective, we want to buy stocks that are cheap relative to their sector peers and their country peers. We want to see growing earnings expectations out of the company, we want to see strong, recent long-term and short term momentum. And we want to see solid quality in the form of prudent top-line growth as well as strong free cash flow conversion. Now, you mentioned from a top-down perspective, we also look at country aggregate and macroeconomic characteristics to help inform our trade-off because there are 48 different countries in our universe. And so, there are a lot of trade-offs that need to be made.

Ryan Myers: From a country aggregate perspective, we're essentially looking at the entire opportunity set within a country on value growth and momentum dimensions. And then from a macroeconomic perspective, we prefer countries with lower political risk, with high current account surpluses or low deficits with attractive currency characteristics and with improving leading economic indicators. And then, from a quant process, we can very seamlessly roll all of these six factor category scores into one final alpha score that allows us to form the final portfolio.

Remy Blaire: And now, Vic, moving on over to you. I know that with your approach that value is key components. So, can you tell me about your views on volatility as well as liquidity, and how you utilize book value within your research process?

Victor Cunningham: Sure. As you mentioned, we're bottom up fundamental value investors. We want to buy companies at discounts to what we consider are net asset value, adding up the assets versus on and off balance sheet liabilities and valuing those assets conservatively. So that's our approach and we're concentrated. We only turn our portfolios over about 20% a year. So, we only need a few investments a year to put in a portfolio. So, we're very picky. So, volatility is our friend. And we wait for volatility show up, and when things get out of favor, then we make our investments, and that's been a very productive cycle for us. So that's something that's very important.

Victor Cunningham: Now, liquidity, given that we are small cap fund is something that's tightly monitored at our fund. And we intentionally are trying to keep the fund quite small in terms of about a billion dollars in AUM so that we continue to execute our strategy effectively. Now, your question about book value is very interesting, because that is something that is core in terms of how we value companies. And last year, it had a tough year with Warren Buffett moving away from it. At Berkshire Hathaway got a lot of bad publicity in the press. But we understand the shortcomings of book value, but it is a star point in our analysis and something that we think about and we think is a terrific reflection over time of how companies allocate capital. So, it's something that is integral to our process.

Remy Blaire: I'll throw out an open-ended question to all of you. We all know that approach is important, whether we're talking about small caps or any other asset class. But we have a section later on in this segment about myths and misconceptions. And some people might think there are only a few approaches to the small cap world. But are there any misconceptions or any myths that you'd like to dispel when it comes to approaching small caps?

Victor Cunningham: I think one myth right now is looking at I think some of the ... People say that it's more risky. But I don't know if you can have a proper risk discussion without factoring in price. And what's happened over the past 5-10 years in terms of dispersion between small caps and large caps. I think that the pricing of small caps have become more and some of those may be inherent risk characteristics are mitigated.

Ryan Myers: I would flag two specific misconceptions. I think that, number one, I hear international small caps are too small an asset class to matter for my portfolio, and number two, that they're more risky. And on the first count, if you look at the ACWI IMI, there about 9,000 stocks. 4,200 of those are in the international or in the ACWI Ex-U.S small cap benchmark. Meaning that almost half of the global stocks that exist are in international small caps. So, by weight, they're about 6%. But Morningstar tells us that only 2% of equity mutual fund assets are invested in international small caps.

Ryan Myers: Now, secondly, to the riskiness question, I mean, I would agree, individually, they do tend to exhibit higher volatility than large caps. That's the nature of the small cap premium and why there's a premium to begin with. However, what's interesting is once you combine them into a portfolio, they exhibit statistics that are very similar to large cap stocks, and that's because their pairwise correlation is so much smaller. If you take every single pair of stock in the index, they tend to be very idiosyncratically driven, and have very low correlation with each other. In fact, in the ACWI Ex-U.S Index only 0.14, which is half that of the MSCI World. So bottom line is you get tremendous diversification benefits by adding them to your portfolio, while also capturing the small cap effect in terms of returns.

Rayna Lesser: One of the common misconceptions that I'd like to dispel is the fact that the asset class is risky, so that you have to own a more diversified portfolio to reduce risk. Yes, the prices can be volatile in the small cap market, but if you focus on the right businesses, you're able to mitigate some of that risk. What we've found is that in our focus on high quality compounders, the margin of safety is in the quality of the business and that those businesses actually tend to be less volatile in choppy or declining environments. And so, it takes away some of those emotional pain points for investors.

Rayna Lesser: And what we found in the face of volatility is that often investors get very emotional and they buy, and they sell at entirely the wrong times. That can really get in the way of delivering long-term investment performance. So instead of adding companies like that to our portfolios, we focus just on the high quality companies. And we don't try to add risk just for diversification sake by adding lower quality businesses.

Remy Blaire: And there are financial professionals in the viewing audience who are watching this. So, you might have a financial advisor who gets approached by their client and their client is concerned about small caps being very risky. So, in a nutshell, if that financial advisor had to tell their client that that's not the case, what would you advise them?

Rayna Lesser: I would suggest to them that there are ways to access the best parts about the small cap asset class without all of the risk. When you think about it, all of the mid and large cap companies that we admire, they started off as small caps one day too. And oftentimes, their best performance happened when they were smaller companies. But the key is focusing on the right businesses, especially businesses where you're able to reduce your exposure to financial risks or macro risk, or even some kind of idiosyncratic risks relative to the business.

Rayna Lesser: The way that we do this at Polen Capital is that we avoid companies that are very cyclical. We avoid companies that have heavy exposure to commodity prices or interest rates or the FDA. We really want to focus on companies that have control over their own destiny. And we find that by eliminating companies like that, their success really comes down to the skill of the management team. And they have more control over their future.

Remy Blaire: Ryan, Vic, would you like to weigh in?

Ryan Myers: Yeah. I would tell that financial advisor that the choice to omit any asset class is potentially risky. Because if you're looking for a truly diversified portfolio, you need to hold the entire market or some subset of it, including international small caps. And even though it's 6% weight, as I detailed before, it offers tremendous diversification benefits, and you're still getting a hold of that small cap premium, which is, I said those that outperform large caps in the long-term.

Victor Cunningham: On the same note, you also have to look at what's happened. I mean, I would argue that given how well large caps is done relative to small caps that the risk return profile is much better in this point. So, I think you need to look at where you are at that point in time, as opposed to just making a blanket statement that it's more risky. It'll go in and out of favor.

Remy Blaire: And indeed, we are seeing the longest bull market in history. So, we do have to consider what we're seeing in terms of the broader market. This might be an obvious question, but it is a small caps masterclass. So, I'd like to ask each and every one of you, what make small caps so great?

Victor Cunningham: The potential for growth. I think, as Rayna mentioned, you can buy these companies at market caps where they have a lot of running room to grow and invest in the future. So, if you're buy and hold like we are, it's much better to be able to buy them when they're in their infant stages and really participate that growth in the early cycle. And that's where really the true compounding comes in.

Remy Blaire: Rayna?

Rayna Lesser: I would really agree that that compounding is really the best part. I've had many experiences over my career to see companies that started off as very small companies that today are anywhere from 50 to over 100 billion in market cap. It's pretty exciting when you find one of those, but you really need to make sure that all the right conditions are in place for that to happen. Because there are many small cap companies where they don't have those conditions in place. Just the same, I've seen many companies that are more one hit wonders in the category, and they've got something good, but they can't repeat it.

Rayna Lesser: And so, to us at Polen Capital, we're really focused on finding companies that are always investing in their futures. That is super important, because if you've got sustainable growth with high returns on capital, it attracts a lot of competition. And so, you need to have companies that know how to scale innovation, and where management teams have a really good long-term strategy and know how to invest for that.

Remy Blaire: And Ryan, what about you?

Ryan Myers: Yeah. We think international small caps are probably one of the least efficient equity asset classes out there. If you look at the typical company in the ACWI ex-U.S. small cap index, it only has four analysts covering it, about one out of five companies don't have any analysts cover it. If you want to short the entire index, it'll cost you about 220 basis points a year, which is twice that of the large cap equivalent, and seven times that of the MSCI USA Index. So that adds to the inefficiency. The other thing about the index is it makes passive replication very difficult. Because there are 4,200 stocks in the universe, the largest single component is only 23 basis points. And so, there are, frankly, aren't that many ETFs that even attempt to replicate it.

Ryan Myers: There's one that I have in mind that tries to track the footsie equivalent, the FTSE Ex-U.S. small cap index, and it's generated 430 basis points of tracking error over the last five years. And so, our view is if you're willing to tolerate that level of tracking error, you might as well active returns to go along with it. And given all the inefficiencies, active managers actually have a very good track record in international small caps, generating about twice the alpha that active managers have in the large cap space. So, for a variety of reasons, they're very attracted. But the inefficiency really makes it well-suited for active management.

Victor Cunningham: And to Ryan's point, that's only getting better.

Ryan Myers: Right, exactly.

Victor Cunningham: What's going on in the marketplace right now and less coverage. So, I think the benefits of hunting in these areas is more fruitful than maybe have in the past.

Remy Blaire: Well, I think there is some obvious and not so obvious answers to that question, and perhaps that will end up on the CE quiz. So, I do want to move on to the investment landscape looking forward. Now Rayna, you did highlight the importance of company's culture when it comes to the space, but how do successful businesses make decisions that you think lead to long-term success?

Rayna Lesser: I think that management teams need to make decisions that are in strong alignment with their employees and their customers. When I look out at the many unprofitable businesses today, what seems obvious is that companies aren't pricing their products or services properly for the value add that they provide to their customers. And while that sounds like a simple thing, with so many unprofitable businesses out there, it's a rarity. And so that's just one example. But also, I can't overemphasize how important culture is because it really elevates everything that a company does when they get it right.

Remy Blaire: And what goes into your research process?

Rayna Lesser: For us, it all starts with screening our universe, where we're looking not just at market cap but we're trying to isolate certain sectors and industries that we believe really lend themselves to long-term compounding. We focus mostly on businesses within technology and consumer, and then some healthcare and industrials. And we exclude any industries or sectors where there's a lot of cyclicality or the commodity or interest rate exposure that I described before.

Rayna Lesser: After that, we're really looking at quality metrics and growth metrics. We're looking for sustainable growth over very long periods of time, we're looking at things like return on invested capital, free cash flow conversion, we're looking at leverage ratios. And what we're really trying to find is evidence that a company can deliver sustainable growth with high returns on capital for very long periods of time, and that they have the right balance sheets to do that. So, once we find companies that exhibit those characteristics, that's when we really start to do the work.

Rayna Lesser: What we're really looking for is companies that have strong competitive advantages, repeatable sales processes, where we really understand where growth is going to come from in the future. We're looking for robust business models, and that includes the margin structure of the business, the returns on capital, the balance sheet, and then we're really focused on finding effective management teams. And to us that means a management team is operating from a position of strength today but is also really focused on laying the right groundwork for the future. So, there we're looking for strong capital stewardship, and a lot of evidence that a company can deploy capital in such a way that they'll be able to sustain their growth in the future. To us it's those value creating reinvestments that they do that really helps keep a company's flywheel going.

Remy Blaire: Rayna, before I move on to you and back to Ryan, I do want to get your time horizon. How long is long-term for you?

Rayna Lesser: Our turnover rate is about 20% per year, and so we're holding companies for five years on average. When we're evaluating companies, we're really trying to get comfortable with what a company looks like 5-10 years from now. And that's where this focus on the future really matters a lot. If you look at many investors in the small cap universe, if you're only going to own a company for 12 months or 18 months, you don't need to worry so much about what's going to happen three to five years from now. But we have to pay a lot of attention to where we think a company will be in the future. And often that means that we find ourselves focusing on areas that maybe won't change as much.

Remy Blaire: And now moving on to you Ryan, I do want to get your take on conditions that boost a small cap performance in your area. So, the two largest economies in the world, US and China, they have been in the headlines on the fundamental front for various reasons, including the trade war as well as the recent coronavirus outbreak. But what countries do you spend the most time analyzing and what conditions are you looking for?

Ryan Myers: Yeah, absolutely. So fortunately, the US is outside of our universe and China is actually only 2.2% of the international small cap index. So, it's much smaller than the large cap space. So, our direct exposure to those two economies is low. However, indirectly as you noted, global economic growth expectations have taken a significant hit, at least short-term, due to coronavirus. Small caps tend to perform and risk on environments when investors are feeling more confident about the future, typically, also coincide with periods of higher inflation expectations. And also, when mega caps aren't outperforming a very big way like they are right now.

Ryan Myers: I mean, everyone knows the FANG stocks in the US, well, there's an EM equivalent, which is the BATS, Baidu, Alibaba, Tencent, Taiwan Semi, Samsung, that are even a larger portion of the EM index. And so just any rotation of market leadership away from those would certainly benefit small caps. Finally, you asked about focus countries. And as I said before, we have a very large landscape of 48 different countries. There are only two countries, Japan and the UK with weights over 10%. And the rest are much smaller. And given this breath, we think that our quantitative approach really makes the most sense because almost in real time, we can make the trade-offs that we need between the countries to adjust to a changing landscape. So, in terms of right now where we're finding the most attractive opportunities, it's the Netherlands, it's Brazil, and more recently, it's China given some of the dislocations.

Remy Blaire: Okay, Ryan. Well, now that we've covered that, I do want to turn the focus over to you, Vic. Now, tell me about the divergence that we're seeing between large caps as well as small caps and between growth and value and what your focus is right now.

Victor Cunningham: Both have been out of favor for quite some time. If you look at the 10-year numbers and in small versus large and value versus growth, they've been underperforming. Now, we don't really think about investments in terms of value investments versus growth investments, we do believe in growth. Our founder Marty's to say, if the company's not growing, then your net asset valuation is probably incorrect. So, we care about growth, but we don't want to pay a lot for it. We're value investors and we are trying to find situations that are misunderstood.

Victor Cunningham: Many of the companies in our portfolio have complicated management structures or ownership structures that don't really lend themselves to indexation or aren't as obvious to maybe the naked eye and require that analysis. So, our portfolios are different. And we're trying to find things that are misunderstood, assets that maybe aren't getting enough recognition in the marketplace. So that's kind of where we're spending our time. And if you think about where we're focused right now, I'd say we're a little bit more in a de-risking phase. We have a sleeve portfolio that is made up of, we call our kind of time marks best situation bucket, and that bucket got up to about a third of the portfolio.

Victor Cunningham: It's like we have few energy investments in there and things that are deeply, deeply out of favor, well-capitalized. We're comfortable with their position, but they're just under a lot of pressure from a stock price perspective. That sleeve has compressed from better third down to a quarter over the past year as the markets went up. So, we're definitely focusing more on protection of capital rather than growth of capital. But we're still optimistic that there's plenty of good ideas in the portfolio.

Remy Blaire: Vic, you just mentioned energy there, and we know that growth affects that space. So, can you give us a little bit of insight into what you're paying attention to?

Victor Cunningham: So, we're still optimistic that oil is very important part of the equation. But right now, if you look at the oil sector on its own, it's down two-thirds over 10 years. So, it is under ... It is really the only sector that's been down over 1, 5 and 10 year periods. It's been under a ton of pressure and really investors have become agnostic to it or against it. So, we think that's an opportunity. So, we're looking for companies that are very well capitalized in that space that don't have any financial risk because that's critical in everything we do.

Victor Cunningham: So for example, we have a company named Tidewater in our portfolio that went through the bankruptcy process. Their balance sheet was cleansed in that process. They've got a strong balance sheet. Their revenues are growing, cash flows are stable, and they've got a great portfolio of assets that we think aren't getting much value in the marketplace. Those situations are very interesting to us. We're patient investors, so we will wait out for the sentiment to shift. But we think when it does, companies like that will be strong contributors for our shareholders.

Remy Blaire: Well, Vic, later on in the masterclass, I'll be asking you a little bit more about that sector. But I do want to move on over to small cap realities. Now, we know that there are big fluctuations when it comes to the space in a short period of time, depending on what we're looking at. But Rayna, when you look across the small cap landscape to find companies that you consider a great investment, why is a concentrated portfolio best businesses an approach that you think provides these compounding returns?

Rayna Lesser: So your question is about concentration, and to us it's pretty simple. The reason why we own so few companies is because the types of companies that we look for are really hard to find. And when you think about kind of the nature of our universe and the existence of so many companies that are unprofitable or that are over levered, and then you layer on all the different things that we're looking for in terms of repeatability of growth, high margins, the right kind of management team, value creating reinvestment, it's hard to find all of those things in combination. So, we believe that the only way to truly get a high quality portfolio in this small cap universe is by managing it in a concentrated fashion.

Remy Blaire: Rayna, now that we've gotten your take on this space, Ryan, can you tell me why you think international small cap stocks are under appreciated? And as a category tell me about the less exposed things that you're seeing when it comes to the potential risk of trade barriers.

Ryan Myers: Yeah. They're certainly under appreciated. I don't have a great answer as to why because they're very attractive. I mentioned they're very inefficient, passive replication is hard, active managers have a much better track record. When it comes to trade barriers too, they're much more immune, because if you take your average international small cap company, well, fully 60% of its revenue comes from its domestic market. And that compares to 43% if you look at the equivalent of a large cap. And so, they're much more focused on their domestic economy, so any trade barriers or tariffs will be less impactful for them.

Remy Blaire: And before the move away from you, Ryan, since we're talking about trade barriers, can you give us what we're seeing right now? Can you give us a little bit of further insight about what you expect to see and what we're seeing right now.

Ryan Myers: Yeah. I mean, everyone's obviously focused on China, US specifically. We had the January 15th announcement of a preliminary deal between China and the US. And the basic, a lot of the specifics weren't explicitly revealed, but the core idea was China will buy more in terms of agricultural purchases, and over time, there's a hope that will lead into more of a deal with regard to intellectual property and items like that are probably a bigger barrier to a deal getting done. So, there's preliminary hope. Obviously, the coronavirus sort of has potentially disrupted that. It may reduce the dollar volume of the final agricultural purchases.

Ryan Myers: However, China has been very explicit just in the last few days about its willingness to stimulate the economy. I think for now it's longer term desire to reduce credit growth in the country has been tabled. And they're more focused on reducing taxes, lending to businesses affected directly by the coronavirus and sort of stemming the tide. Because it's sort of a very big political risk for the leaders in China right now that they sort of have to address this before anything else happens.

Remy Blaire: I think you've highlighted some of the uncertainties that are out there in the investment landscape. But, Vic, I do want to get your take on some of the small cap realities and in particular to leverage building. So, what do you pay attention to in terms of small caps, especially when it comes to index names?

Victor Cunningham: Balance sheets are really everything in our firm, so we don't have much tolerance for a balance sheet leverage at all. So, what we're seeing right now, if you look at The Russell 2000 Index, things are going in the opposite direction. You have debt to capital ratios right now at 30-year highs. As Rayna mentioned earlier, you have close to 40% of the companies in the index that aren't making any money. Those are not favorable conditions and we're positioning our portfolio directly away from that. If you look at, we have 22 non-financial companies in our portfolio, eight of them are net cash. In addition to that, we have management teams that we feel are more contrarian in nature. So, we're optimistic that not only do they have the financial wherewithal, but also the courage to put money to work when maybe things are more complicated than they are now.

Victor Cunningham: We're also quite vigilant about late cycle behavior. So, for example, we have one company in our portfolio that had been doing very well. When we purchased the company, they were net cash. They decided to do a couple of acquisitions, let their leverage ratios get up to outside of our tolerance levels. We immediately exited the position. So, we really don't want to be left if there is a hangover and we'd rather be safe than sorry. So, we're sticking to our knitting in terms of sticking with companies that are dedicated to keeping very strong balance sheets, because if interest rates do go up, there could be some companies that are going to have to pay the piper.

Remy Blaire: And I think this is a good time to segue into sectors. I know that each and every one of you have highlighted certain sectors in this masterclass so far. But Rayna, can you talk a little bit about some of these swings we see in terms of investor preferences and effect on portfolio returns? Do you think these effects are transitory and what do you think provides lasting effects when it comes to investing across market environments?

Rayna Lesser: I think that by focusing on companies that are well-positioned to deliver no matter what the backdrop, then you can avoid some of the volatility that we experienced in the small cap market. I don't think that this movement in prices is transitory. I think it's something that we'll always experience and that we have always experienced in the small cap market. But I do think it's something that you can work to avoid in your investment process. And by focusing on companies that have more inside of their control, you can help to mitigate that risk.

Remy Blaire: And Ryan, moving on to you. I want to hear about your sector perspectives when it comes to your holdings over at Causeway. What were contributors as well as detractors to performance, and what were some of the notable underperformers as well as performers, and why do you think that was?

Ryan Myers: Yeah. From a sector perspective over the past year, we've had the best stock selection in consumer discretionary, in financials, in healthcare. Some of these stocks we even still hold. Take a company like Qualicorp in Brazil, they have an effective monopoly on offering private health insurance there. And the stock still trades at a reasonable valuation, still has a very strong earnings growth, despite the fact that it's tripled over the last year. Where we've had challenges is in the more cyclical sectors such as industrials, energy materials, obviously energy and materials have lagged across markets due to commodity prices, but there are also smaller parts of the international small cap landscape.

Ryan Myers: Looking forward, we see the best opportunities going forward in financials, in healthcare, and more recently also in IT as well. Specifically, we've seen given some of the demand disruptions, recently we've seen some opportunities in the smartphone hardware supply chain companies in Korea, Taiwan that are particularly attractive.

Remy Blaire: And now that we've gotten Rayna as well as Ryan's perspective in terms of sectors, you highlighted oil earlier. And so, could we get a better idea of where oil fits in the bigger picture and a little bit more about your contrarian approach.

Victor Cunningham: If you're a value investor, and given the carnage that's happened in the sector, you really need to be picking through. But we understand that there's a lot of risk associated in we're in. Because of the cyclicality of the business, we really are only interested in companies that have super strong financial positions. So that's something that of the example I gave earlier is pretty much close to a net cash balance sheet. We're comfortable taking that risk as long as the management team is dedicated to keep their financial position strong so that they're going to be in a position of offense.

Victor Cunningham: And the interesting thing is because there is so much disruption, companies that do have strong financial positions are in positions where they can take advantage. Tidewater, for example, did an acquisition last year with stock, but they were able ... Which can be quite value creating over time. So, we like the fact that companies are in a position where they can be patient, they can play offense, and can position themselves for better times. So, I think as long as we have the balance sheet strength and the management competency, we are comfortable waiting into that space. It's never going to be a giant position for our firm, but we do think that the risk return trade-off is quite favorable now. So, we're comfortable owning those stocks at this point in the cycle.

Remy Blaire: Well, Vic, you've covered the energy sector and given us your take on oil. So, let's move on over to agriculture. We know that we've seen ags in the headlines given the trade war and recent tariffs. But what's your focus on this space?

Victor Cunningham: We think it's an area that's ripe for opportunity for a few reasons. First, corn prices have been down for multiple years, so the farm economy has been under stress. But that has been punctuated by what's happened with the trade war and China. So, you what you're seeing is its capital levels across the industry are under stress. So, what we've been trying to do is we've been trying to search for companies that are extremely well capitalized and are in a position to play offense to try to inject capital and to try to grow during this tough time in the cycle. So that's an area that we've been spending a lot of time on and we've actually found one investment idea that we're purchasing currently, that we think could really be a superb compounder for our shareholders over time.

Remy Blaire: And we're back to the myths and misconceptions of small caps. I know that we've highlighted some of them earlier in today's segment, but do you have any other myths that you'd like to dispel whether it comes to growth versus value within small caps, or what it actually means to invest in the sector?

Ryan Myers: I would add one more, which is in the international landscape, the common perception is okay, these are internet startup companies in the small cap. So, it's all IT. But internationally, that's not the case at all. I mean, these happen to be smaller companies that are older, that are more mature companies that are just smaller. And so, you actually have a very good diversification sector-wise in terms of, at least in the international landscape.

Rayna Lesser: One of the things that stands out to us is the fact that many growth investors are attracted to the highest growth companies in the universe and feel that that's really the best way to attack this segment of the market. We disagree with that. We focus more on companies where we feel like the level of growth that they're delivering is repeatable. And what we found is that when you focus on companies that have really high levels of growth, oftentimes they can't repeat it, which means there's a much wider range of outcomes for those companies and for their underlying stocks.

Victor Cunningham: Just succinctly, risk is a relative measure. So, I think you can compensate for risk with paying the right price. So, by being disciplined on price, you can overcome some of these inherent risks. That drives our behavior every day.

Remy Blaire: Well, some of the points that you mentioned when it comes to myths and misconceptions, it sounds as though we have the ingredients for a bad startup movie or B-rated startup on small caps. Now, as we get into the latter half of the masterclass segment, I do want to get your insights when it comes to the small caps space. What do you think is the best way to approach this space, especially since we just highlighted some of the myths and misconceptions? Ryan, would you like to start?

Ryan Myers: Yeah. Well, obviously at Causeway Capital, we run a more quantitative approach to small caps. Unlike in the US, you have 48 countries in our landscape and 4,200 stocks, very flat index. And so, a quantitative approach to us makes a lot of sense, given just the tremendous breadth of the universe. Because we can look for value, we can look for growth, quality, they're not mutually exclusive given the breadth of the universe. And then we can make trade-offs in real time between these countries and sectors as dislocations occur. So, I think for those reasons, given the tremendous breadth of the universe, we think a quantitative perspective makes sense.

Ryan Myers: And to the misconception about risk, I mean, we have our own proprietary risk model that we use to assemble the final portfolio. So, we're trading off all these risks in the risk model. And at the end of the day, assembling a portfolio with the highest expected return per unit of risk, given the entire landscape. Given all those pieces, it'd be very difficult to do that purely fundamentally.

Rayna Lesser: At Polen Capital, we believe that sustainable alpha and lasting long-term performance really comes from owning the right companies, making good decisions and staying in the market. That's something that's it's really hard for investors to do in the face of volatility. And that's why we're so focused on owning higher quality businesses where there's a more narrow range of outcomes. That enables us to stay in these investments and benefit from the compounding that these companies can provide over long periods of time. And it also enables our clients to stay invested, because the swings aren't so wide, and it takes away some of that emotion and the inherent biases that come out in the face of volatility.

Victor Cunningham: I would just add too that right now with the popularity of index funds, being able to align yourself investors that have high active share funds that really aren't index-like is a prudent way to allocate capital right now. Because there's a lot of things that either don't lend themselves indexation because of their makeup or because of their liquidity profile, and because a lot of these funds have gotten very large. That provides an opportunity to people who really are truly running small cap funds that, that landscape is getting less competitive, and that and that makes it more fruitful for investing.

Remy Blaire: And one thing that I thought of is when people are new to a certain segment of the market, and for most of the viewers in the audience, they are financial professionals. So, they're familiar with what small caps are. But some of their clients may not be and might come with them with lots of questions and say, should I be watching the Russell 2000 if I'm interested in small caps. Just as someone might say, if I'm interested in technology, should I look at the NASDAQ Index or a certain segment of the index? But when it comes to small caps, what do you think a novice investor should be looking at?

Rayna Lesser: I think that it's really tough to focus on the Russell 2000 as a proxy for what small cap can be for investors in the right businesses. If you look at that benchmark, we've mentioned here before, you have many companies that are unprofitable, you have companies that are over-levered. You have companies that have both of those things combined, which adds even more danger. So, if the index is not the thing that you want to own for access to this asset class, and it's also not the thing that you want to watch as a proxy for high quality investing in small cap. We like to look more closely at the S&P 600, where all of the companies are profitable. That's a better proxy for us.

Ryan Myers: I think in the international space, as I said, our index is the MSCI ACWI ex U.S. small cap index. And by virtue of its construction, as I said, the largest single component is only 23 basis points. So, it's very flat, which means it almost resembles an equal weighted benchmark, which removes a lot of the biases that we see in today's flow weighted benchmarks, given the enormous concentration that happens from, as I mentioned before, the FANG stocks and the bad stocks in the EM. We actually think the index is reasonably good but problematic because you can't invest in it. Even more than in the US, internationally, as I said, there just aren't many passive products out there because they just can't replicate that many names.

Victor Cunningham: If you choose to do an index, then that's one way to do it. But if you choose to do active, I think temperament is always very important. So really trying to think about how the manager describes this process and seeing that's something that agrees with your temperament is critical. Because if it's something that you're going to get scared out of during times of fear, then it's probably not going to be for you. So, you need to get comfortable on a deeper level in order to invest for the long-term.

Remy Blaire: Well, if the issue or explanation of small caps comes up at Thanksgiving Day dinner, then I will make sure to bring up all of these points this coming holiday season. As we wrap up today's discussion, I do want to get closing comments from all of you. Rayna, starting out with you, you've mentioned and reiterated that long-term is your focus instead of a short-term market swing. So, tell me how your management teams work to ensure agility?

Rayna Lesser: It's an interesting question, and I might look at it a slightly different way. Sure, when all the right conditions are in place, and a company has a skilled management team, and is investing the right way for the future and has a great culture, that can enable agility where they can really respond quickly to changing market conditions. But where we've had our most success is actually with management teams that have a disciplined process with disciplined action, and where they're really focused on actually staying in the course when things are changing around them. That's where we've had the most success.

Remy Blaire: And we that change is constant and we don't have a crystal ball. So, Ryan, does the overall outlook for smaller cap equities remain favorable in your perspective?

Ryan Myers: Yeah, we still think it's very favorable. I mean, if you flash back to the beginning of the year before coronavirus, we saw leading economic indicators improving, we saw the yield curve steepening. All of these are very good signals for small cap performance. And assuming the coronavirus follows a similar path to SARS in 2003, if you use that as a template, yes, there was a brief interruption for business but there was also a sharp snapback and a step back to risk on environment after that. In the meantime, we think that international small caps offer a great value especially in emerging markets where the EM small cap index is now trading cheaper than the EM large cap index, which has not occurred very often and it's been more than a few years since that's happened.

Ryan Myers: Looking forward, I think if I had to impress something on a new investor, I'd say that in international small caps, given the breadth of opportunity there, the typical, the traditional trade-offs that we're used to just aren't applicable. Usually, typically think, okay, if I'm buying value stocks, you have to give up growth. If I'm buying growth stocks, I have to give up quality. The nice thing in international small caps, in our portfolio for instance, our portfolio trades at a 37% discount on Ford P/E to the index, and yet it has 36% higher long-term APS growth, and a 47% higher return on equity. So out of all these attractive characteristics, you really can have them all given the breadth of the universe.

Remy Blaire: And Ryan and Rayna, we've gotten near closing comments. So, Vic, looking ahead, are you finding fundamental reasons to be encouraged when it comes to small caps?

Victor Cunningham: Absolutely. A good example of that is we have a handful of regional bank investments throughout the country. And it's interesting as we've completed the last earnings cycle to hear about how debt pay downs are running ahead of schedule, deposit growths are up. So, it seems the economy continues to be strong. I think one of the interesting dynamics of what's happened in a lot of the markets have become momentum market. Technology, for example, really drove the index return last year and the Russell is up over 50%. So, there are segments of the investment universe that really aren't getting as much attention.

Victor Cunningham: So taking a contrarian approach, and being disciplined about your process, and staying away from companies that might be getting over-levered and thinking this interest rate environment is going to continue to forever is a solid way to position your portfolios for perhaps rockier times. But you're still getting good prices on your initial investments and with the ability to grow over time.

Remy Blaire: Well, I think we've been able to cover a lot of ground in today's master class. So, thank you each and every one of you for your insights.

Rayna Lesser: Thank you.

Remy Blaire: And thank you for watching. I was joined by Rayna Lesser Hannaway, Portfolio Manager and Analysts at Polen Capital. Ryan Myers, Quantitative Senior Research Analyst and Strategist at Causeway Capital. Victor Cunningham, Portfolio Manager at Third Avenue Management. From our studios in New York City, I'm Remy Blaire for asset TV.