Active Management: Downside Protection Shines Through
November 5, 2019
Remy Blaire: Welcome to your Small Caps Masterclass. The final quarter of 2019 got off to a volatile and uncertain start. With 2020 right around the corner, all eyes are on the road ahead. From the macro outlook to industries and sectors, we'll take a closer look at the investment landscape for small-caps.
Remy Blaire: Joining me today, Bill Costello, Senior Vice President, Co-Director of Equity Portfolios and Senior Portfolio Manager at Westwood Group. Brian Lund, Managing Director and Portfolio Manager at ClearBridge Investments. And Jay Kaplan, Portfolio Manager and Principal at Royce Funds.
Remy Blaire: Gentlemen, thank you so much for joining me for today's Masterclass. Now first and foremost, I think it's very important to define small-caps depending on who you're talking to and who your audience is, the definition might be different. So, starting out with you Jay, can you give me your definition of small-caps?
Jay Kaplan: Sure. At Royce, we use a definition of 3 billion in market cap or less.
Remy Blaire: And what about you?
Brian Lund: ClearBridge we tend to stay below three and a half billion on purchase and then keep the overall portfolio in line with the Russell 2000.
Remy Blaire: And to you.
William E. Costello: At Westwood we're somewhat similar to these gentlemen. We define it as the Russell 2000 value, which is the index that we compete against. Typically, we purchase between 200 million and 2 billion and we tend to sell when the stock hits about 4 billion.
Remy Blaire: And when we're talking about small-cap investing, I think it's very helpful to get your individual approaches before we get into this Masterclass. Jay, could you give us your approach when it comes to this type of investing?
Jay Kaplan: Oh, of course. Well, I'm a contrarian value investor, but I'm looking for good quality stocks, so I look for strong balance sheets. We want companies that have very strong finances, good returns on capital or returns on assets, and valuations that basically are at on sale prices. So, it's good companies, great financials, on sale, and usually they're on sale because there's some issue and we want that strong balance sheet so that there's enough time for the issue to get worked out and hopefully the stock gets revalued and it goes higher.
Remy Blaire: And Brian, what about your approach?
Brian Lund: Well, for ClearBridge small-cap what we try to do is create a variant perception that we have, whatever the company may be. If there's a reason why we think it should be valued differently from how the market is valuing it, that's our key. So we start with the expectations in the market price, what return on capital, what investment rate, what growth rate is necessary for it to be worth what it's trading for right now, and then see if we have a reason to believe that one of those factors should be better than the market expects. Whatever kind of company it is, we'll buy it in that case, and as that discount closes, we readjust and find something else.
Remy Blaire: And Bill, moving on to you. Could you also give us more insight into your approach?
William E. Costello: Absolutely. We're quality value managers so we focus on the value side of the equation, but we really want to stick to the higher quality names. We look for companies that have good balance sheets, good free cash-flow characteristics, good return on equity or return on invested capital, and we try to find a stock that we think is selling at a discount to its intrinsic value, which might be its future earnings stream.
William E. Costello: We don't play the deeper value names, the low price-to-book, price-to-sales, those don't really factor into our thinking too much. We want more of the higher quality names.
Remy Blaire: And I think it's very helpful to get your individual approaches before we get deeper into the advantages as well as disadvantages of this asset class. Jay, starting out with you, in late August we did see a notable shift to value and it gave a value advantage for Q3. Can you tell us what you're seeing in terms of performance for the Russell 2000? And for the viewing audience, although it's made up of financial professionals, can you tell us what the Russell 2000 growth is and what you're seeing right now?
Jay Kaplan: Well, it's interesting. On August 27th, actually, we saw that inflection in the market and... I focus on value, and in the month of September, value was much better than growth. And that's the first time that's happened in a sustained way in quite some time. The fourth quarter of 2018 was okay, but it was really quiet a month. And now we're sort of back to where we were before, and we're in an environment where the unknowns are probably higher than ever, there are political unknowns, there are economic unknowns, there are marketplace unknowns.
Jay Kaplan: And when you roll that all together, there's a big cloud from trade, there's a big cloud from recession fears, and there was a shift into value in a way from defensive when it looked like things might be okay. And now there's a tweet that says, "Baby things aren't going to be okay again," every time there's another tweet, you can feel the market shift as it digests the news. So, we're in an environment that's showing slower corporate growth. Earnings are still growing, but they're growing more slowly. So, they haven't turned negative yet. But the market and the Fed, by its actions, everyone is trying to figure out where we are in the economic cycle and how far along are we. And that I think is kind of the backdrop and the uncertainty that we have now.
Remy Blaire: And you mentioned the word unknown. Are the unknowns that we currently face, are they greater or different than unknowns that we've seen in the past?
Jay Kaplan: Oh, they're... The unknowns are always different. If we knew what was going to happen tomorrow, we'd place one big bet, and everybody could go home and buy an island and be happy. But what keeps everyone on their toes and everyone interesting is there's a lot of noise, and in the small-cap world there's not that much liquidity, so the volatility that comes from the lack of liquidity when there's a lot of noise, can be pretty significant. But if you're a long-term investor like we are at Royce, and you're thinking about what's going to happen three, four, five years from now and you're trying to invest in businesses rather than just trading pieces of paper really that are stocks, and if you can drown out the noise, you can actually be okay.
Remy Blaire: Well, in this day and age of social media, it does appear as though we have more noise than we did at the beginning of this current bull market.
Jay Kaplan: We do. It's fast and furious now, it really is.
Remy Blaire: And moving on to you, Brian, can you tell me about the current market expectations and how the different perceptions create opportunity, especially in the small-caps space?
Brian Lund: Yeah. Well, as Jay was saying, there's a lot of hurting behavior in the market right now. When there's a tweet about trade going well, there's a whole set of stocks that does well. When there's a tweet about it going badly, that whole set of stocks does poorly. Growth has been a concern for some time, so growth is at a great premium right now. And it's getting to the point where a firm like ours who is more or less indifferent between value and growth styles, we used to source a lot of our best ideas from growth buckets, companies that the market just wasn't appreciating how strong their competitive position was.
Brian Lund: Now the market is over appreciating the strength, the competitive positions, in a lot more cases. We found ourselves underway information technology now for the first time in a decade probably because the multiples there have just become unsustainable. Where we're getting a lot more ideas are where babies are getting thrown out with bathwater. You know, people want to move away from levered companies, and so all levered companies are going down. But there are some in there that the leverage is less onerous.
Brian Lund: They have asset back, liabilities that they can shed, they can trade assets for their debt, one way or another, they're not going to be as liquidity trapped to somebody who's simple, whose debt was based on their future cash flows. So, we can take a company and have a variant perception that this leverage is not as bad as that leverage even though they all went down the same way together. It's a bad way to live in the market because it feels like you're just getting whipsawed back and forth, but it's going to be good in the long run for stock picking.
Remy Blaire: And gentlemen, both of you mentioned time horizon and I think that is very important when it comes to the small-cap space. So, for viewers out there who are curious about what you mean when you say long-term, what is your definition?
Brian Lund: Well, we value the companies on a long-term basis. We're thinking about what their value is going to be with a long competitive advantage period and then a residual value. Whether we hold them long-term or not, depends just on how long they stay undervalued. But when we say long-term time horizon, that's what we mean. What is the company going to be worth over its period of existence?
Jay Kaplan: There's a whole school of folks who spend their lives worrying about a penny of earnings beat or a penny of earnings miss, and trade around on those real small increments. And we try to really ignore those, we actually try to use those as opportunities to go against the market. But we really are thinking about, what if we own the business? What do we think that business is worth? And presumably it's not worth that today. So, we're willing to wait and hold on, till we get to the value that we think the company actually deserves.
William E. Costello: That's actually how we think about it as well. As owners of the business, if we had it as a private company, do we like it? What do we think it's worth? Typically, our horizon is somewhere between three and five years. When we do our financial projections and we do fundamental work, we go out with balance sheets, income statements, and cash-flows five years out for every company we own. That's really the timeframe we're thinking of. If you look at the turnover of our fund, you'd say we're a three year time horizon. It kind of works into that. So, we have an intrinsic value that we think is in every stock that we buy and sometimes it's realized quicker in some stocks than others.
Remy Blaire: And, Bill, could you tell me a little bit more about prioritizing the quantitative assessment of absolute downside risk?
William E. Costello: Okay. That's part of our whole process. We have a three step process, and the first step when an analyst looks at a stock is to look at the downside in absolute terms, try to find it, make sure it's quantifiable, and make sure that it's reasonable and acceptable. So, we focus on that first before we look at the upside in the stock. And quite honestly, if we can't define what the downside is quantitatively, we won't bother looking at the stock anymore. And if it's not an acceptable level then obviously we don't look at it either, because we try to protect on the downside, and over time we've done a good job of doing that.
Remy Blaire: And I think that's helpful to understand, to see how it mitigates against the loss of capital. Now Brian, are small-cap companies generally less affected by some of the global trade conditions and more domestically driven would you say than other stocks such as large-caps or even mid-caps?
Brian Lund: I think there's a perception out there that that is true. And so again, when you have trade noise come up, small-caps may suffer more in that environment. I think the global economy is now so complex, so intermingled, that to understand the direct and indirect effect on an individual company, of trade tensions, is very difficult. You might be a small-cap supplier of nails, but you get your steel from Canada. And when its tariff goes on, steel from Canada, you're out of your supplier.
Brian Lund: In many ways, large-caps have more flexibility because they probably have more complex supply chains, that they can move around, move manufacturing from one country to another. So, it's a perception. I don't think it's true, I do think that everybody benefits from an economy that's working well, and everybody's hurt by an economy that's working poorly.
Jay Kaplan: I think part of that... and I agree that there's a misperception, part of that misperception I think comes from the fact that there are a lot of small-cap banks buried in the indices and those are very domestically focused by and large. There's a lot of REITs and those are also mostly domestically focused. There are lots of utilities, those are domestically focused. And I think that the greater world extrapolates that into small-caps are not global, but the global supply chain is in fact there, and so it's not as insulated as people think. It definitely is.
Brian Lund: And even in banks, we've had a situation where they're lending to domestic companies, but when they lend to a company that gets supplied by a Chinese company, they have the credit problem. And these days in small-cap banks, if you have a credit problem, one bad credit, you are going down, down heavy.
Remy Blaire: And I think all of you have highlighted both the advantages as well as disadvantages of small-caps, but when we see volatility, we know that there are risks as well as opportunities. So, Jay, I want to ask you about your approach to volatility before we take a closer look at the advantages and disadvantages.
Jay Kaplan: Well, at Royce I would say volatility is our friend. It gives us opportunities to either initiate new positions, get out of older positions, and more than that, trade around existing positions. Because they move because of the lack of liquidity, or stocks do move around a lot and sometimes they look cheap and sometimes they move for not a lot of reason, and maybe you want to take some off the table. So, volatility is our friend. And if you look at some of our strategies, like our total return fund, for example, it's among the lowest volatility small-cap strategies in the marketplace, and there is a place for that during times where volatility gets amped-up a lot. Value strategies tend to do well when there's more volatility, and we have not, until recently, had very much.
Remy Blaire: And could you elaborate on how you've all taken advantage of volatility in different environments?
Jay Kaplan: Until recently there really hasn't been that much for quite some time, and we can come back to zero interest rates and how that's really kind of dismembered the capital markets in a major way. But volatility, gives us an opportunity to add to positions, trim positions, accumulate stocks that we'd really love to own, but the prices weren't right. Gives us an opportunity to sell our stocks to others when they want to pay up more than we think they're worth. And in fact, if you think about it, we have a total return strategy at Royce, that's a very low volatility strategy, and when markets go up and down, it tends to do okay. We're happy about volatility.
Remy Blaire: And Jay, now that you've given us your approach to volatility, can you tell me how you've taken advantage of volatility in different types of environments?
Jay Kaplan: Well, in an environment like the one we've been in, it gives us an opportunity to buy stocks that have really been tossed away for the wrong reasons, more for the... for macro headline news reasons, rather than stock reasons. That's an example of, you can buy companies in today's world that are cyclical and have fears about recessions clouding over them for single digit multiples and a lot of them pay dividends, and we think that's an example of how the volatility from headlines can present great investment opportunities.
Remy Blaire: And Brian, moving on to you, what are you seeing when it comes to the current growth and value spread in the market?
Brian Lund: Yeah, exactly. We've seen much the same thing. There are some sectors, materials, energy, where you can find good companies in the midst of ones that do have bigger problems, companies that are earning good returns on capital and they're paying dividends and you can buy them at really good prices right now. On the growth side, it's significantly harder to find areas where anything that's growing is meaningfully undervalued because there's been such a thirst for growth from investors in the market. But there still are some candidates out there, especially in, again, kind of areas that otherwise are not as sexy.
Brian Lund: You can have an energy company that has a really good product and it's growing and is getting tossed away with other services companies in a way that's inappropriate. Again, we want to look at the company and our job is to say, "How is this company standing out from what the market thinks of it right now?" You know, it's a little bit like horse race handicapping. It's not about whether you think the horse is going to win, it's about what are the odds on the tote board, and do I have an advantage when I choose that horse at these odds? We can find long shots that come at good odds, and we can find favorites that come at good odds.
Remy Blaire: I think that's an interesting analogy and maybe helpful to some in the viewing audience. Bill, moving on to you, you say that you focus on quality companies. Could you tell us how they offer long-term return premium? Do you do the sustainable competitive advantage as well as pricing power?
William E. Costello: Sure. We definitely focus on the quality end of the spectrum, and we think over time the companies that have good return on equity, good return on assets and invested capital, compound that value within the stock going forward. So, when we look out, we're looking at a company that is able to generate earnings growth and have an attractive return, generate free cash flow, which allows them to either reinvest in other businesses, reinvest in their own stock, or return it to shareholders through dividends. And over time we feel that that compounds a lot of value within the stock itself as the market comes to appreciate that, which usually leads to some multiple expansion and a better price, more in line with the intrinsic value that we see in that stock going forward.
Remy Blaire: And gentlemen, I think it's helpful to take a step back and look at what we've seen in terms of performance for some of the indices. Jay, the Russell 2000 has pulled back about 9% over the past year in comparison to the S&P 500. Why do you think it's so important to focus on the long-term horizon?
Jay Kaplan: Well, the short-term horizon could be really tough. Tell me what the weather's going to be next week, no one really knows. It really all depends on patience and time horizon. I think it's fair to say that the trade in the S&P 500 is very crowded, has been very bid up, and zero interest rates has helped that a lot. The Russell 2000, part of the Russell has been bid up, a third of the Russell has no profits. That part of the Russell, in a zero interest rate environment, those very long duration assets, sometimes where their business outcomes are quite binary in areas like biotech for example, those companies were very bid up, but the rest of the Russell has really been kind of back on its heels.
Jay Kaplan: So if you look at reversion to the mean and what can happen, let's go back to our September example, in a very short period of time, that growth value trade reversed like that. So I think that trying to pick a very short period of time, you never know what's going to happen, but an asset allocation over time with some of it allocated to small-caps, because we know that over the very long period of time, everybody's seen the Ibbotson data, over a very long period of time small-caps tend to have done better, small-cap value has tended to do pretty well against that, but that's been a little bit disrupted by the term structure of interest rates that we've had since the end of The Great Recession.
Remy Blaire: And for those in the viewing audience who may not be quite so familiar with the relationship of interest rates and the small-cap asset class, what would you say to them and how would you say that rates have affected the small-caps space through different economic cycles?
Jay Kaplan: Generally speaking, higher rates are okay. When you sort of get to sub-sectors it differs quite a bit. But in the value world, zero interest rates have not been great. So, I am looking forward to higher interest rates and a steeper yield curve. And if we should have economic growth rather than a recession, we will get to that, and the Fed is pushing the short end down, they are fighting against the long end, and we'll see what happens there. But if we don't have a recession and we return to growth, we may get higher rates, we'll get a steeper yield curve, that should be relatively good for small-caps in general, except for the riskiest lowest earning companies.
Brian Lund: Yeah. And it's been a phenomenon throughout the market for the last few years. The cost of capital is low, and so biotech companies in the public have been able to get good funding at preclinical phase one kind of moments in their life, which is very early, very early to be getting public capital. And in the private market it also has been able to get funded extremely early, and that again is also a result of cost of capital being so low. That's problematic in that area of the market.
Brian Lund: Elsewhere in the market though, I think one of the ways in which small-caps is in some way superior to large-caps is, while there's more volatility, individual companies, there is more diversification. So, when you're buying the S&P 500 at this moment, you are buying a big chunk of 10 companies, and then a bunch of other smaller positions. When you buy the Russell 2000, you're getting a lot of very small positions. So, you're diversifying a lot more than if you're going the S&P. Basically, you're buying Facebook, Netflix, Amazon, Google, Apple, Microsoft, and some others. That's what I really like about small-caps, that I have all kinds of different pools to fish from. I don't have to have an opinion about Facebook at this moment.
Remy Blaire: And Brian, before I move away from you, I want to ask you a question about shareholder value. Do you think companies are rethinking the meaning of this right now?
Brian Lund: Yeah, the Business Roundtable put out a paper recently and it generated a lot of headlines that said something like CEOs have decided that shareholder value isn't working anymore. And that was ludicrous. What they were saying was a very politically savvy way of expressing that, we're not only about shareholders, we're also about customers, making sure they're satisfied, employees are satisfied, we don't hurt the environment, we do good for society.
Brian Lund: When Al Rappaport wrote about creating shareholder value in the 1980s, he noted all that. He said, "In order to create shareholder value, you need to have a sustainable company over a long period of time. To do that, you can't have big environmental liabilities at your feet. You can't mistreat your employees, they'll leave. You can't mess with your customers; they will not buy your product after the first time." So, they're saying they're going to do, they're going to invest in their employees, and they're going to not pollute the environment, great! That's what they should have been doing before, and most of them who were thinking truly about creating shareholder value, were doing that.
Remy Blaire: And while we're on the topic of shareholder value, Bill, I want to ask you, how do you see shareholder value being created with small-caps?
William E. Costello: Well, I think it's very similar across almost any cap size. I think the things that companies do well in creating shareholder value to the point of serving all those constituencies well, that's what a good company does over time. You can't favor necessarily one class over another, the shareholder return is the most important thing, is we sit and look at the asset class but overall you do everything right and the value accrues to the shareholders over time. And when you don't follow that playbook and you deviate from that, that destroys shareholder value.
Brian Lund: And I think this also does, it speaks to the misperception that people have about what ESG investing, environmental, social and governance investing, is. At ClearBridge we have focused on ESG factors for many decades and the reason is because those are the source of sustainable businesses. Those are markers of companies that are going to be around for a long time, and they are going to compound value. And they have been predictive of positive returns. So, it's not a feel good thing, it's an actual money making endeavor.
William E. Costello: I think we all did to some degree is fundamental analysts look at all those factors and factored it into our analysis, it just didn't have a fancy title or something there that you could glom onto, but it's always been a part of our process. We always look at governance, especially that's the one that stands out the most from where we sit at Westwood, but it's always been a focus of ours. It's just come into more of the mainstream now. But I think any fundamental manager has always looked at it through that lens, but just didn't know what the lens was called at the time.
Jay Kaplan: And when a lot of those things don't happen, you get activism sometimes. There's, especially in larger caps, but there's a lot more activism right now than there's been in a long time. And the other thing you get in small-caps, when companies don't do it the right way, you often get a lot of M&A. People will often say to me, "Well, don't small-caps turn into big-caps? Aren't you trying to find the next Google or the next Microsoft?" And I usually say, "Well, here's the real deal. The real deal is, most small-caps don't become large-caps. They really don't. A lot of the really good ones get bought by somebody else because they're so good. A lot of them that aren't so great get put out of their misery and bought by someone who makes them better. And then a lot of companies they have fits and starts and they stay small-cap for a long time." So, there's a lot going on in our world, there's a lot to choose from and it makes it very interesting, and there are tons of opportunities all the time.
Remy Blaire: And I think each and every one of you have highlighted some of the misconceptions as well as myths surrounding small-caps, and since we've already jumped in, do you want to highlight any other myths out there that really get to you when it comes to small-caps?
William E. Costello: I would say just the perception out in the marketplace of the volatility in the small-cap space being that much higher than the large-cap space. I don't think that's a correct assumption or perception that people have. I think if you focus on the right things in the small-cap space, you have lower volatility over time, and better returns.
Brian Lund: Yeah, exactly. As Bill said, I think people don't realize the degree to which you're really buying one sector and very few companies when you're buying a large-cap index portfolio. When you're buying the S&P 500. And to think that it's less risky to invest in 2000 different companies than it is to have 20% of your money in 20 different companies, I just think that's misplaced.
Jay Kaplan: I think we probably, I don't want to speak for everybody else, but I think we all suffer from the 24 hour news cycle and the TV business news cycle where if you flip on a broadcast TV business channel, they're going to talk about five or six stocks over and over and over again, and they're never talking about the things that we're invested in, and I think that's terrific for us. And I think a lot of people tend not to think about the kinds of things that we do also terrific for us, but then again, people then might ignore the opportunities in what we do. And I think that's a big misplaced part of the portfolio.
Jay Kaplan: Small-cap has been underperforming large-cap for a long time now. That will not be sustained forever. History always repeats... It doesn't always repeat itself, but market cycles do come and go and they repeat themselves and there will be a time again where small-caps do in fact do better than large-caps, and I think the viewers would be held in good stead if there is always some allocation within a big portfolio to small-cap stocks.
Remy Blaire: And Jay, you mentioned the word opportunity and you also highlighted the fact that although we're surrounded by information 24/7, there's so much on business news, whether we're watching streaming or actual broadcasting, but you were saying that they're not focused on the opportunities. Where are you seeing the opportunities?
Jay Kaplan: Let me give you a couple of examples, no names, but we'll talk in concept and I think I can do that. One of the areas that's of interest to me lately is footwear, which is really not sexy at all and kind of boring. But footwear and apparel, those businesses are under a gigantic trade cloud. We don't make a lot of shoes in America anymore, we haven't in actually a very long time. But there's a company that sells family footwear. It sells at a very low-teens multiple, which is a multiple well below where it's traded through most of its history. It has a nice dividend yield. And a big chunk of its business is in athletic and sneakers. There's a big back to school business because the kids need new sneakers, and there's a boot business in holiday, and there are new shoes at Easter. All of those sneakers are made in Vietnam, they're not made in China. Very little of their product, very small percentage, is made in China.
Jay Kaplan: But the stock has been thrown out like everything's made in China, and it's a company that used to grow stores a lot, took a breather from growing stores for a few years, and it's just on the cusp again of heading back into store growth, which should make the sales grow and the earnings grow, and they're not being given any credit for that because there's this trade war cloud. So that's one example.
Jay Kaplan: I own another footwear company because you're on this footwear theme, where it trades at a single-digit P/E, it has a yield of almost 6%, it has stores all over America. You've probably been in one, but we're not going to name it. And instead of being like a heavy duty family kind of chain, they sell more to everybody, and over time they didn't have kids' shoes. So, the moms would have to go someplace else. So, they added kids' shoes in their whole chain, expanded their market. They bought a company that looked like them in Canada, and they're turning that around, and that's working out very, very well.
Jay Kaplan: There's a new trend... It's not really a new trend, so in footwear, everyone's afraid that the retailers will be disintermediated by Amazon, so all the retailers want to own brands and make stuff. So, this company bought another company that gives them the ability to design and source their own shoes. They have a lot of private label, which they'll now make themselves increase their margins and they're going to try to develop their own brands, which should also come at a higher margin, and the stock trades at nine times earnings with an almost 6% yield, and it's nuts.
Jay Kaplan: There's a lot of that kind of thing going on in the world today. If you do your homework and you're willing to look over the cloud and say, "You know what? Even if the trade issues don't go away and it really gets bad over the next 18 to 24 months, those problems will be solved. Manufacturing will be moved over time. Chinese manufacturers are already giving price concessions to make up for some of the issues. Consumer prices will have to go up if there's another round of trade," so if I can look through that, a company like this is not going to sell at nine times with a 6% yield, it's just not.
Remy Blaire: Well, that's really interesting, Jay, because I wouldn't think of footwear initially, but I also do know that there is a big market reselling expensive sneakers and that there are people who are of the younger generation who are flipping sneakers for a profit.
Jay Kaplan: They are.
Remy Blaire: Well gentlemen, do you want to weigh in on this as well in terms of sectors where you're seeing opportunities?
Brian Lund: Sure. Mine is a core fund. We're trying to source opportunities across the market at all times. I could tell you where we find a little bit easier and harder. A year and a half ago we were finding regional banks sort of very difficult to find stocks that were really attractive. They were mostly trading at very high multiples of book, the loan growth was good, but there's no provisions in the earnings, and so in some ways their P/Es are being overstated right now relative to a normalized credit cycle, but credit's been excellent. So, it was difficult to find something where I could say, "I have a real variant opportunity on this stock."
Brian Lund: Fast forward to now, banks are much less popular, rates are coming down, yield curve is inverted, and net interest margins are compressed, and credit is still good, but everybody's waiting for the credit shoe to drop. And that is a place where when we've seen a couple of credit shoes drop, even though they weren't significant parts of the portfolio, so it wasn't like losses were enormous, they were more like a little bit more like average, these companies were being sold down to tangible book value even though they have mid double-digit, mid-teen ROEs, Returns On Equity.
Brian Lund: That's been a place where we've really found some great ideas in the last year. So metals, materials, other kinds of things that have been subject to trade issues, retailing and apparel, those are other areas where we're finding very good companies that are trading at either low multiples, often below replacement value, sometimes at a quarter of their book value, their tangible book value, so those are very attractive but we do need to kind of keep a lid on how much we want to do in that kind of thing because we don't want to skew our portfolio too much so that if it really is a bad recession, we suffer. Valuation is not a very good protector on the downside in a recession, so we want to have earnings quality in there with that, we always measure our portfolio against our benchmark in terms of those factors.
Brian Lund: So on the earnings quality side, we're able to find good companies that are reasonable in areas like tech, in semiconductors, but it is much more challenging now than it was. We used to be very pleased with our software holdings and now it's really, really hard to find something in software that's interesting. That's an area where we think that eventually we're going to get a reversion and those valuations are going to come back down to something more reasonable and we'll get benefit from that because we'll outperform the benchmark on that point, and we'll get a benefit from outperforming in the more leverage, more hard good areas of the market that rebound.
William E. Costello: Going on those themes, I agree with most of what everybody said. But one thing I would go back to just a little bit, when you were talking about the business news and how it's always in your face nowadays it seems like, and Jay was saying, that's true but you don't really hear much about our companies, that's one of the things that I think is an advantage that we have is just there's less information, the small-cap stocks are more misunderstood, and that just leads to more opportunities for us.
William E. Costello: We've been finding them broadly in the industrial space, that's the area we've been adding to and we're overweight there. That and consumer staples. We found that some of the small-cap consumer staples of which there aren't really that many, have gotten somewhat cheaper and we've been taking the opportunity to buy them. Conversely, the medical space is really hard for us. It's hard to find good companies. It's hard to find good valuations. It seems like the stocks that have good valuations are poor companies with issues or you have all the companies in there that don't have the earnings.
William E. Costello: The other place, to your point, is the tech stocks. We've been underway tech and we just haven't been finding as many opportunities as we would like. We know most of them are very good businesses, but it depends on what you pay for a good business, and there's a lot we're not willing to pay up there, especially on like the software side of the business. That's an area that we've been underway and have been having difficulty finding new ideas.
Jay Kaplan: Just to jump on something Bill said a second ago, I've been doing this for a couple of years now and on the topic of misunderstood, the Wall Street analysts coverage in the universe of companies that I traffic in, just continues to get thinner and thinner and thinner. So, you really have to do more of your own homework than you ever did before, which makes actively managed products in small-cap, I think, a real value adds. The coverage has really fallen by the wayside in a lot of small-caps stocks.
Brian Lund: And not just the number of analysts, but the quality of what they're producing. They're not putting it as nearly as much time into the analysis as they used to, and I've been doing it probably fewer years, but I remember a time when you would regularly get an initiation on a company that would be 20 pages. Now it's, "Here's my initiation," hold, two pages.
Jay Kaplan: Yeah.
Remy Blaire: And since you highlighted the fact that there are fewer analysts focusing on a lot of opportunities out there, Jay, I want to get your take on what we're seeing in terms of the economic outlook and what this means for small-caps going forward.
Jay Kaplan: Well, I think all the loud drum beats now about the economy are, there's a recession right over here. And the Fed actions would lead you to believe that the Fed believes that there is a recession right over here. At Royce, we spent a lot of time sitting down with the senior executives of companies, and lately I've asked each one of them, "From where you sit in running your business, do you see any signs of a recession?" And I'm not getting any yeses. I'm really not. So, I think business on the ground in the United States of America is actually okay.
Jay Kaplan: Now growth may be slowing, sales may be slowing, earnings may be slowing, but they're still growing, or be it at a slower rate. It has not turned negative. So, I think one of the biggest opportunities in the market is to go to those stocks that have been tossed out because of fears of a recession, and if it turns out that there is not a recession and the Fed has fought it off, those stocks can go up quite a bit. So, we'll have to see what happens. But I think that's one of the dominant themes right now.
Remy Blaire: And Brian and Bill, when it comes to the big R word, what are your thoughts?
William E. Costello: Well, I sort of agree there, that recession's been in the future for the past couple of years and we're seeing it. When we see the economic data, I agree it's definitely slowing, but we don't see a recession on the horizon. And to Jay's point, we talk to all our companies as well and we ask that same question and they don't see it. So, it seems to be this phenomenon that's always a few feet ahead of you that you never catch up with. At least it's been that way for years now. We will have a recession; they didn't outlaw them -
Jay Kaplan: Yeah, someday.
William E. Costello: But we don't see it anytime in the near future.
Brian Lund: Yeah. At ClearBridge small-cap, we try not to even guess at what the future is going to bring. That's not our forte. That's not our expertise. We can't do that consistently well over the long-term and we don't really think anybody else can. It's all about the odds. Again, to Jay's point, the pricing is showing very, very high odds of a recession. I am willing to take the other side of that now. If that's a 60% chance in the next year versus an 80% chance, that's still a big chance of recession, it could happen, but the certainty with which stocks have been reacting to news flow, the certainty with which people take a tweet about the trade deal being solved or it never being solved, you can't act with certainty in this market. And when someone else is going to be willing to put money down with certainty, I'm usually willing to bet against that.
Remy Blaire: And indeed, there is a lot to digest when it comes to analyzing what's happening in the broader economy as well as the marketplace. Now Bill, I want to go back to you. Could you tell us your experience with performance in the later stages of an economic cycle when it comes to consistency?
William E. Costello: Typically, we've done better, and I think focusing on the quality end of the spectrum helps. When we look at the companies today and we're probably in the later stages to some degree, how elongated that'll be is up for question certainly. When you look at the companies that have high debt loads, a third of the Russell 2000 are not making money, if companies aren't making money now and they have to service debt, what are they going to do when a downturn? How are they going to survive? So, I think that bodes well for our style of investment, and anybody who focuses on quality fundamentals, I think we're in a good place at this point in time.
Remy Blaire: And Brian, moving on to you, expectations for growth companies in general have become very high. Tell me about the opportunities to outperform.
Brian Lund: Yeah, we're finding ways in which we can outperform by not buying ridiculous valuations. Unfortunately, one of the detriments of working with the Russell 2000 is, a company can do extremely well, and everybody can be very excited about it. June comes and the Russell rebalances, and it goes out of our index and then we don't benefit when it falls apart the next year. That's always difficult to see.
Brian Lund: But because the valuations are so broadly high in some areas, we think that we're going to be able to benefit from not being in areas that are overpriced. We also think that... There are a lot of growth areas where patience is just really, really short. Biotech is not an area that we... We're regularly underweight because of our inability to forecast whether something's going to be successful, then the payers are going to cover it, then it's going to get reimbursed by Medicare, then people are actually going to prescribe it.
Brian Lund: But there are drugs that once they hit the market, they have a little trouble with getting that payer coverage and getting the doctors to recognize it fully, but it's a good drug and effective drug for population that needs the help. That's a growth opportunity that a lot of times biotech investors are just throwing out saying, "I'd rather invest in a sexy cancer curing drug rather than a glaucoma drug." But glaucoma is a serious problem for millions of people, and they will be willing to take this drug once it gets all the coverage. So, we can find a number of things like that in health care even when valuations generally are very high.
Remy Blaire: And Bill, going back to you, can you tell me a little bit more about why an active multifaceted approach to analyzing profitability as well as stability is so important across industries?
William E. Costello: Well, I think because the characteristics are different across the industries, and I think when we look at them, they each have their unique characteristics and we look at them across multiple ways. We obviously look for the profitability, we do DCF analysis on all the companies, but more broadly we just focus on individual companies and how they're doing. And that really lends itself to that approach I guess, if I would say.
Remy Blaire: And gentlemen, I want to let you know that a lot of people in the viewing audience, they may be very experienced in the small-caps space, they may not. So, when they're talking to some of their clients, for the case of advisors out there, and they get questions about small- caps, what do you think is the best way to approach that question in this current investment landscape?
Jay Kaplan: Well, I guess one of the ways I would answer that, when you think about some of our strategies at Royce, our value strategies, they often provide a way for a client to benefit when the market goes up, maybe not benefit as much as the markets uplift, but history has shown that on the downside many of our strategies, particularly our total return strategy, has done less bad, if you want to say less bad, less bad when times get tough.
Jay Kaplan: The issue for an advisor is, we really have not had a tough time in the small-cap market in about 10 years. So, it is very difficult, I suspect, to make the case to a client about what do you do when things go down? Because there's a whole generation of investors now that has never seen a down. And I can't tell you when, but I can tell you that there will be more downs, and the downs that we've had have been short-lived blips with a real spring back forward. And there will be a time when the market goes down, whether it's 20 or 30 or 40% and it'll stay there for a while. And when that happens, there's going to be a whole class of investors that doesn't know what to do, so a good low volatility small-cap value strategy within an equity waiting can hold a place there.
Remy Blaire: And Brian, what is your take?
Brian Lund: Yeah, I think the asset class definitely needs to be part of client portfolios. Large-caps don't offer significant diversification, you really need to have the extra diversification of small-caps, I think to provide a balanced portfolio to your clients. They need to be aware of the large-cap concentration. That is a major issue for anybody who's buying large-cap stocks right now. If you're a passive investor, that's definitely true, you're definitely buying big portions of individual companies in large-cap. It's better at small-cap, but to Jay's point, that index includes about a third of companies that don't make any money, and more and more have been coming out every day.
Brian Lund: My inbox is filled with IPOs every Monday these days, and they are not all solid gold. Let me tell you. So, you're buying a lot of things that are out there now because the capital is available now. And when the water, when the tide goes out, we're going to see who's wearing swim trunks, and a lot of those companies are not and you're going to wish I think, that you had an active manager who was more discerning in how they were choosing their stocks than the index.
Remy Blaire: And Bill, what is your take?
William E. Costello: Well, I would say I couldn't agree more with these two gentlemen.
Brian Lund: We're boring now.
Jay Kaplan: We're all coming from a similar place.
William E. Costello: Yeah, and we think active management is important and especially in the small-caps because of the reasons we've highlighted in the passive index that when you're buying that you probably don't know what you're really buying as an individual investor. And then also to Jay's point I think we've shown value over time and I think most successful money managers have by protecting on the downside and participating in the upside, whether you participate in a 100%, a little bit over, a little bit under, but the downside protection is what really shines through, and that's I think where you differentiate yourself over time.
Remy Blaire: And gentlemen, we've been able to cover a lot of ground in this Masterclass discussion, but we can't deny the fact that we're in the final quarter of 2019. And if we think about the way that Q4 2018 turned out, that was clearly unexpected. That does reiterate the fact that we don't have a crystal ball. As we wrap up the quarter and head into 2020, there is a lot on the horizon, including of course the US presidential election, but staying away from that, what is your overall outlook as we close out 2019?
Jay Kaplan: Well, we're right on the cusp of earning season and for those who don't follow small-cap companies tend to report a little bit later, so the big banks have reported, most of my companies, I suspect Brian and Bill's companies have, most of them have not reported either, so we're about to hit probably a volatility moment, we'll get more outlooks, and we'll hear a lot more from companies about what's going to happen.
Jay Kaplan: But again, I'm staying on that same message of the economy remains okay. So, if you buy good businesses with good returns, good balance sheets at the right price, if the company hangs in there, you should be fine. But could there be volatility? Oh yeah. Can anything happen? Absolutely. But hopefully we'll be in a good place to take advantage of that.
Brian Lund: I gotta tell you Remy, I loved the fourth quarter of 2018, I loved that. And I loved the early first quarter of 2016, when we had a huge drawdown. Because to Bill's point, and I think it's generally true of active management in small-caps, downside protection is our forte, so we outperform in that downturn and we're finally getting a good look at some stocks that we've wanted to own or even have owned in the past, but just got to be horribly expensive, and we're able to pick them up at much more reasonable prices.
Brian Lund: I think the market is due for that in a bigger way than even those two drawdowns, and I know it doesn't sound good, but I'm really excited for that to happen because I love those periods. That is a time when investors are not distinguishing between quality and poor quality, they're just throwing everything out and it's a wonderful... It's like getting chum thrown to the sharks. It's like, oh, it's chum time.
William E. Costello: That was so true in December of 2018. There were some stocks that we had the opportunity to buy that we really probably never thought we'd be able to buy. That just turned out to be a great time to participate in the market. We were fortunate enough to be able to do that. And then as far as an outlook goes, I agree with the earning season coming up. We own 62 stocks, only one of them has reported so far. It's going to be volatile in the next few weeks, probably next three, four weeks. But that volatility, as we've all said, we embrace and that gives us the opportunity a lot of times to take advantage of it, whether it's selling stocks that other people have bid up on the earnings or vice versa, some stocks missing the earnings, and it gives us the opportunity to step into them, maybe we've been watching them for six months, two years, and the time is there.
William E. Costello: But we don't see the economy doing badly, so I would say I'm cautiously optimistic. Of course, we are going to have down days, we're going to have drawdowns from time to time, which is healthy in the marketplace. But we see steady growth going forward and it looks like from here, I'd say 2020, seems like a regular year where we should see normal growth. I don't know that that's going to happen, there's going to be a lot of headlines between now and then, and it's going to be probably choppier than that scenario would lead you to believe, but we don't see a recession on the horizon and we think the market will do fairly well going forward.
Remy Blaire: Well indeed, hindsight is 2020, so we'll see what happens in the next year, which is 2020 as well. I think we've covered a lot of ground and we have some very interesting analogies regarding small-caps.
Remy Blaire: Gentlemen, thank you so much for joining me today.
Jay Kaplan: Thank you.
Brian Lund: Thank you.
William E. Costello: Thank you.
Remy Blaire: And thanks for watching the Small Caps Masterclass. I was joined by Bill Costello, Senior Vice President, Co-Director of Equity Portfolios and Senior Portfolio Manager at Westwood Group. Brian Lund, Managing Director, Portfolio Manager at ClearBridge Investments. And Jay Kaplan, Portfolio Manager and Principal at Royce Funds.
Remy Blaire: From our studios in New York City, I'm Remy Blaire for Asset TV.