MASTERCLASS: Small Caps - October 2020

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  • 56 mins 42 secs
Two experts explore the current small cap investment landscape, compare value and growth strategies, and share what goes into the bottom up research process. They also explain potential diversification benefits and why it could be small caps stocks' turn to shine after years of large cap outperformance.

  • Brandon M. Nelson, CFA®, Senior Vice President, Senior Portfolio Manager - Calamos Investments
  • Bill Hench, Portfolio Manager and Principal - Royce Investment Partners

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MASTERCLASS

Jenna Dagenhart: Welcome to Asset TV's small cap masterclass. We'll explore the impact of the Covid crisis, various value and growth strategies, and how to spot new opportunities. Joining us now to share what could be small cap's turn to shine after years of large cap outperformance are two experts, Bill Hench, portfolio manager and principal at Royce Investment Partners, and Brandon Nelson, senior vice president and senior portfolio manager at Calamos Investments.

Jenna Dagenhart: Everyone, thanks for joining us. I want to start with the current landscape and important considerations for investors. Brandon, if you've mainly been invested in large caps, why should you even care about small caps?

Brandon Nelson: Sure. The main reason is that small caps tend to be a winning asset class. It hasn't been true for the last few years. Large caps, especially large cap growth, has been a pretty dominant asset class, but small caps, if you look back 100 years, tends to be a winning asset class, and tends to be fertile ground for finding big winners. A lot of those large caps that had been winning in recent years used to be small caps, so we focus on that small cap terrain and try to find those next big winners.

Jenna Dagenhart: Bill, a lot of the big-ticket companies are getting most of the attention, but the number of startups right now is actually pretty off the charts. Are there lower barriers to entry?

Bill Hench: Lower barriers to entry, possibly could be part of it. I think what's more important is that the tools that small companies have that allowed them to grow so quickly, or scale I think is the word you're supposed to use now, right? You could scale so much quicker because so many of those things that used to be fixed costs when you were starting up a company are now variable, right? So, whether it's your back office with Amazon, or Microsoft, or Google, or your healthcare, your phone system. Just about anything that's an expense, manufacturing obviously was the first one, can now be sourced and outsourced, and you could really do what companies were telling us they were going to be doing 15 or 20 years ago, which was concentrate on their core competence, right? But now you can do that, and it allows you not to tie up capital and it allows you to grow really without a lot of the headaches that you used to have, whether it be hiring an accounts receivable department, or hiring an accounts payable department, or making sure that your PBX worked. All those things are now no longer part of the equation.

Bill Hench: With that, you're going to get a lot of startups, and you're going to get a lot of startups that are doing exactly what you've seen, especially on the growth side of these companies, just having these absolutely magnificent 40, 50%, 60% revenue growth periods. That becomes pretty profitable pretty quickly.

Jenna Dagenhart: Yeah, and many people might not know this, but a lot of companies that we think of as big and successful today got their footing during prior economic recessions, for example Microsoft, General Motors, Airbnb, Uber. Why do you think this is in such a chaotic market environment?

Bill Hench: Well, you always have opportunities in chaos, right? And even personally. If you think about a lot of people as they move up the ranks, why are they doing it? They're doing it because something happened, a position opened or because there were cutbacks. You fill in that void, and with small companies today, or reviewing those companies that you mentioned, they filled in the void, but one thing that they had with them was access to capital or had capital themselves. Even if you're not a newer company, if you're a smaller company, you're doing what most rational small businesses or big businesses were doing in chaotic times or uncertain times, right? Your balance sheet is actually ironically getting better because you're holding back on spending where you can, maybe not on R&D, but maybe on hiring and things like that. You're selling assets or you're selling products, or your balance sheet is getting better, and you're in a position to take advantage of things when the sun comes out.

Jenna Dagenhart: Yeah, chaotic times, volatile times can actually be good for small cap managers too, right Brandon?

Brandon Nelson: Yes, it's a lot like what Bill said, and just being opportunistic. We've seen a lot of examples of that in this recent downturn. Companies being forced to get more efficient during the Covid downturn. Revenues have fallen for so many companies, but we saw that the good companies didn't just sit on their hands, they made changes, and they streamlined operations, they got more efficient with the infrastructure that they had. As revenues start to recover, you're seeing a disproportionate margin expansion because of that efficiency. They've essentially increased their earnings power during the downturn.

Brandon Nelson: So, we've tried to identify a lot of those companies and have already seen some of the fruits of those tweaks to their business as revenues have picked up here.

Jenna Dagenhart: Bill, what evaluation ratios tell you?

Bill Hench: Whatever you'd like them to tell you, because they're all over the board, right? As Brandon will tell you there are thousands of companies that we could look at, and there are parts of this market that are truly reflecting very good news or perhaps expectations of good news, and there are others where it's really awful, right? So, if you're spending time looking at energy names, you're saying, "Wow, these valuations tell me that things are really bad, right?" But if you're looking at SaaS names, you're saying, "Wow, the adoption rates, and renewals and expansion is absolutely terrific." So tell me what you'd like the answer to be and I'll give you the examples to prove that answer is correct, because it really is, and especially now with what's happened with Covid, where some parts of the economy have been turned off and others have been not only left on but left to prosper in ways that no one could have ever imagined. So, it's really all over the board, and if you can catch one of those where you do have these incredibly depressed valuations because of the circumstances as they are, and you see some sort of change happening, it's just absolutely terrific and it pays you immediately.

Bill Hench: We own a little company called Owens & Minor, and they're a healthcare distribution but they also make masks and other protective equipment. They were going through a difficult turnaround, but that turnaround just became a lot easier to do with that tremendous wind of that Covid situation at their back now, and the stock has gone up dramatically. So, if you could find those types of opportunities, you should be able to do pretty well. But the answer really is that the valuations are just some are high, some are low, some are in between. It's pretty normal.

Jenna Dagenhart: Brandon, what do you make of P/E ratios?

Brandon Nelson: We're above average relative to history if you look long term, and I'm speaking about the S&P 500 specifically, and there are good reasons for that too. Interest rates are at a very low level, and presumably sustainably low, and that would argue for higher valuations than normal. Breaking down a bit more on valuation overall in small caps specifically, they look really inexpensive versus large caps. [And that’s based on] a variety of valuation metrics, not just P/E ratios, price-to-sales ratios, price-to-cash flow ratios. 

That, I think, is incrementally attractive to an advisor who might be considering reshuffling some of the allocations. Again, we know large cap growth specifically has been a big winner as an asset class for the last 3.5 years. The valuations there have expanded. I think it makes sense to start looking at small cap as an asset class. It's typically an outperforming asset class in the early days of a new bull market, which I think we're in. It's typically an outperforming asset class coming out of a recession, which I think is where we're at economically.

Brandon Nelson: It wouldn't surprise me if you get some money flow rotating into areas that haven't performed as well, especially in small cap growth where fundamentals have actually been very strong, similar to large cap growth, but yet the valuations are extremely inexpensive relative to large cap growth. Some data I just looked at recently showed we're in the 15th percentile, looking at a variety of valuation metrics. That's the 15th percentile of small cap growth in relation to large cap growth, looking historically. So that's very cheap, and again, you're not giving up much fundamentally, if at all, by looking at that small cap growth universe.

Brandon Nelson: So, I think it wouldn't surprise me if we get some strength in that small cap growth asset class. It feels like it's their turn. We don't necessarily need that for the funds that we manage. Year to date small cap growth is lagging meaningfully behind large cap growth, but we're up materially year to date in our performance, but I think it could sort of turbocharge performance if you get some rotation in the small cap growth going forward. So, we'll see its potential. It makes sense to me that it would happen. It seems like the time is right for it to happen, but time will tell.

Jenna Dagenhart: Certainly, time will tell. Brandon, some people push back on the idea of investing in small caps complaining that debt levels are too high or profitability is too low for many small cap companies. Is that true? If so, why should investors bother investing in small caps at all?

Brandon Nelson: Great question. It is true at the index level. If you compare, side by side, small caps versus large caps, you will see higher debt loads, you will see lower profitability. That doesn't mean the asset class is not worth paying attention to. The problems really surface at the company-specific level when you have high debt loads, low profitability and you're not growing. That's a big-time problem. That's where you often get what are known as zombie companies, where their days are somewhat numbered in terms of viability. This is where I think it pays to have skilled active management in small caps to sort through the rubble, where it pays to go with an active manager that's good at dodging those problem stocks and will gravitate toward companies that have much brighter prospects. 

So, why bother with small cap as an asset class? Because that's where your next huge winners are going to come from, and you want to have someone navigating through that universe and trying to find those big winners for you. They're there, you just need to find them and know where to look.

Brandon Nelson: The further down the market cap spectrum you go, the more inefficient it is and the more opportunity there is as a result. Small cap is littered with tremendous opportunities and inefficiencies. So, it's our mission to try to uncover those and try to add value for shareholders in our mutual funds.

Jenna Dagenhart: Yeah, and Bill, I think Brandon brought up a good point here. It appears we're now in the midst of a new bull market after the longest bull market in history was ended with the Covid crisis, and then we had a very short recession. That being said, why is timing so important, especially with small caps, and what does history tell us?

Bill Hench: I don't know that timing is that important because I think year in and year out, whether it's a great market, a bad market, or a poor market, you're going to look and you're going to see small cap funds at the top of the list, and you're going to see small names at the top of the list per performance every year. It's the reality of small numbers, right? It's easier to double in size from 50 million to 100 million in revs than it is to double from a billion to two billion. There are however points that if you look through, go back to '02 and then '08, and '11, '14, fourth quarter of '18, you can say, "Wow, had I got jumped into small cap then it would've been really great." Because you did have these tremendous rebounds from difficult periods, right? And '02 it was tech, in '18 it was financial crisis, et cetera, right? So, there's always some event. You had something here as well, right? I think our fund was down somewhere in the mid 40s at the bottom in Covid, and now we're I think, I don't know, we're down in three or 4%, 4% around there.

Bill Hench: So you snap back quickly. Is there more volatility? Yes. I don't know that that means that there's more risk, however. So, timing wise I think you could buy these things whenever you want because just the mere fact that they are the size that they are allows them to grow much easier over time. You'd like to do it when you've got a little wind at your back, but you don't always have that wind at your back. When you don't have the economic wind at your back, usually you're not paying as much.

Bill Hench: Do it over time and then you don't have to worry about being right. You'll always point to a point where you say, "Hey, look how cheap I bought this here. What a great bargain I had." You can ignore the times when you bought it a little higher.

Jenna Dagenhart: Yeah. Brandon, anything you've learned from history or anything that you're considering right now in terms of where we are in the cycle?

Brandon Nelson: I actually agree with a lot of what Bill said. We focus on finding secular growth situations where it won't matter that much whether growth is in favor or out of favor, or whether the economy is growing at 3% or contracting by 1%. We spend our time trying to find those bottom-up situations where the company is in its own bull market. It's got tailwinds, and it's going to grow at a robust rate and sustainably for several quarters in a row and it doesn't need the macro as a tailwind. It doesn't need the timing to be just right where we are in the cycle. That can be a tailwind or a headwind, as Bill pointed out, but we spend less of our time forecasting the macro and more of it on the bottom-up stock analysis itself, the company analysis itself. 

To go back to what I said before, I just so happen to think that the stars have aligned in such a way that it could be a pretty fruitful environment for the small cap asset class overall. It just seems like the timing is right for that to sort of mean revert and take some leadership role again.

Jenna Dagenhart: The tide could be turning there.

Brandon Nelson: Could be.

Jenna Dagenhart: And Bill, how are cultural shifts as a result of the Covid crisis trickling down to the markets? How has the evolution of the Covid crisis affected people's behavior, also investor behavior?

Bill Hench: Well, most of this is short-term, right? Because we're still going through it, right? So, you've had the stay at home culture, and I can even remember when I was traveling by car in March, April, May, June, the only places that had lines were fast food joints that had their drive-throughs open. Then if you look in parking lots, Home Depot and Lowe's are crowded, but save that in change. You've had this tremendous move back to home buying, which has been very beneficial for the builders and everybody around it, and real estate people, and mortgage insurers and people like that. Surprisingly you've also had tremendous rebound in car sales, inventories on lots are as low as they've been in years. Then you've had victims as well. So, for every Home Depot and Lowe's you also have an airline or a restaurant company, or other business that's just been absolutely decimated.

Bill Hench: Again, you've seen this short-term. We don't know how it's going to play out, specifically for a fund like ours. We were able to buy companies that are probably much more hopeful to be in Brandon's type of portfolio than ours because of their growth, but in the short-term it looked like growth was going to be, and it has been, inhibited because of Covid. But there is clearly some things that are going to last a long time and some things that don't. We don't know if we're going to be working from home, or we don't know if we're going to have less office space. I could remember many years ago I worked at a tech and biotech firm that brought a lot of these companies’ public, and everybody said, "There's going to be no more road shows and so much less visiting." Because of things like we're doing right now, and if you look over time, road shows for IPOs actually got longer because more people wanted to sit face-to-face with people.

Bill Hench: So, some of the assumptions that I think we're making are clearly going to be right and others are going to be just dead out wrong, so we'll see. I think either way there's so much happening and there is so much confusion, and there should be confusion about how it's going to work, that you're going to be able to get whether it's in growth, or value, or core, pick whatever you want, you're going to be able to get opportunities to make some bets where I think you could get some significant returns. And probably, you asked before about timing, and this is probably one of those times. Despite the fact that we've recovered, I think the vast majority of names are nowhere near their old highs, and in point of fact it's not much different than it was prior to Covid, right? We had just a concentrated few doing well and others doing sort of okay.

Jenna Dagenhart: Brandon, large caps have been a better performing asset class than small caps in recent years. I wonder though, it sounds like you think now is the time for those roles to reverse.

Brandon Nelson: It could be the time for those roles to reverse. I think it's important to know that, looking back multiple decades, looking back 100 years or so, you'll see small caps do tend to be a winning asset class versus mid-caps and large caps. They tend to perform very well. They've not performed very well over the last 3.5 years, and there have been some reasons for that. What could cause that to change is something we're going through right now. What typically causes small caps to outperform large caps and mid-caps is when you're in the early stages of a new bull market, which I think we are in, and when you're also coming out of a recession in the overall economy, which I think is also the status of where things stand today.

Brandon Nelson: Just being inexpensive versus large cap, which is also the case, is not in and of itself enough typically to cause a mean reversion where small caps tend to outperform going forward. But here we have inexpensive valuations of small versus large and we're coming out of a recession, and I think we started a new bull market. It just seems like the deck is more stacked in favor of small cap outperforming from this point going forward than it typically would be. Importantly, we don't necessarily need small caps to be outperforming large caps for us to add value and for us to win. Case in point: year to date small caps have been lagging large caps meaningfully, yet we've put up a pretty impressive performance overall that's even ahead of a lot of the large cap performance, even though we're trafficking in small cap companies.

Jenna Dagenhart: We'll talk a little bit more about how you're finding opportunities, that process, and some examples later in the program. But before we get there, Bill, do you think that the small cap rebound has been underwhelming in the grand scheme of things? I mean, they've come a long way, but would you expect more of a rally on the heels of such a sharp downturn?

Bill Hench: I think it's pretty much been as expected. I talked before about Owens & Minor, right? And it did really well, and we've continued to, we cut it back, it got too big for us, so every day we clipped it back, we continue to clip it back a little bit, and we have others like that. We have some home builders where we're clipping them back as well. We still like them, but we have a discipline on size. I think small cap on the value side is what I'd speak to. I can't speak to the growth, but on the value side it's doing what you would think, right? The banks are doing poorly, there's no net interest margins to speak of, right? Their other businesses are getting eaten alive by PayPal, and Square, and Rocket Mortgage and all these other companies, right?

Bill Hench: Energy, there's an abundance of oil and gas, and it's been a poor performer. You look on the industrial side, you've got aerospace and energy, both not doing well, right? So, it's hard for the industrial small caps to do well. So, when you look at the small cap index on the value side, I'd be more surprised if it was beat in growth, because it shouldn't be, right? Because it just doesn't have that type of environment. Going forward, can you make money in it? Yeah, because ... Without a doubt, just as many times before, some of these things will be left at prices that are just too cheap, right? And they sell off, and lots of times in our market on the value side you don't have to actually get great results or great economic news but rather just an abatement of selling to make money, right? Because the liquidity is a real issue in our part of the market, right? So, when that liquidity that hurts you so bad in the ugly times turns, and when people get excited or want to be a part of it, or join the small cap rally, that liquidity becomes your friend, because there is no inventory to buy, right? Just like there's no one to buy it when it's for sale sometimes.

Bill Hench: When everybody wants to come in no one wants to sell it, and you get these nice moves that people will say, "Oh, it's ridiculous, and these are low quality companies going up." And all these other nonsense, right? But you can make a significant amount of money and you can make it from the things that you talked about before, timing, volatility, all these different things come into play, but it's been disappointing that the gap has been so dramatic between growth and value for us and between big and small as well, but we had it our way for a long time before that. Perhaps we'll get it back some other way, but there's enough in the market, in the value market to still make very, very good returns because you have lots of technology, you have a lot of healthcare, a lot of things that traditionally were just the domain of the growth player, but through circumstances of the market have now become part of the value plays, and those are great names to have an ability to own and buy, and hopefully sell back to people in the growth period when they get better.

Jenna Dagenhart: I see you smiling over there, Brandon. Anything you would throw in?

Brandon Nelson: That's the way it works, right? The value guys scoop them up at the bottom and once the visibility gets better and fundamentals start to improve and those valuations expand, that's when we tend to show up and start buying into those stocks, when it becomes believable that the fundamentals are actually improving. So that's why I'm smirking, because we traffic in different parts of a company's life cycle, and that's the way it works, and it's very efficient, I think, having both growth and value investors work that way. Yes, I think what Bill said makes sense.

Jenna Dagenhart: Yeah. Bill, what's it like when you find a growth company that actually fits the bill of a value stock?

Bill Hench: So that's what we try to do all the time, right? So, we try to buy, we buy value stocks but we hope that they just get better to where they used to be. So, in other words, I'm not buying a lot of unproven things that didn't make money ever and now they're going to start to make money. We're buying things that used to be really good or used to be growth stocks and are going through a difficult time, and hopefully they get that formula back that made them so appealing because they had these great statistics, great margins, that they'll be bought back again.

Bill Hench: So it's nice to make the money, but it's also very frustrating to sell your last shares of Generac knowing full well that things are still going well and probably going to get better, or it was difficult to sell United Rentals when it was a $4 billion company, and then you looked and someone has the indecent move of telling me that it's now 10 billion or 12 billion. Oh, my goodness, but as Brandon said, that is the cycle. There are people like Brandon who run that type of money much better than we could do it. So, if I held on to it, I wouldn't know what to do if it went down or up from there. I'd probably panic in or out five times, but I know in its earlier part of its cycle, when things are going from not generating good returns, or maybe from burning cash to all of a sudden starting to generate cash. That's a part of the cycle that we operate in, and it works out for us.

Bill Hench: So we've done our jobs. When I'm selling those last shares of companies like that and others that I've mentioned, it's great, they've made us a lot of money usually, and they're going to continue to work because they're not going to just stop working because they're not a value name anymore, right? They're going to do well because just precisely what Brendan said, they've proven that they could do this, and it's something that they hopefully could continue to do for a while, and that's how they become mid-caps and, in some cases, big caps, right?

Jenna Dagenhart: Yeah. Sticking with this debate over growth and value here, Brandon, if investors are putting their money into small caps, how would you advise them to tilt exposure to small cap growth or small cap value?

Brandon Nelson: It's a great question, and I think I would probably have exposure to both. I would be tilted, though, more toward growth, and I'm biased, given that I traffic in growth stocks. As I put myself in the shoes of an asset allocator or advisor, and if I'm thinking about moving assets away from large growth because the valuations have expanded so much and they've outperformed now for so many years, it seems more reasonable to me to allocate to small growth from large growth, because the fundamentals in small growth are still very strong and they trade at a big discount to large growth. So, you're getting the clarity of fundamental strength at a discounted price. In small value, things are a lot murkier. Bill touched on industrials, banks, energy, there's more on the come there fundamentally. There's just a lot more murkiness, and they're cheap, but they're cheap for good reason, and it's because the fundamentals are so dicey, broadly speaking.

Brandon Nelson: I just think to go from large growth, which is really on one side of the spectrum, to small value, which is really on the opposite side of the spectrum fundamentally in terms of fundamental strength, it seems like a big reach, where small growth is more of a gradual move away from large growth. So, I think it's more palatable to go that direction.

Brandon Nelson: So, within that small cap allocation, I'd probably be leaning 80% small growth, 20% small value. That's just me. Why have any in small value? Because we might have a market that doesn't care that fundamentals are murky short term. They might just love small value [stocks] because they are cheap, and things just getting less bad would be enough for that to be a leadership asset class. Hard to know, and the data is actually pretty mixed. When I mention that small tends to outperform large coming out of a recession and in the early stages of a bull market, there have been many instances of that. Sometimes small growth leads, sometimes small value leads, call it a coin toss. That doesn't really give you clarity on where you should go. So, I default back to what I said earlier. There's nothing better than an investment that has strong fundamentals, that's got a very reasonable valuation, and I think that's what you get with small growth, so that's where I'd be tilted.

Jenna Dagenhart: The small cap growth and mid cap growth mutual funds that you manage are well ahead of their respective benchmarks for the year. Calamos Timpani Small Cap Growth Fund (ticker CTSIX) was up 27.71% year to date as of September 30th, and Calamos Timpani SMID Growth Fund (ticker CTIGX) was up 27.03% as of the end of September. What's driven such strong performance at a time when large caps, as we've been talking about, have been so dominant and small caps in general have struggled?

Brandon Nelson: A few things, and it's the result of hundreds of decisions to buy and sell stocks, or not do anything with stocks, of course. But from a high level, we've seen that growth has been a better place to be year to date than value. The market has embraced growth stocks pretty meaningfully this year, and we are definitely pure in terms of our approach to investing in growth. We don't drift, we’ve got a lot of style purity, so that's been a tailwind in and of itself, just having a bias toward growth. 

But having said that, it's been a lot more than just being exposed to growth stocks. We've added a lot of value with trades that we've made, year to date, both buying and selling. We've done an analysis that shows that the December 31st, 2019 portfolio, without a single trade all year through September 30th, was way ahead of the benchmark. But when you layer on the trades we've actually done and you look at the actual performance, less the performance of the buy-and-hold portfolio, you'd see a very positive number that you can conclude is the value-add from trades we've made.

Brandon Nelson: So it's been meaningful, and in other words, we've done a good job of navigating through this incredibly choppy environment. I'm really proud of the fact that in the first quarter of the year, when things were basically collapsing toward the end of the quarter, we outperformed the benchmark by several hundred basis points. In the June quarter where you had sort of the mirror image of what happened in the first quarter, we outperformed the benchmark. We had two extreme situations, and we were able to navigate through both extremes and add value relative to a passive approach, and in the September quarter we added on additional outperformance.

Brandon Nelson: g

Brandon Nelson: One thing my mentor taught me back when I first started in the industry years ago in the mid '90s, was "Don't fall in love with your companies." And I never forgot that. He said, "You may know everything there is to know about this company, and you might think it's a great company, and it probably is, but it may not be a great stock for the next six months, 12 months. There's a difference, and don't fall in love, don't lose your objectivity." 

At the end of the day, we follow the rules of our process and when a stock stops following the rules and doesn't check the boxes that we like to have stocks check, then we reduce exposure. Move on and find the next one. There are so many stocks to choose from. Don't waste your time on stocks where they're not checking your boxes. So, I think that also played a role in our year to date performance. We've added, again, value on stocks that we've bought, but very importantly, a lot of stocks that we've sold have persisted as losers after we sold them. That's very typical for us. We've done analysis on that for the last several years, and that is definitely a pattern. Stocks we sell tend to persist as losers after we sell them, and we saw that for the last several years, not just year to date performance.

Jenna Dagenhart: Love that piece of advice too about never falling in love with a company. Bill, I wonder, do you have any advice that you've learned over the years that you'd like to share on investing in small caps?

Bill Hench: Well, for us the advice would be the specific part of the small cap market that we're in, which tends to be turnarounds and companies going through difficult times in the short term. For us it's two things, just keeping yourself cheaper than the market, and being diversified. So, we always run with a lot of names. In our part of the market concentration kills, whereas in other parts of the market that's how you make your money, right? By getting attached to big bets that could pay off for a long time. In our part of the market our job is to buy things that are significantly cheaper than they should be or that they would be if things were going normal. So, we hold things from abnormally low valuations to normal, and that change from sort of really bad to okay is good enough to make a substantial amount of money, good enough. I think we're about maybe by 15 or 16% ahead of our competitors in the last 12 months, and this year we're probably, I don't know, 12% better. But this year, if you call my sister, she'll tell you that you're losing 4.5%. What are you doing? Relatively fine, but in the long term we tend to get paid for that, for holding things as they go through that change from sort of not doing so well to doing okay.

Bill Hench: We sell them when they're okay, which is somebody else's game, and when we do our job they tend to do better for a while. If I could figure out how to run a fund that just does that, that'd be in pretty good shape, I guess. But the advice is to do your work. As Brandon will probably tell you, there's less and less research, and there are less and less providers out there to sort of do modeling and other things that maybe we were used to getting do. So, you do a lot of the work yourself, and you be patient, and the good news is most of these companies are run by very, very good management teams, but they're all subject to the world's craziness, right? They're subject to Covid, they're subject to their customers doing something. Their customers can merge and they could lose business, new technologies come along. You just have to be aware of what you own and hope that you own the right things, but patience in our part of the market pays off a lot as well.

Jenna Dagenhart: Mm-hmm (affirmative), probably good advice in all regards with life, be patient there. I want to spend a little bit more time on how you're finding opportunities and that process. Brandon, can you give us some examples of stocks in the portfolio that get you excited?

Brandon Nelson: Sure. So, things that we look for in any stock, no matter what sector it's in, we look for companies that have a robust and sustainable growth profile. We also look for that growth to be underestimated. In other words, we want fast growth and we want companies meeting and exceeding expectations. When you get both of those things happening at the same time, and companies can show evidence of that for multiple quarters in a row, you tend to see the valuations expand. 

Bill mentioned Generac. That's a company we own, it sounds like Bill used to own it. They have a really strong track record of showing sustainability of growth and also meeting and exceeding analyst expectations, and what do you know? The valuation has expanded meaningfully, and fundamentals there are very strong. The product that they manufacture, the main product is standby power generators for both commercial and residential. Residential backup power demand is extremely strong right now, and a lot of different catalysts are driving it. One, just the nesting that's taking place within the home, people are spending so much time at home, working from home, working out from home, kids are getting educated from home. You just can't afford to go for a sustained period of time without power. You're relying on that home power so much more than you ever used to.

Brandon Nelson: You combine that with all of the horrific headlines across the country relating to wildfires, and hurricanes and other sort of power disruptions, and that's also playing a role in the demand for getting a backup generator for a home. There are only 4% of homes in the U.S. that have a backup generator. So, we think that's changing, and it's a very open-ended market right now where there's a lot of growth potential and room to further penetrate. Their business is really strong and they actually are having a hard time keeping up with demand. So that's a name that comes to mind with a lot of fundamental momentum and checking a lot of those boxes.

Brandon Nelson: Another one I'll point out that’s in the portfolio is a company called Lithia Motors. They have a nationwide footprint of auto dealerships, which might seem like a sleepy, kind of GDP-like growth industry, but they're seeing some cyclical tailwinds as we bounce off the bottom here in the economy. They're best of breed operators, and they're really good at managing assets efficiently, and managing these dealerships efficiently, very profitably. When they reported the June quarter back in mid-July, they provided something that a lot of companies haven't done, and that was a long-term forecast. So, they're good at operating their existing stores, they're also good at acquiring companies and streamlining those operations, incorporating their best practices and getting those operationally running at an operationally sound level. They gave this forecast for five years out, for 2024, and they said, "We think we're actually going to earn $50 of earnings per share." And this is on their website, in their slide deck. You can look it up yourself. 

In 2019 they earned about $12 of earnings per share, and you've got this roadmap between the existing stores that they're running, the new stores they're planning to acquire, and now they're rolling out an e-commerce platform called Driveway, and that's what gets you to that $50 of earnings per share over the next several years.

Brandon Nelson: It's not too often you can find a company sticking their neck out like that and giving long-term guidance and giving you that sort of visibility on the growth trajectory. That's amazing growth, going from $12 of earnings per share up to $50 of earnings per share over the next several years. That's a very interesting situation, and it could get rerated higher as well as this e-commerce portion of the business, Driveway, gets traction. It's in its infancy right now, but that's a portion of the business that's likely going to fetch a higher valuation multiple than the rest of the business.

Brandon Nelson: That's another name that comes to mind, where we think they're in control of their own destiny, so to speak, and just having a reasonable macro backdrop is all they really need. They've proven that they can be efficient operators, and I think they've earned the benefit of the doubt on that longer term forecast that they provided. So, it has a lot of features that we find attractive.

Jenna Dagenhart: Yeah, that's a pretty bold call there. I wonder, Bill, something that Brandon said about the wildfires made me think about environmental, social governance factors. How do you factor those in as a small cap manager?

Bill Hench: I think most good managers have been doing that their entire career, they just never were told that it had a name, right? You don't want to buy anybody who's got crummy governance, you don't want to buy anybody who's got a crummy environmental record, you don't want to buy anybody with social issues attached to the thing. So, I think we've all sort of been doing those without really sort of checking a box saying we're doing it, but nonetheless it becomes a bigger and bigger issue. We don't separately monitor that, but meeting with management is key to our process, keeping on top of what they're doing and anything that could adversely affect their standing or their valuation is obviously important. Those are three things that no one in their right mind would ignore, let alone somebody who is running money for other people.

Bill Hench: So, it will continue to grow because managements are changing, right? Younger people are coming in, right? So, a 40-year-old CEO, she probably has a different perspective than a 65-year-old CFO, right? Or from just because of the frame of reference, right? So, I think the managements themselves are going to be driving it more so than ... Everybody thinks, "Oh, the investment community, the shareholders are going to drive this." I disagree. I think the management teams at the companies are going to be the ones driving it, and they're going to be rolling out that information just as commonly as they roll out quarterly data on their financials. So, it'll continue to grow I think to the point where it's sort of not thought of as separately, but rather just part of a whole package, right? Just like you'd say quality of management, quality of the balance sheet, [inaudible 00:45:40] what's their ESG, and maybe we'll call it something different, I don't know. These are things that you look at forever.

Bill Hench: I mean, in our world the biggest thing that pops up that is probably something in governance where since we do a lot of turnarounds, a lot of the new managements that come in on these existing base of business have to hire good people, right? And how do you hire good people? Well, you pay them. How do you hire somebody, if she's coming from a good company, how do you bring her to your company which is sort of in trouble and maybe needs a lot of works? You got to pay them, so you give them options and things like that. Sometimes we'll see in our governance what would normally look like bad governance, right? You're issuing too many options. Well, nonsense, you're issuing options because you want to attract good people to make those assets more valuable for the shareholders and the stakeholders and everybody else involved.

Bill Hench: I think there are great things that could come of this, but I also think there are subtleties that depending on what part of the market you're in will really sort of change that answer, whether it's good governance, or bad governance or things of that nature. What you do with options at a high growth company is going to be very, very different than what you do at some of my companies, right? We'll see, but it's inevitable that it's becoming bigger and bigger. Somebody told me not too long ago, we were lamenting the fact that energy is never going up, right? Oh, my goodness, it's never going to go up, and somebody said, "Bill, when's the last time you saw anybody under 40 buy an energy company for their portfolio?" And there's a certain amount of truth to that. It's not only something that is changing and has environmental issues, but it's one that people don't necessarily want to be, not all people, but there's a certain number of managers who just aren't going to bother. To be determine.

Jenna Dagenhart: Yeah, that's interesting. To be determined, yes. And that's an interesting point that you make about some of these ESG changes coming from within with the management at the company level. I know Costco, for example, recently pulled a certain kind of pimento cheese off the shelf after the management of that company said something that they didn't agree with. So, it's just interesting we're already kind of seeing this playing out to some degree.

Bill Hench: Well, I mean, your workforce. So, I have two of my children are in the workforce now, and things that I never thought of when I was in my 20s about my work environment, or customers, or things like that, are sort of things that they think about all the time. So, it is inevitable, and no matter what the money management people think and the people rating ESG funds think, it doesn't really matter because that change is going to be much more profound from inside the companies, and it's going to force it. So even if we did nothing, I think there'd be just a dramatic change in how that's looked at.

Jenna Dagenhart: Bill, would you like to share any graduation stories of companies that have moved on to the mid and large cap space?

Bill Hench: Brandon talked about Generac, which I'm scared to look at now because we don't own that anymore. It's been United Rentals, and gosh, I don't know, just they've ... Some of the semiconductor names, the big semiconductor manufacturer names. But unlike growth, a lot of the names, especially in the more cyclical parts of the area, tend to stay small, right? Because there are limitations to just how big they could get. We have a lot of M&A. We'll lose 15 to 25 names a year that'll get bought out. But for the most part, if you look at things like aerospace, maybe some defense names, unless they get bought, they've got a small enough little spot in the market where they're not going to get big. They're never going to get to be a mid-cap, or not even a mid-cap, let alone a big cap. So, it's mostly technology and healthcare names that get bigger that we sort of lose to the mid cap folks. That's bad, but there's always a whole slew of new companies coming out.

Bill Hench: Now one of the nice things that's happened this year, and in a year that you just don't know what's going to happen it's a tremendous number of IPOs, right? And I don't buy the calendar, we don't play the calendar, but what we do in about up to 25% of our fund at times are what we call broken IPOs or companies that came out with lots of fanfare and for whatever reason missed. We try to see if they could get back on the good growth bandwagon again and pick it up from there. Those tend to be amongst the biggest wins that we get.

Bill Hench: Yeah, you hate when they get big, but you know you've done your job, right? So yeah, everything that we have has a termination point. If you look at the top 20 names that we own, most of those are for sale because they've done so well, not because we like them so much. The stuff we really like is at the bottom of the portfolio that we're hoping a year from now things are going to get better, right? I hope a year from now more people eat at Chuy's and BJ's Restaurants and get on JetBlue and things like that. Whereas some of the other names, I wish them well, but I can't own them anymore because they've sort of gotten to a valuation that's out of my parameters.

Jenna Dagenhart: Kind of a good problem to have.

Bill Hench: It's a high-class problem, it's exactly right.

Jenna Dagenhart: Finally, as we wrap up this panel discussion, given everything that we have discussed today, I wonder where do we go from here, Bill? Million-dollar question, right?

Bill Hench: Where do we go from here, right? You know only a couple of things, right? You know we will have an election and you know people will spend, and when I say people, I mean the people that we elect will spend more than they should. So at least in the short term you'll have an economy that's probably in much better shape than anybody realizes, right? Right now, you could get a sense of that when both new industries, similar to a lot of banks probably that Brandon owns, and older things, things that we've owned, and things like housing, and autos. You mentioned Lithia, and there's Sonic, and there are all these other great little companies. I think we should be okay. You've got a situation where there's not much inventory, right? The auto companies on the lots not so much inventory. Some home builders have trouble filling out the appliances so they can get their CFOs to sell a house because everything was closed for three months, right? And that supply chain disruptions.

Bill Hench: So I think once we get over the hysteria and the feeling of being everything is always bad that you get from the media usually, and you stop looking at the numbers, at some point people are going to have to admit that mortgage apps being up 20% plus year over year, week after week, and refis being up 30 to 50%, and car sales much closer to 16 to 17 million than seven million are really, really good things, right? And all these wonderful companies that are coming out and making everything more efficient, and the fact that Amazon and everybody else was able to keep our economy open, when most of it had shut. Those are pretty powerful things. So, when you get a little certainty back into this market you could make the argument that a lot of the things that Brandon and that we're investing in should do really well. Now, there are going to be parts of the market that are awful, you bet, they always are. But there should be ample opportunity to make money, and lose money.

Jenna Dagenhart: Always. Over to you, Brandon. Finally, what's your longer-term outlook for small caps?

Brandon Nelson: If you can't tell already, I'm pretty optimistic, pretty bullish. I think we're in the early stages of a new bull market. I firmly believe that. The economic datapoints I think are going to get better, very short term. The election is such an overhang and such a question mark right now that I think getting it out of the way, regardless of the results of the election, will be a positive catalyst. I just think it's a fertile market for opportunities and I think active management is probably underestimated. There's been such a big move for passive investing, and I think this has been a big-time year. I think it's been a wake-up call for a lot of people that active management can make a big, big difference. This year has been very telling, I think, for that point.

Brandon Nelson: I would stay invested, allocate to smart managers that know what they're doing. Hopefully, I'm one of those, and I think Bill is. I can already tell just from meeting him today. Yes, I would stay engaged in the market. I think there is a lot of fear, and there's been fear the whole way up. People have been fighting it and scratching their heads and saying, "This is not right. How can the stock market be rising when the economy is so lousy?" There are so many question marks, and the market didn't care, it just powered ahead and I think that's probably going to continue.  

Jenna Dagenhart: You'd say stop worrying and stay invested.

Brandon Nelson: In a nutshell that's it, that's it.

Jenna Dagenhart: Well, thank you so much for your time. It was great to host both of you.

Bill Hench: Thanks very much.

Brandon Nelson: Thank you.

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