MASTERCLASS: Small Caps - October 2021
- 56 mins 08 secs
Inflation expectations, supply chain disruptions, and the regulatory backdrop are a few of the many considerations that small-cap investors are monitoring.Channel: MASTERCLASS
Two experts discuss why people sometimes tend to under allocate to small caps, compare active vs. passive management, and outline the ways that quality and a quant approach can add value.
Two experts discuss why people sometimes tend to under allocate to small caps, compare active vs. passive management, and outline the ways that quality and a quant approach can add value.
- Miles Lewis, CFA®, Portfolio Manager, Principal - Royce Investment Partners
- Ryan Myers, Quantitative Portfolio Manager - Causeway Capital Management
Jenna Dagenhart: Welcome to Asset TV's Small Caps Masterclass. Joining us now to share more about their approaches and different opportunities within the small cap universe, we have Miles Lewis, Portfolio Manager, Principal at Royce Investment Partners, and Ryan Myers, a quantitative portfolio manager at Causeway Capital Management. Ryan, investors tend to under allocate to small caps. Why do you think this pocket of the market is often overlooked?
Ryan Myers: Yeah, I think there's a general perception that maybe because these are small all companies that they may not matter or may not be consequential to ultimate return profiles, but if your goal is ultimately to get broad equity exposure, then small caps are definitely a key piece. And when you move into the international space, which is more of my focus, things become much more exaggerated. You're obviously struggling against the general home bias. U.S. investors in general tend to be overallocated to the us and underallocated to many global markets. But in my universe at least, we cover 48 different countries. And so it's a key piece sort to the global economy, getting exposure to that and actually, Morningstar quotes that if you look at U.S. equity mutual fund assets, only about 1% are allocated to international small caps.
Ryan Myers: And that compares to about 6% if you just look at their market value as a percentage of the total ACWI IMI index. And so, what's even more impressive though, is that by number, if you look at the number of stocks in the ACWI x-U.S. small cap index, roughly 4,400, which are actually 48% by count of the ACWI IMI index. So again, very big impact in terms of the number of names, in terms of the opportunity set. And one additional reason is that this space just isn't well followed by the sell side. If you look at the average number of sell side analysts on your typical international small cap stock, it's about four and that compares to 13, if you move into the international large cap space. So all in all, very interesting opportunity set and a key piece of anyone's portfolio.
Jenna Dagenhart: Miles, you manage a fund focused on dividend payers. Why does quality matter in small cap?
Miles Lewis: So, I guess the starting point would be that we kind of view dividends as a very crude beginning analysis for quality. And then from there, we have a much more nuanced definition, but in terms of dividend payers, just briefly, we like the space because our research shows that they outperform non-dividend payers over time. They do so with less risk. They have more attractive valuations and they tend to have higher returns than invested capital. So they're better business models. And in terms of why quality matters, small caps are very different than large caps. I think there's a general view you that small caps are structurally more risky. And I think as an asset class, using risk adjusted returns, that's maybe a fair point, but they get riskier when you get into individual stocks. And so the reason for that, just to kind of speak generically, a small cap company may be monolithic in its business model.
Miles Lewis: They may make one widget. And if that widget gets disrupted by technology, the company has no business. Whereas large cap companies tend to be much more diverse, more breadth and depth of products and services. And so small caps can be somewhat riskier on an individual stock basis. And so we believe that owning high quality companies is a great way to mitigate that risk. And one of the ways that we try to do it is focusing on preservation of capital and having better risk adjusted returns. And I think the easiest way to do that frankly is to not lose your investor's capital to begin with and starting by owning quality companies goes a long way towards achieving that goal. And so quality, I would also say is a term that gets thrown around pretty haphazardly. And we have a pretty nuanced definition.
Miles Lewis: So I mentioned that we start with dividends as just a crude indicator of quality, because it shows cash flow generation, management's thoughts and capital allocation, but on our team, on the total return team at Royce, we actually have a much more nuanced definition of quality where we define the quality of the business, the quality of the financials and the quality of the management. And we actually have a scorecard that ranks each one of those things. So business quality would be things like the source and duration of the competitive advantages, the pricing power of the company. If you have a good business, you usually have good financial attributes, so that would be high returns on invested capital, capital light businesses that throw off a lot of cash and things like that. And then management we think is particularly important in small caps.
Miles Lewis: So we want to look at their capital allocation track records, their incentive structures, are they aligned with us as shareholders, and that's important in small caps because the impact of a CEO can be far greater and small caps than large caps. If you think about, like a Procter & Gamble, for example, that CEO is presiding over a number of different businesses, each of which is kind of its own smaller midcap company. And so their ability to impact the company making strategic or capital allocation decisions is somewhat limited given the size and global presence of that company. Whereas the CEOs of a typical small cap company are usually very intimately involved in their businesses, both operationally and from a capital allocation perspective. And so their ability to impact shareholder returns both positively and negatively with capital allocation is really important. So we want companies that generate a lot of cash and have good businesses, but we want management teams that know how to allocate it. So we think that quality is just a great way to sidestep torpedoes in the portfolio to begin with and research shows that quality wins over time.
Jenna Dagenhart: Mm-hmm (affirmative). And what about quant, Ryan? What are the advantages to approaching small caps from a quantitative perspective?
Ryan Myers: Yeah, I mean I think there are three key advantages. The first is just the universe as I alluded to before. It's such a broad, flat index overall. There are 4,400 companies across 48 countries. The largest in our index is 24 basis points. And so it would be very difficult to comprehensively cover that universe from a purely fundamental perspective. The second advantage to quant is that it really allows diversification of alpha sources. Our alpha model examines stocks' relative strengths along four bottom up categories. First is valuation. So we want to find cheap companies and cheap companies relative to the country and sector. We want to see growth. We want to see positive revisions from the sell side. We want to see strong technicals. And then we also want to see very strong what we call competitive strength, which has a big quality tilt that Miles just discussed because it is very important in small caps.
Ryan Myers: And then we also couple those bottom up factors with various top down factors to help us make trade offs between all of the countries in the opportunity set. And just the sheer breadth of this universe means that we can find portfolio candidates that really check every one of those boxes that I just mentioned. In other universes, larger cap universes, you usually have to make trade offs. You may find a really high growth company, but it trades at a very expensive valuation. In small cap, you can really find all of those qualities in one particular company. And to give you a sense of that, our international small cap portfolio trades at less than half of the forward earnings multiple of our index, the MSCI ACWI x-U.S. Small cap index.
Ryan Myers: It has twice the ROE. It has more than twice the EPS growth. It has higher embedded momentum, higher embedded revisions. And so those kind of portfolio statistics would be very difficult to achieve in other universes. And then a final advantage to quant is really just the rigorous risk management. We have a proprietary risk model that analyzes a stock's exposure to over 100 different individual risk factors. And then as we optimize, it basically sees how each of those risk factors offset each other as you combine multiple positions into the portfolio. And so that the final portfolio we end up with really represents the highest expected return per unit of risk. But I would be remiss to not mention the fact that we do have a fundamental team that sort of provides an extra layer of risk control on the back end. We're realists in the fact that you can't quantify everything in the world so that when it comes to regulations, litigation, corporate actions, M&A, we run our trade list by our fundamental colleagues to make sure that we're not missing anything, that there's not anything outside the scope of our quantitative models, and we really see that as an extra risk layer on the back end.
Jenna Dagenhart: Miles, any areas that haven't quite broken out yet?
Miles Lewis: Yeah. Look, I love talking about individual industries and stocks, kind of the yin to Ryan's yang. We really like the property and casualty insurance space, which admittedly is kind of a boring space, but that's one of the reasons we like it. At the risk of putting some of our viewers to sleep, I'll explain a little bit about the insurance industry first and then I'll kind of talk about why we like it.
Jenna Dagenhart: Sometimes, boring is good.
Miles Lewis: Oh look, as value investors, boring is great. We love boring. Usually, things that are exciting have big multiples. So the insurance industry is kind of a better business model than I think a lot of people appreciate. So if you look at how they make money, they make money by issuing policies where they get premiums and their policy holders renew 85% to 90% of the time. So that's kind of like recurring revenue. The other way that they make money is they get the premium up front and then the losses aren't paid out for several years. And so that's called the float and they invest that float. And most companies do that pretty conservatively, which means they're putting it into fixed income. And a fixed income investment is effectively a contractual obligation to pay a coupon payment over some period of time.
Miles Lewis: So the vast majority of an insurance company's revenues are recurring in nature. Where the industry gets a bad rep is one, they have volatile losses because they don't really know what their cost of goods sold is until sometime later in the future. And then two, it's perceived as a commodity industry, which is generally true. We buy insurance based on price, but there are certain types of insurance companies that consistently earn 15% to 20% ROEs, which is pretty impressive when the overall industry doesn't earn its cost of capital. So why do we like the space? To understand that, you kind of have to understand what's called the pricing cycle within the industry. So it's a very cyclical industry, but it's not cyclically tied to the broader economic cycle. It's tied to pricing within the industry, which is effectively a function of capital flows in and out of the industry.
Miles Lewis: So when capital is leaving the industry, because there's maybe large losses from a hurricane or there's a pandemic, and people are reluctant to put capital to work. Then what happens is the pricing power begins to shift in the favor of the insurance companies and prices start to rise. And that's known in insurance parlance as a hard market. And we are in the midst of a hard market. It actually began a few quarters before COVID, and COVID served as an accelerant. So prices have accelerated. And historically, what you've seen is that when the insurance industry has a, a multi-year period of good pricing, the next three, four, fivce years show really good margin expansion, higher ROEs, acceleration in book value, growth and earnings per share growth. And so we think that that's the environment we're entering into right now.
Miles Lewis: In addition to that, terms and conditions within the industry are much tighter. So for every policy that you're getting, you're paying more, but you're getting less coverage. The analogy I like to use is it's McDonald's charging you more for a Big Mac while simultaneously shrinking the size of the burger patty. That's pretty good for their margins. So the insurance business is doing that right now as well. So there are these really strong, powerful, fundamental tailwinds building in the industry. And you overlay that against a group of stocks that has to your point, Jenna, generally lagged the market. And so the result of that is under performance and attractive valuations. A lot of these companies trade for less than tangible book value, quite a few at single digit earnings multiples. And so we think that's a phenomenal risk reward when you factor in these strong fundamental tailwinds with underperformance and attractive valuations.
Jenna Dagenhart: Single digit earnings multiples, what are those? You don't see those too often. And Ryan, how does the opportunity set differ internationally versus in the U.S.? which countries and sectors are most heavily represented in the international small cap universe of stocks?
Ryan Myers: Well, for one, obviously we're dealing with 48 countries instead of one. So it's a much broader geographic landscape. And if you look at the composition of our index, there are really only two countries over 10% of the index, Japan and the United Kingdom. And it drops off pretty dramatically after that. Interestingly, China, which sort of dominates the large cap space, is only 2% of the small cap index. So it's much less influential, much less impactful in the total grand scheme of the universe. If you compare the sector composition between U.S. small cap and international small cap, what you'll find internationally is a little higher weight to industrials, a little higher weight to materials, especially from some of the emerging economies and a little less weight to financials overall. But the differences aren't terribly different. I'd say one additional difference is that in the U.S., there's sort of a natural perception that small caps are these young upstart companies. What we find is that the average age of the companies internationally tends to be a little older than those in the U.S. And so they're in many cases, mature businesses, mature companies that just happen to still be small in size. Again, as Miles mentioned, sometimes that relates to just narrowly focusing on one business, but they tend to be in many cases sort of mature businesses without much startup risk.
Jenna Dagenhart: Now turning to inflation, we hear so much about inflation these days, Miles. How concerned are you about price levels as a headwind for some of the small cap companies that you own?
Miles Lewis: Yeah, I'll start with my opinions on inflation, which should be taken with a grain of salt. I can tell you, look, we're bottom up fundamental investors. And from the bottom up perspective, inflation is very much alive and well, despite what the yield on the tenure treasury bond would tell you. It started with raw materials. It's spreading into wages. You're seeing supply chain issues cause inflation. You're seeing inflation in freight. I mean, it's really ubiquitous. And we see it in every company that we look at. We hear about it from every CEO that we talk to. So it's very much alive and well. And the key debate obviously is the duration of inflation, and I'm not well suited to have a strong view on that. The bond market certainly appears to be in the side of the fed that it's going to be transitory.
Miles Lewis: We really don't know. I think you can make some pretty powerful arguments that it could last longer than people expect, and be structurally higher for a period of time. But ultimately, to your question, Jenna, what does it mean for us as small cap investors? It kind of goes back to quality. We think that owning quality businesses is a really good hedge against inflation because if you think about one of the hallmarks of a really good business, it's pricing power. And so what we have seen thus far over the last few quarters for total return, the primary fund that I'm involved with, which owns really high quality companies, is that their margins have been very, very resilient. Some of the companies are passing them on in real time. Some of the companies that we own will have a little bit of a lag, but they'll catch up after a quarter or two. And if inflation does roll over, they'll actually see some margin expansion on the way back down. And then we own a few companies where we actually think that they'll benefit from inflation and actually see expanding margins. And so we feel really good about the portfolio holdings that we have and their ability to withstand inflation. And again, that comes back to quality, which I think is important in this environment.
Jenna Dagenhart: Ryan, is there a general perception that small caps are riskier? Actually, I'm not going to ask because okay, Ryan, there's a general perception that small caps are riskier. Is this true? How do correlations among stocks impact risk management?
Ryan Myers: Yeah. I mean, I think there is that perception. I think it really goes back to the size premium in general, which has been researched for decades and the risk explanation for why small caps in theory should have higher returns is the fact that they are riskier, that they have a higher risk of failure. And so as an investor in small caps, you should be compensated for that risk with higher returns. And as Miles alluded to, it's true that if you look at the volatility of individual stocks, it tends to be much higher than large caps. However, that's really not all of the story. If you're assembling a portfolio of stocks, what also matters is the correlation of one stock with the next stock, and how the ultimate portfolio fits together. And the international small cap universe is very unique in that it's very heterogeneous. There's a lot of idiosyncratic drivers of individual stock returns.
Ryan Myers: And so it creates what we call low pairwise correlation. If you just take the average correlation of one stock with the next and repeat it for every combination of stocks in the universe, it's about half what you observe in the U.S. And so that makes putting together stocks into a portfolio, the final volatility of the index is actually not too dissimilar from a large cap index. And to give you an example of that, over the last 10 years, if you look at annualized volatility of the international small cap index, it's about 16% compared to about 15% for the large cap index. So again, it really comes down to the fact that these stocks are very idiosyncratically driven and therefore, create very low correlation with each other.
Jenna Dagenhart: And Miles, could you speak to the nature of the recovery supply chain issues and people's willingness to wait for those supplies?
Miles Lewis: Yeah, Jenna, it's been really fascinating. I mean, I think I'm stating the obvious that the recovery is booming. Obviously there's going to be some softness here in the near term because of the Delta variant. I think our view is that just gets pushed into Q4 or '22. And so kind of on a two year stack basis, you'll still have pretty robust growth, but that is creating supply chain issues. And I think what happened here is people shut down because of COVID and typically, coming out of a recession, it takes a couple years, sometimes longer to get back to kind of your pre-recession levels of output and because of the nature of this recovery and the pandemic we got there in a quarter or two and supply chains just simply weren't prepared for that strong snapback in demand.
Miles Lewis: And so that's creating huge bottlenecks everywhere. I mean the two that stand out to me that are kind of most obvious as an everyday consumer are automobiles, where inventories at dealerships are at all time lows. Of course, that's largely a function of a shortage of chips predominantly coming out of Asia where they can't do final assembly of the vehicles. The other one is furniture. If you order a sofa today, it could take you six months to get it. So we do believe that a lot of this delays and backlogs that are building because of these supply chain issues will ultimately show up as real demand. I mean, going back to the sofa analogy, if you buy a house and you need a sofa, you can't not have it.
Miles Lewis: You're not going to have your whole family sit down on Sunday on the floor to watch football games. You're going to eventually need to buy the sofa. There are risks if this continues for a long period of time. One, it's very inflationary. Two, it could cause demand destruction. And then the third thing is you risk what's called double ordering. So companies start saying, "Oh gosh, I'm not sure if I'm going to get that part or that supply that I need in my manufacturing process. So I'm going to order 50% more just to have a buffer." And then that creates kind of this vicious cycle where other people do it and they start bidding up prices. So we think the demand will ultimately be met, but I believe that these supply chain issues are going to take a little bit longer than many think to work out.
Miles Lewis: And I think that for a couple reasons. The first is that if you think about factories right now, kind of globally probably, certainly in the U.S., they're running all out. And they're really just doing that to meet demand, right? They're trying to run as fast as they can to get that couch to you in six months, but they're not building inventories, and inventories will eventually need to be rebuilt. We had a just in time inventory manufacturing kind of world in corporate America pre-COVID, where you just bought enough parts and supplies to meet your current production schedules. That may change, and so people may want to have some safety stocks. So the inventory rebuilding could be even more pronounced, which is going to put more pressure on supply chains to meet demand when this current demand kind of starts to subside.
Miles Lewis: You have economies that are recovering at different speeds. So there are lots of economies around the world that are well behind the U.S. in terms of their recovery. And if they see similarly strong rebounds, then that's going to put pressure on supply chains globally. And then the last thing is just that I think in certain instances, new capacity takes time to add. I mean, it is not cheap, easy or fast to build a semiconductor fab. You can't have one of those done by the holidays. That takes years and billions of dollars. And so I think some of these issues are going to persist longer than people expect. And that's kind of one of the fundamental reasons that I think inflation may run a little bit hotter than people think.
Jenna Dagenhart: Who would have thought that minivans and sofas would be such hot commodities in 2021?
Miles Lewis: Yeah.
Jenna Dagenhart: And yeah, to your point about economies recovering at different speeds, Ryan, I'm sure this is something that you're watching closely given your international focus.
Ryan Myers: Yeah, absolutely. I mean, it's interesting because a lot of the emerging world, I would say excluding China, are finally getting past earlier waves of COVID and so they're seeing sort of a resurging demand relative to the U.S., which is arguably later in the recovery, Delta variant aside. So yeah, I would agree with Miles that it's definitely contributing to perhaps some sustained global demand. And we see it in, our fund is overweight, a lot of the marine shipping companies and you see it there sort of front and center, both demand being very strong and supply being constrained to Miles' earlier point. In some cases, shipping rates intra-Asia are up five times year to date. And so that's creating, obviously supply chain shortages. And that's due to a variety of things, labor shortage, supply constraints, port congestion, and to Miles' earlier point, same with shipping, much like semi conductors, it takes two years to build a new ship in many cases. And the old ships are being scrapped for environmental reasons because they're not compliant with current emission standards.
Ryan Myers: And so this will take some time to store it out. And that's why as a sub segment of the transportation sector, we definitely like some of the shipping names currently because they're actually benefiting from these temporary shortages and they'll eventually work out. But as I said, it will take some time. It will take probably a number of years to fully work out.
Jenna Dagenhart: I believe the number of ships waiting to unload at ports is at record highs right now. Ryan, in what market environment do you expect small caps to outperform large caps?
Ryan Myers: Well, I mean, going back to their long term track record, they do have a track record of performing very well across market environments. I think if you had to characterize when they perform even better, it would be largely during risk on periods. Obviously, investors need to become comfortable with the fact that we're not at the very end of an economic cycle, that maybe we're at the beginning or middle. That gets people a little more comfortable with small caps in general. I think again, going back internationally, what we've seen too, especially in emerging markets, what you saw is small caps underperform large caps in 2016, '17, '18, '19, '20. And it was because of the big China mega caps. They were really dominating growth. They were sucking up a lot of investment dollars at the time. That's obviously reversed into 2021.
Ryan Myers: And as a whole, international small caps have outperformed large caps by about 7% year to date through the end of August anyway, and in emerging markets, it's much more dramatic. It's 18% between emerging market small caps and emerging market large caps. And I think, again, it comes back to sort of the potential end of the Fang dominance of the equivalent in emerging markets, which is sort of the BATs, the Alibaba, the Tencent, Samsungs of the world. They're sort of taking a backseat in terms of returns recently, partially because of regulation, partially because of other issues. But again, going back to the long term track record, small caps do tend to outperform large caps over long periods of time.
Jenna Dagenhart: Miles, you keep a spreadsheet of macro themes from earnings calls that you're listening to. What are some of the main issues that you've been observing lately?
Miles Lewis: Yeah, there are a lot of the things that Ryan just talked about actually. So I had the spreadsheet that I track for all the quarterly earnings calls that I follow every quarter for all the businesses that we own. And I inserted a column recently about a year ago to kind of just keep an eye on the macro. And the one thing that stood out very clearly over the last three or four quarters was inflation. We've already talked about that one, but there were a few more that kind of emerged here in the most recent quarter. And those were supply chain shortages, which we just talked about. They were labor shortages and they were freight issues. So on the labor side, there's a dearth of skilled labor in the manufacturing economy in the U.S.
Miles Lewis: And in some cases that is limiting companies' ability to fulfill demand. Most importantly, it's causing wage inflation, which as we all know, is sticky and will eventually get passed along to the end customer. And then on the other side of it is freight, which is what Ryan just mentioned. Ocean freight is a huge cost. I saw things that's at 4x to 5x as well. It's because there aren't enough containers. It's because the infrastructure at the ports isn't well suited to meet huge volumes of containers coming off all at once. And so you literally have goods sitting on ships off the coast of California, just waiting, and that can take weeks or months. The other freight issue that's a little bit more of a domestic issue is trucking. So trucking, like ocean freight, those spot rates have been going up very, very significantly.
Miles Lewis: And historically, that's kind of been the cure for high trucking prices or spot rates was high spot rates because eventually, it attracts new trucks, new supply and new drivers, and they come back down. You're not really seeing that right now, and it's because of labor shortages on the trucking market. So if you think about the life of a trucker, that's a tough job. You're on the road for long periods of time. You're not sleeping in your own house. You're away from your family. It's a monotonous job. And so when there are better alternatives, truckers oftentimes tend to gravitate towards those, and one of those industries is the construction industry, whether it's residential construction or non-residential construction. And those two industries, particularly residential are doing very well right now. So it's hard to see how those issues get fixed in the near term. But again, kind of coming back to quality, we want to own companies that have the ability to withstand those pressures and also kind of the operational acumen and efficiency to manage through it, whether it's reengineering products to take costs out, to manage inflation or finding new efficient ways of manufacturing your products to preserve your margins. Those are the kind of companies that fare very well in an environment like this one and the types that we gravitate to.
Jenna Dagenhart: And of course we're experiencing all these issues as more and more people are just clicking and having things ordered right to their door versus going to a store. We're seeing such a rise in online shopping, which isn't helping. Now, Ryan, how's the regulatory backdrop impacting international small cap companies?
Ryan Myers: Yeah. I mean obviously, China is dominating the headlines from that perspective recently. And as I said before, China is a much smaller part of the international small cap universe, only about 2% total market value versus about 12% in the large cap space. And so it's less of a concern and the companies, the Chinese companies that are in the index tend to be sort of outside the regulatory crosshairs of China, but that's certainly something we're monitoring because what began as really an anti-competitive crackdown on Alibaba late last year has expanded pretty dramatically into some targeted social initiatives and outcomes with regard to video games and education and even casino gaming. And so it's something that we keep a watchful eye on. And we really depend on our sector focused fundamental team to alert us to any changes in the regulatory environment, whether it's at the country or sector level. But second, I would also make the point that small caps, international small caps generally have a much smaller revenue percentage coming from abroad. They tend to be much more domestically focused companies. And so if you believe that either trade barriers are increasing globally or to the extent that COVID sort of restricts international trade for a more extended period of time, these companies are much less likely to be impacted because they're getting most of their revenues from their local economy.
Jenna Dagenhart: And Miles, back to some of the macro themes, how are you monitoring interest rates and monetary policy given the relationship to dividends?
Miles Lewis: Yeah. As you've kind of gathered, I'm a bottom up fundamental investors, so I think it's hard enough to forecast the financials of the businesses we think we really understand. So my ability to kind of peg the direction of interest rates in the U.S. is pretty limited, but I'll throw out my views. I kind of try to bring it back to fundamentals. And I think it's interesting to do kind of a compare and contrast between 2019 pre-COVID and where we are now. And if you look at 2019, nominal GDP growth was about 4%. CPI was a little less than 2%. Unemployment was I think in the high threes. And the 10 year was somewhere around 200 basis points. Fast forward to today, nominal GDP growth is going to be 10% plus this year. It's going to be 6% plus next year. Unemployment rate should kind of end the year in the high 4s, a little bit higher, but not materially.
Miles Lewis: So if you look at inflation today, it's running much hotter multiples of what it was back in 2019. And where's the 10 year? It's at 130 basis points. And so to me, the fundamentals clearly suggest that rates should be higher, but of course they're not because of extraneous forces like the Fed or foreign buyers, who are relatively attracted to the rates here in the U.S. versus lower rates abroad. And so what does that ultimately mean? We're kind of in the view that a strong economy and the Fed that's eventually going to taper, which removes a large incremental buyer should result in higher rates. And so to your question, Jenna what does that mean kind of for dividends and dividend yield? Of course, higher rates do create more competition for dividend yielding stocks or higher yielding stocks at least, but there's a couple counterpoints that I would make in the small cap space.
Miles Lewis: The first is that Royce's research shows that when the 10-year is rising, small caps historically outperform on average. And so that's a good backdrop there. And the second thing as it relates to the dividend payers that we own at least, we're not owning dividend payers strictly for the yield. So we do not really do much in the kind of bond proxy space like REITs or utilities. The dividend payers that we own tend to be more cyclically oriented, specifically financials, which would obviously benefit from a higher rate environment as well as industrials and materials and things like that that are kind of more procyclical. So I think it depends on kind of the composition of the dividends that you're looking at within the small cap space. But I do think higher rates being a good tailwind for small caps is pretty powerful as well.
Jenna Dagenhart: Ryan, looking at your models, can you do discuss any recent model enhancements from your quantitative research?
Ryan Myers: Yeah, I mean I alluded to one initially, which was our competitive strength, our research into quality, which Miles has spoken about. We added that as a factor category late last year after extensive research. Again, it goes back to the perceived risk that small caps have a higher chance of failure. And so what does it mean to try to exclude those? We found very useful theoretical framework in Michael Porter's Five Forces. Of course, he's a professor at HBS and his Five Forces really try to isolate the characteristics that are consistent with very strong potential industry growth. And we basically try to apply that at the company level. And so if you look at what the characteristics are that make a good small cap company really have some longevity, we place a lot of emphasis on margin trend, increasing margins on increasing returns.
Ryan Myers: We examine the industry structure of a specific company, how its market share is changing over time in addition to balance sheet strength. And so it really comes back to quality. We see a lot of those factors to be very good compliments to value too, which is much more of a contrarian indicator. And then in terms of current research, one of our interesting projects that we've been developing for a while is natural language processing of earnings call transcripts. And so we use basically machine learning technology to analyze specific words and phrases that come up in these earnings calls and then see how well those are correlated with future positive earnings revisions. And so far, we've found a lot of very positive traction. Again, whenever you're using machine learning, there's a chance of overfeeding and finding patterns that aren't necessarily repeatable. And so we've been doing a lot of road testing with our fundamental analysts, making sure that they agree with sort of the sentiment score from a particular transcript versus how they read the transcript, or if they listen to the call, how they perceive that call to go. But we think there's something very promising there to develop or to incorporate some time in the future.
Jenna Dagenhart: Big fan of the Five Forces, and I'm sure you are as well as a Harvard alum and Miles, I know you probably studied that in the CFA curriculum as well.
Miles Lewis: Absolutely, yeah. We use it every day.
Jenna Dagenhart: Now, Miles, how's the choppiness of market leaders creating opportunities to get in and out?
Miles Lewis: Yeah, it's a really interesting phenomenon, Jenna. I think the one thing I'd kind of just say as an overarching statement is, and Ryan probably knows this stuff better than I do as a quantitative person, but the asset classes of the groups of assets that worked the best over the last 10, 12 years are very unlikely to work the best over the next 10 or 12 years. Financial history suggests that that's a very remote possibility. And part of that is that valuations get stretched, whether it's the 10 year bond trading at a 75 PE with no growth and negative real returns or mega cap, or high growth tech stocks trading at big multiples. Ultimately, those returns are more subdued. So we think we're likely going to see a different regime over the next kind of five to 10 years.
Miles Lewis: And that ties into your question of this kind of chopiiness in the market, which to me, I call it a tug of war. And it seems to be between kind of the new defensives of you mega cap, tech and growth and bonds. I guess bonds have always been defensive. And those tend to do very, very well on a day when the market is maybe concerned about the Delta variant or the long term outlook for COVID and then vice versa when the market is less concerned about the pandemic, or feels like we're getting back to normal. You see the more cyclically oriented things like small caps and value and financials do very well. And what's fascinating to me is that this tug of war isn't happening over kind of a few months where one does well, and then the other doesn't.
Miles Lewis: It happens on a day to day basis. I mean, you'll literally see it every day. One group will outperform and then the next day, the opposite group will outperform. And so that to me says that the market is kind of confused and not sure which way things are going to shake out. And we believe that it's probably going to shake out in favor of value. Royce's research says that when nominal GDP growth is 5% or more, value tends to do very, very well. So that's one thing. We think there's a lot of different reasons to believe that this value cycle we think we're entering is different than the head fake in 2016. And so ultimately, what that does is it creates opportunities for long term patient investors like those of us here at Royce. I mean, we're looking at three to five years. And so the market will in this environment leave behind entire groups of stocks or individual stocks simply because they're kind of not what the market wants at that very moment.
Miles Lewis: So a great example would be a company called Silgan Holdings, which we own. It's a packaging company just up the road in Stamford, Connecticut, and they make everything from metal food cans for pet food and tuna to the tops on Gatorade bottles, to the dispensers for perfume and cologne. So it's a kind of a consumer packaged goods arm supplier. And so that means it's a very steady, predictable grower with good predictable cash flows. It also means that it's a very defensive business and that it did very well in 2020. And the byproduct of that is that 2021 creates difficult comparisons because of how well they did during the pandemic. And so the market has kind of not left it for dead, but let the stocks significantly lag other small cap value stocks. And when we step back and kind of zoom out, what we see as a really good business with contractual earnings, the ability to pass through price very quickly, and a company that has compounded earnings per share at 10% plus over a decade and free cash flow per share closer to 20% trading at less than 12 times earnings and a 9% free cash yield.
Miles Lewis: So it may not work in the next three months or the next six months, but we're pretty confident that over the next three to five years, the value that they've created over the last 10 years will be there over the next five to 10 years. And it also is a nice defensive stock, which is great for a kind of low volatility fund, like total return. And so that's just one example of some of the opportunities that are being created between this kind of tug of war in terms of market leadership.
Jenna Dagenhart: Ryan, how does active management stack up against passive in the international small cap space?
Ryan Myers: Yeah, it stacks up quite well. If you look at the track record, active managers have a much better track record at producing alpha among small caps, and especially in international compared to large caps, a lot of it comes down to just the inefficiency of the space. I mentioned before much less sell side coverage overall. It costs a lot more to borrow. And so shorting is much more expensive when you get into international small caps, which just encourages further inefficiencies. And that obviously creates an opportunity for active management. Also I would say that the valuation dispersion tends to be much higher. So the difference between what's really expensive and really cheap in international small caps is much wider than you see in other universes. And so arguably, there's more information content in the, value spreads and therefore, looking at valuation actually does count for something in international small gaps.
Ryan Myers: And then of course it comes back to the size and the breadth of the universe, and the fact that passively replicating a universe with 4,400 stocks where the largest one is 24 basis points of the index is practically impossible. There's one ETF that comes to mind that tries to track the FTSE equivalent of the international small cap index. And over the last five years, it's produced annualized tracking error of about 4.4%. And so, obviously our opinion is if you're going to generate that much active risk passively, you might as well get some active return earned to go along with it.
Jenna Dagenhart: What about the performance of international small caps versus other equity asset classes?
Ryan Myers: Yeah, I mean I mentioned it earlier, but over the last 10 years, international small caps have outperformed international large caps by about 180 basis points annually, and with only slightly higher volatility. And so the sharp ratio ends up being about 17% higher than in large caps. And so the long term track record is there. I'd say again, going back to emerging markets specifically, there's been a trend from 2016 to 2020 where large caps were really outperforming, but that was mostly attributable to the China mega caps. And that trend is obviously reversed this year. It's true that U.S. small caps have outperformed international small caps over longer periods of time, especially in the last 10 years, but the two have performed pretty comparably in 2021 so far, at least through the end of August, but now you have this big valuation disconnect.
Ryan Myers: Obviously the U.S. market, U.S. small caps trade at about 22.5 times forward earnings compared to international small caps at about a little over 16 times. And so we think that it's easier to find some better valuations internationally currently. And if you look at what's worked in international small caps, to go back to Miles' point, there has been some ebb and flow, but through the end of August, it really has been the cyclical sectors, industrials, financials, energy and materials that have led the way in the international small cap space while some of the more defensive sectors like staples, utilities, healthcare have lagged.
Jenna Dagenhart: Miles, some bears are saying that stocks have gotten too expensive. How have PE ratios evolved in the small cap space? We're seeing an uptick in valuations, but earnings seem to be keeping pace.
Miles Lewis: Yeah, Jenna, that is kind of the mainstream narrative that valuations are rich. And to an extent that's true. I think it just depends on where you look. I mean, large cap indices are expensive, particularly relative to small caps. Growth stocks are extremely expensive, particularly relative to value stocks. So I think it kind of depends on where you look. The corner of the market that we focus on is small cap value stocks. And I would suggest to your viewers that we see a lot of value. Ryan just said, U.S. small caps, I think at 22.5 times forward earnings, the total return portfolio that we manage is a little over 13 times forward earnings. And that's not just being dragged down by banks and insurance companies, which are the traditional value sectors.
Miles Lewis: And we've got lots of good industrial businesses, tech, materials in there. They're really good companies trading at very undemanding multiples. And so I've been pleasantly surprised with the amount of opportunity that we've found. I mentioned PNC, which we like a lot. We do like banks a lot. They've had a good run, but we think net interest margins are bottoming and will begin to expand as they kind of remix their balance sheets from earning nothing at the Fed towards putting it into loans as loan growth picks up and loans yield 3% or 4%. So that's a good mix shift. We think that M&A is going to continue to pick up. We actually had a portfolio company here today announce an acquisition and the stock was up nicely. We also like industrials, as I alluded to. We've got some industrial companies that trade at less than 12 times earnings.
Miles Lewis: And historically, when you see a cyclical trading at a lower multiple like that, the market is usually implying that the cycle is about to end and that those forward earnings estimates are too high. And we just kind of have a hard time believing that given that we are in the very early innings of a recovery, and that's not just history, but it's also what our CEOs of the companies that we own tell us. And then we're pretty constructive on housing too. There has been a pull forward of some demand because of COVID obviously, but we think structurally, the U.S. market is underbuilt after over a decade of not adding to housing stock following the housing crisis in '09 and '09. And so that creates opportunities along the housing supply chain, which is pretty broad and interesting. And one area that we like there is title insurance, which is not something people would think of as housing, but it is. It's a direct play on housing.
Miles Lewis: And this is an industry structure that's effectively an oligopoly. The top four players control 80% or 85% of the industry. They have very good pricing power. They have very attractive margins and they trade for 10 times earnings or less. And they're a direct bet on the housing market. So we've thrilled to find some pretty attractive opportunities. And we think the valuations of the stocks that we own are very compelling, particularly against the backdrop that you were kind of alluding to earlier with valuations being pretty rich everywhere else.
Jenna Dagenhart: Yeah. It's funny you mentioned that. I actually just saw a report from realtor.com that the U.S. is short within 5 million homes right now.
Miles Lewis: Yeah, different people have different numbers. I think it's safe to say that it's short, whether it's 3 million, 5 million, 7 million, it's short.
Jenna Dagenhart: Yes, certainly. Well, Ryan moving over to you, what are some of the characteristics that you look for when selecting stocks? And could you discuss a few of the stocks that your portfolio currently holds?
Ryan Myers: Yeah. As I mentioned earlier, we look for a variety of different bottom up characteristics. We want to see cheap companies that are growing. We want to see positive earnings revisions, positive technicals and good competitive strength. And we find a lot of companies in this space that tick all of those boxes. One of those right now is a company called Hyosung TNC, which is a South Korean fabric producer, particularly spandex. They're actually the largest global producer of spandex, with about 30% market share. And I think as we can all admit during the lockdown, we've all started wearing a little more spandex.
Jenna Dagenhart: Guilty, yeah.
Ryan Myers: So spandex prices are actually up a lot due to demand. And actually some of their key inputs, the prices have fallen so margins have increased. There are some capacity additions on the horizon, but we expect demand to more than offset that. And this is a stock that trades at just five times 2022 EPS. So we like that. Another interesting company is called Royal Mail in the UK. They're the sole provider of letter delivery services in the UK. And obviously that's a shrinking business and not that exciting, but their other business is a logistics and parcel delivery service that's, pan-European, that's much more interesting. Obviously, as you mentioned earlier, it's benefited tremendously from the spike in e-commerce from the lockdown. There's obviously a debate, whether that's just a pullforward, a future demand. We think instead that habits have sort of permanently shifted and there will be a higher base level for parcel deliveries going forward. And again, this stock trades at 7.5 times 2022 earnings. It's got a net cash position, pretty strong dividend growth overall. And there's been rumors that they've been trying, they've been looking into, splitting the two businesses, which would obviously unlock further value.
Jenna Dagenhart: And Miles, any final thoughts on your end that you'd like to leave with some of the financial advisors, financial professionals out there watching today?
Miles Lewis: Yeah, maybe just one. I beat the drum pretty hard on quality. We stick with quality throughout the cycle. It really doesn't matter if low quality is working or something else is working. We don't chase those things, but I do think that now is actually a very opportunistic time to be looking at quality. The high quality stocks that we follow have lagged low quality stocks dramatically over the last 12 to 15 months. As a result of that, high quality stocks are about as cheap as they've ever been versus low quality. And then the last thing I'd say is that Royce's research shows that in the second year of a bull market, you typically see quality begin to outperform as that baton gets passed from low quality to high quality, and we are obviously in the second year of the market. So we think it's an opportunistic time to be looking at quality, even though we stick with it through the duration of the cycle.
Jenna Dagenhart: Ryan, any conclusions that you'd like to share?
Ryan Myers: Yeah. I mean quality is certainly always important. I mean, I would also say that now's a pretty good time for value. We obviously saw post-vaccine news, a value rally for some months. More recently, there's been a debate on where we are in the cycle and what that means for value. What you can say though, is that generally speaking, higher interest rates are bad for growth companies whose duration is longer, whose cash flows are coming farther into the future. And so as the Fed hikes eventually, as they taper and eventually hike and as EM, central banks hike particularly, and by the way, they've actually led the Fed. They've been increasing rates quite a bit this year, a variety of EMs, Mexico or Russia, just to name a few. Those should benefit at the margin, the higher rates should benefit value companies overall. And so we do look at a variety of different factors when we're looking for portfolio holdings, but value is still the biggest component, the biggest input of our process. And we think that the backdrop is pretty favorable right now.
Jenna Dagenhart: Well, Ryan, Miles, I wish we had time for more, but we better leave it there. Thank you so much for joining us.
Ryan Myers: Thank you so much. Thanks for having us.
Miles Lewis: Yeah. Thank you so much, Jenna. I really appreciate it.
Jenna Dagenhart: Of course, and thank you for watching this Small Cap Masterclass. I was joined by Miles Lewis, Portfolio Manager and Principal at Royce Investment Partners and Ryan Myers, Quantitative Portfolio Manager at Causeway capital management. And I'm Jenna Dagenhart with Asset TV.