Small & SMID Caps – 2020 FAQs
Cambiar Small Cap Portfolio Managers Andy Baumbusch and Colin Dunn answer some of the most frequently asked questions regarding small-cap and midcap stocks.
Performance in the small and SMID value strategies was strong in 2019, what gives you confidence it is sustainable?
First and foremost, delivering strong investment results is about picking the right stocks, which starts with robust industry and company-specific research at the analyst level. Cambiar has invested heavily in our domestic analyst team over the last four years, adding four individuals that bring extensive experience, a rigorous approach to research, new points of view and a wider variety of career vintage. Returns from these individuals have been strong, rounding out a research team that has collectively led to stock selection as the largest source of the outperformance produced by the portfolios in recent years, including 2019. With strong inputs at the analyst level, a clearly defined ‘Alpha Hypothesis’ for stock selection and portfolio construction and a management structure to support broad accountability, we are excited about our chances of delivering attractive returns to clients over the medium to long term.
What are the key attributes you look for in an investment candidate? Alternately, what metrics would constitute a red flag?
Initial underwriting of any position is the most critical determinant of both forward return potential and risk mitigation. We are looking to identify businesses that possess a durable structural advantage – be it a differentiated product and/or market position that is verifiable in above-average financial metrics over time – in margins, return on invested capital, and ultimately a pattern of consistent free cash flow. Metrics we are particularly sensitive to are of course absolute valuation in and of itself. And then leverage – which can not only impact the going concern realities of an ill-positioned business in a period of stress, but can also disproportionately impact equity valuation in surviving businesses as an enterprise value-based metric compresses. We are also wary of the popular, yet ill-considered adjusted EV/EBITDA reliance by management teams, Boards and private and public equity investors.
Given that we are in the latter stages of the cycle, can you comment on the investable universe for Small-Cap? Are there certain sectors that offer more/less opportunity?
The 10+ year bull market, extraordinarily low cost of capital, tight credit spreads and mountains of private capital have undoubtedly winnowed the spectrum of interesting opportunities down the market cap spectrum. In addition, with near 40% of the Russell 2000 non-earningI, the need to be circumspect with small-cap exposure has arguably never been higher. The good news is that we feel small caps still possess their own volatile trading character, which in combination with the reduction in liquidity brought on by the rise in passive equity strategies and tools consistently creates attractive entry points in high-quality small-cap businesses if one is able to exercise patience and maintain opportunistic capital to pounce. In recent months we have uncovered opportunity in a diverse set of businesses in energy, industrials, financials, REITs, and health care, continuing to dig across sectors.
What impact (if any) has a persistently low rate environment had on the investment process?
Persistently low rates have at some level enabled less advantaged businesses and non-economic capacity to persist (see 40% non-earners per the above), which in its own way has impacted inflation or lack thereof, and created a somewhat self-perpetuating dynamic. While we have been a little more flexible on absolute valuation parameters in rate-sensitive sectors like REITs and Utilities, we continue to use relative valuation to US Treasury yields as a sanity check in those companies. Away from the rate-sensitive, we continue to focus our research and investing in businesses less reliant on either the capital markets broadly, or a low cost of capital specifically, to fund/construct their operating business model and/or long-term capital structure. While markets are sanguine about debt levels and ability to pay today, the turn can happen fast, and we seek to provide adequate downside capture as a critical component to preserving long-term, compounding returns in small-cap equities.
Value vs Growth has continued to be a headwind, can a value investor be effective in this market?
Whether a “growth” or “value” market, identifying and executing on an attractive entry price for a high-quality business is always possible. We have been effective in recent years on the back of excellent core research, price/valuation discipline and keeping a balanced set of value drivers top of mind across the wider small and SMID portfolios. Research has that although the value investor has earned 36% less wealth than the growth investor since the start of 2007, the value investor is still 6.1 times as wealthy as the growth investor over the period from July 1963 through September 2019II. Financial gravity and cash flow based returns have a history of winning out in the long run over multiple itself. There are many narratives seeking to explain why the investing world has changed forever – perpetually low-interest rates, explosion in private markets, technological change, etc. We are unable to conclusively prove otherwise at this juncture, but sense continuing to focus on high-quality stocks, and understanding how their excess cash flows can continue to accrue to the minority equity holders of those businesses will prove a value accretive effort for our patient long term clients.
Please discuss future performance expectations
Year to year performance of any capital market is always uncertain, as it pertains to equities, especially in high active share portfolios as at Cambiar, stock selection is likely to remain a key driver. However, given our stated preference for quality businesses, the portfolio skews towards highly profitable companies, with low leverage and tends to have an above-average market cap versus the index, given larger companies tend to post superior margins, returns and free cash flow characteristics. A “risk-on” rally where lower quality businesses rip to the upside would likely present a headwind to performance on a relative basis. But we are prepared to endure these likely periodic events as the types of companies we are pursuing are more likely to be able to compound annual returns over a multi-year period given their superior market positions reflected in their margin and return profiles. We also believe this bias is more likely to yield better downside capture as market selloffs periodically occur, as companies with more durable earnings streams better weather leaner times given robust free cash flow and modest leverage allowing for a tangible financial cushion versus peers. All-in, whatever the ultimate investment backdrop in 2020 and beyond, we have confidence in our ability to deliver strong returns for clients on a rolling 3 and 5-year basis.
IIRobert Arnott “Report of Value’s Death May Be Greatly Exaggerated”
Certain information contained in this communication constitutes “forward-looking statements”, which are based on Cambiar’s beliefs, as well as certain assumptions concerning future events, using information currently available to Cambiar. Due to market risk and uncertainties, actual events, results or performance may differ materially from that reflected or contemplated in such forward-looking statements. The information provided is not intended to be, and should not be construed as, investment, legal or tax advice. Nothing contained herein should be construed as a recommendation or endorsement to buy or sell any security, investment or portfolio allocation.
Any characteristics included are for illustrative purposes and accordingly, no assumptions or comparisons should be made based upon these ratios. Statistics/charts may be based upon third-party sources that are deemed reliable; however, Cambiar does not guarantee its accuracy or completeness. As with any investments, there are risks to be considered. Past performance is no indication of future results. All material is provided for informational purposes only and there is no guarantee that any opinions expressed herein will be valid beyond the date of this communication.