After a period of small cap underperformance, the focus may shift to fundamentals.
Small-capitalization equities have underperformed larger stocks over the past year, and experienced a particularly rough stretch of negative performance in the second half of 2015 and into early 2016. The Russell 2000 Index, a popular benchmark for smaller stocks, declined more than 25% from its peak last June through a low in February of this year. To assess risks and opportunities in small caps, we tapped into the insights of two of Neuberger Berman's small-cap equity managers, Benjamin Nahum and Robert D'Alelio.
Benjamin Nahum : Contrasting today's market for small cap stocks with June of 2015, we see significantly more value but with greater volatility. A year ago it was the inverse. Arguably the current environment presents more challenges, including economic deceleration and uncertainty with regard to China and central bank policy, but for long-term investors, we see a far more appealing value equation in small-cap equities today than there has been in quite some time.
Robert D'Alelio : When prices get lower, stocks can become more attractive, provided your time horizon is sufficiently long. It's worth noting, however, that lower prices don't necessarily equate to an attractive small-cap market. Roughly one-third of the companies in the Russell 2000 are projected to lose money over the next 12 months, so selectivity is important. This is one reason we think small-cap equities are an area that stands to benefit from active management.
Nahum : To put our thinking on the attractiveness of current valuations into context, our strategy's "intrinsic value" discount metric exceeded historical averages in February. In our view, a "cheap" or truly distressed market would mean an intrinsic value discount north of 40%. This happened three times in the past 18 years, during periods of global financial panic or systemic risk. We believe our strategy's current intrinsic valuation discount represents an attractive entry level of value. If you think there is a crisis lurking out there, then there could be more downside based on what we've seen in the past. Absent a crisis, the current discount to intrinsic value is appealing.
D'Alelio : To us, the overall market does not look particularly cheap on an absolute basis, but we don't buy the overall market. We buy individual securities, and we focus on high-quality companies with strong balance sheets, high levels of free cash flow and high returns, with barriers to entry. Until recently, in the post-financial crisis recovery, high-quality businesses like the kind we prefer have lagged. Low rates have helped highly leveraged companies and hurt companies with net cash balance sheets. In this sense, corporate savers are no different than individual savers that have been punished by Fed policy. Clearly cash is a "non-earning" asset today; however, it can always be converted into an earning asset via share repurchase, acquisition and so on. It follows that companies with net cash balance sheets have untapped earnings power. So while the market today does not appear to be attractive on an absolute basis, quality looks relatively cheap.
Identifying Attractive Opportunities
Nahum : We are taking a measured approach to adding new ideas to our portfolios and are demanding a higher-quality investment, not simply an inexpensive stock. We look for companies whose share prices have underperformed the market and where there is a compelling value argument in terms of cash flow, earnings or price-to- sales. If our analysis suggests a discount of more than 30% to intrinsic value, we'll investigate further. The idea is to look for out-of-favor companies with strong value attributes, along with capable management teams and credible catalysts for a turnaround in the next three to five years.
D'Alelio : Quality has been out of phase recently but, over a full market cycle, we believe the quality approach works. Small is thought to equate with sexy, new kinds of companies, but we buy established and perhaps even boring businesses with clear-cut barriers to entry. They tend to keep competitors out and generate substantial free cash flow. Because these are not the kinds of companies that need to access the capital markets, they often don't get a lot of attention from Wall Street analysts.
Advantages and Considerations of Small-Cap Equities
Nahum: The small-cap marketplace has been inefficient and volatile, but over the long-term, small-cap value, in particular, has attractive relative returns versus large-caps, as measured by the performance of the Russell 2000 Value versus the Russell 1000 indices since 1979. One reason, in our view, is that managements of smaller companies are often owner-operators, rather than bureaucrats. They tend to be entrepreneurial and creative, and are often more innovative and faster to market than their counterparts in larger companies. We believe these are the people you want to partner with over long periods of time.
D'Alelio : I agree. Also, the inefficiency in the small-cap markets is great for active managers. Why would you want to index inefficiency?
Are U.S. Small Caps Insulated from Global Risks?
Nahum : Small-cap companies are sometimes thought to be insulated from global risks, but we think this is a bit of a red herring. The financial sector accounts for nearly 40% of the Russell 2000 Value Index, and about one-third of those companies are real estate investment trusts, one-third are banks and one-third are non-bank finance companies. U.S.-based, small-cap financial companies tend to have little global exposure. The same cannot be said, however, of small-cap technology companies. So if you want the entrepreneurial benefits of small-cap American tech or medical companies, as we do, you'll incur global risks.
D'Alelio : I agree with Ben that, while small companies are in fact more domestically oriented than larger caps, simplistic analysis using SEC filings tends to overstate the magnitude. For example, this type of analysis would lead one to believe that small-cap energy companies are 100% domestic. While that's technically true, where is the price of oil determined? It's driven by global demand. While it's true that small companies are still somewhat more focused on domestic markets than larger ones, we don't think that should be a reason to embrace or avoid the space.
Outlook for Mergers and Acquisitions Activity
Nahum : We tend to see a lot of acquisitions among our portfolio companies, and we view a company buying one of our holdings as corroboration of our process. Regarding the level of ongoing M&A activity, we think confidence goes hand-in-hand with liquidity and risk premiums, so we find that there is more M&A activity when financial markets and confidence are strong, and that M&A will ebb when markets weaken. Year to date, we have seen healthy M&A activity within our portfolios, suggesting that confidence among corporate buyers and private equity firms appears reasonably solid.
D'Alelio : We experience our share of takeovers within our portfolios, but we tend not to like them unless the premium is very large. That's because we buy into unique, hard-to-duplicate business models. We'd rather own these companies and capture the benefits of earnings growth over the next 10 to 20 years than get a one-time premium and have to redeploy the cash into another company with similar attractiveness, which can be hard to find. As Warren Buffett has stated-the best time to sell a good company is never.
This material is provided for informational purposes only. Nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Any views or opinions expressed may not reflect those of the firm as a whole. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results . Please see disclosures at the end of this publication, which are an important part of this article.
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