Actively Speaking Podcast
Steve Bleiberg, portfolio manager and thought leader at Epoch Investment Partners, Inc. (TD Epoch) takes on current topics and issues facing today's investor.
Actively Speaking Podcast
Early Innings for the Post-Pandemic Recovery in U.S. Small Cap Equities
After struggling in the early part of the pandemic, U.S. small cap stocks have outperformed their large cap brethren since November 2020. Client Portfolio Manager Rick Vandale joins the podcast to discuss what has driven the small cap rally and why we feel it is still in its early innings. We also explore how Epoch looks at value, the prevalence of loss making companies in the small cap index and the importance of active management in the space. (August 17, 2021)
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For institutional investors only. TD Global Investment Solutions represents TD Asset Management Inc. ("TDAM") and Epoch Investment Partners, Inc. ("TD Epoch"). TDAM and TD Epoch are affiliates and wholly owned subsidiaries of The Toronto-Dominion Bank. ®The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries. The information contained herein is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information is distributed with the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein as well as any risks associated with such proposal or services. Nothing in this presentation constitutes legal, tax, or accounting advice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Certain information provided herein is based on third-party sources, and although believed to be accurate, has not been independently verified. Except as otherwise specified herein, TD Epoch is the source of all information contained in this document. TD Epoch assumes no liability for errors and omissions in the information contained herein. TD Epoch believes the information contained herein is accurate as of the date produce...
Hello, and welcome to actively speaking. I'm your host. Steve Weiberg join us each episode as we discuss current issues concerning capital markets and portfolio management, from the perspective of an active manager.
Speaker 2:Well, welcome back everybody. To another episode of actively speaking today, we're going to be talking about small cap stocks, particularly in the U S and to do that, we are joined by a guest Rick van Dale. Who's a member of Epic's us equity team. Welcome Rick.
Speaker 3:Thanks for having me on the program.
Speaker 2:So I want to start by congratulating you and the team crystal, on your impressions. The team published a paper. I think that went up on our website last fall, like maybe October, November, and listeners can find that paper@wwwdoteipny.com and look under the heading that says insights. But anyway, then what the paper said at the time was that there was this tremendous opportunity in small cap stocks and that they had performed dramatically and then were undervalued and so forth. And that certainly turned out to be true. We're recording this in July. So I went and looked at the numbers to the end of June. So for the one year ending June 30th, a few weeks ago, the Russell 2000 index of small cap, us stocks gained 62%. Whereas the Russell 1000 index of large cap stocks gained 43.1%. So big out performance by small cap stocks. Not some people might see that and say, oh, well, I missed it. You know, opportunity is gone. But if you look back even farther, you know, if you extend the beginning of your window back one more year. So look at the two years through the end of June of this year, actually the Russell 1000, the large cap index is ahead of the Russell 2000 over the two years by about a hundred basis points a year on an annualized basis. It's like 23.9 versus 22.9. And if you look back three years, going back to the middle of 2018, it's actually remarkably dramatic. How big a difference there's been between large and small cap stocks over the three years, the Russell 1000 is up 19.1% per year. The Russell two thousands up 13.5% per year. That's the difference of over 500 basis points a year, even with the really good performance of small caps over the last year, they have still lagged large caps by, as I say, over 500 basis points here over the last three years. So that leads to my first question to you, Rick, given those numbers, even despite the good performance last year, do you think small cap stocks to look attractive relative to large caps?
Speaker 3:Yeah, Steve, absolutely. We do believe that small cap stocks still look very attractive relative to large cap equities. And our view is really based on historical precedents or looking fundamentals. And then of course, valuation.
Speaker 2:Okay. Let's expand on all those. I definitely want to come back to the valuation point because, uh, you know, as a firm we had epic have kind of strong views about what value really means, particularly in the digital age that we live in now. So why don't you take us through the fundamental case then we'll come back to the valuation side.
Speaker 3:Yeah, sure. That sounds great. Historical precedent. So first small cap equities historically have performed very well on both an absolute and a relative basis following shock their market declines in the stock market. So for example, since the 1920s, the average bear market decline for small cap equities has equaled 35% and known as how that figure is very close to the 31% decline that we witnessed in the first quarter of last year at the onset of the pandemic, following these sharp market pipelines, historically the forward three or analyzed return on small cap, equities has equal to very robust 13% as compared to only 7% for large cap stocks. So here we have this first historical precedent where small cap equities tend to perform very well during bull market recoveries from their markets, very similar to the environment we're in. Now, the second historical precedent focuses on U S GDP grow. And here again, you must small caps have a tendency to perform very well on both an absolute and a relative basis when us GDP growth is higher. And that essentially reflects the fact that smaller companies are much more sensitive to surges and economic activity, and also sharp increases in consumer business and government spending. So for example, historically when us GDP growth has risen sharply essentially above 2% before, with 12 months in return for small cap, equities has averaged about 13%. So think of what we are right now in consensus estimates for geo GDP growth are very hot this year. Our consensus economists estimates are suggesting that us GDP growth will be about 6.5% for next year. The consensus assessment is about 3.5%. So economists are really predicting that we're going to still have a robust GDP growth for at least the next 15 or 18 months or so. And so again, historically, this has generally been a very good environment for small cap equities to outperform. So those are the historical precedents, but when it comes to really assessing the relative attractiveness of small cap equities as an asset class, you know, I think epic, we really believe as much more important to focus on the fundamentals, estimates such as top line revenue growth, bottom line profit growth. And of course in our case, what's very important to us is cashflow growth. And so it's really here in this area where small cash shies relative to their large cap brethren foreign consensus estimates, again, suggest that small cap companies are going to have much higher revenue grow and much higher profit growth both this year and next year. You know, so I can give you an example for this year. Yes. And it suggests that for us, small cap companies, the average revenue growth rate, that's going to be 13% versus only 10% or large cap companies. The profit growth estimate comparison is even more amazing for us. Small cap companies it's predicted right now that their average profit growth is going to be 100% as compared to only 53% for large cap companies. Now I realized that these Lafayette growth estimate sounds truly amazing, but we all have to remember that that coming off a very low vase last year, when most companies that she saw a decline in their revenues declined their profits during the midst of the pandemic. And then again, the story is really the same for 2022. Again, consensus forecast suggests that small cap companies collectively are going to have much better or higher if you will, revenue growth, profit growth and cashflow generation next year. So at least based on the fundamental look which we think has achieved to our perspective, small cap companies look very attractive at this juncture relative to large cap companies. And that leads us to valuation.
Speaker 2:Yeah. So yeah. I want to talk about that. What, uh, you know, value traditionally in our industry has revolved around things like price, earnings, ratios, price-to-book ratios, but I know that, uh, I think you guys talked about this in the paper last fall and had there been other papers at epic where we've talked about this, that in an age where most companies aren't putting up big factories and bending metal, so to speak, to make their products better, it's much more knowledge based. And you know, things like software or pharmaceuticals book value is it's not clear that it's really a very meaningful concept. And so the price to book ratio probably doesn't mean as much. So how do you guys think about valuation?
Speaker 3:Yeah, I think you're absolutely right to me for an increasing digital world that more and more companies, that capital life business models, in some cases, consisting of jets, employees, and desktop computers, for example, we really think that financial accounting rules are not accurate any longer and really fail to capture the true value of affirm. So kind of consistent with your observations for field samples under generally accepted accounting principles. When a company to invest in either research and development or customer acquisition costs, nos co-investments are required to be expensed immediately, even though the company is going to benefit from those investments for many years, going forward, this has the effect really of part officially pressing the company's reported profits and artificially lowering their stated books, which for some companies then could mean that their stocks actually look overvalued on traditional measures, such as price to book or price to earnings. And mostly when a company invest in, let's just say a manufacturing plan or perhaps heavy machinery, again, under generally accepted accounting principles. Those companies are allowed to amortize the cost of those investments over the useful life of the asset, which in many cases could be 10 and 20 years or more, even though the original investment required a large upfront cash payment. And so this also has the effect of artificially inflating, a company's reported profits and it's stated book value. So in these cases, some companies got least perhaps actually look under valued on a price to book or price earnings days, even though they're really not. So for these reasons, we really think a more accurate measure of value is price cash flow. And in our firm's case, we really prefer to focus on forward estimates of free cashflow. So for example, a typical catalyst that offer we're going to estimate how much cash is this company's business model or business going to generate over the next one to perhaps three years. And does the colored stock price accurately reflect the present value of those cash flows or is the stock either overvalued or undervalued on a price? If we cashflow basis that approach, we think we felt a much more accurate estimates of a company value as opposed to, again, traditional measures, which is price to book, which we believe is currently distorted by county rules.
Speaker 2:Okay. So how do small cap stocks look relative to large caps on, you know, on that basis, like a price to cashflow basis?
Speaker 3:Yeah, so interesting enough, small cap equities currently are trading at historically low valuations relative to large cap equities. And it's important to remember a recognize here that small cap equities almost always trade at a premium relative to large cap stocks, and that generally reflects their better overall growth characteristics or growth potential over time. So it's actually more important to focus on the change in this relative relationship over time. So for example, over the last 20 years, the average small cap premium valuation premium has equaled about 120% today that valuation premium has shrunk to only 108%. So pretty dramatic decline in the relative relationship between small cap stocks and large cap stocks in terms of the valuation the last time, but the relative relationship or relative value was this low was back in 2008 during the height of the financial crisis. So if you really stopped to think about it currently, small cap companies, cheerier top-line growth, superior profitability, and cashflow generation all had a certain point in time when there are evaluations of very compelling on a relative basis.
Speaker 2:Okay. So as we said at the beginning, small caps, uh, as you said, they, they still look attractive, both forward-looking fundamentals, but they have been doing quite well, as we said at the beginning or for the last year. So what's, what's been driving that good performance over the last year or so.
Speaker 3:Yeah, interestingly enough, Steve, the rally in small cap equities today for essentially the last nine months or so or more has been led by low quality companies. And these are companies that are either losing money or they have very low levels of profits and they generally have weaker balance sheets. So just for example, the six month period ended June 30th, the return of the S and P small cap, low quality index equaled 42% versus only 16% for the S and P small cap, high quality index. So a very dramatic difference in performance between those two separately. We also noticed that the weighted average return of loss-making companies in the Russell 2000 small cap index, again on a year-to-date basis and the June 30th equaled 40% as compared to only 20% for the most profitable companies in the index. So, so far today, it really has been low quality companies. Are loss-making companies that have been driving the rally in small cap equities?
Speaker 2:Well, I mean, I may not know much, but I kind of suspected of the term. That's not really a winning strategy. I mean, everything I know about investing says in the long the market rewards companies for being profitable and not for being unprofitable. So do you think what's been going on in the last six months to nine months in small cap world and sustainable in terms of
Speaker 3:No, not really. Steve, despite the recent strong performance of low quality companies, we really do advocate taking a long-term excuse me, a high quality approach. And that's really based on the long-term and a short-term perspective. So two of the favorite metrics we like to work with at epic include free cashflow yield, essentially just a measure of how much free cashflow does a company generate relative to its stock price. And then also return on invested capital or in some cases return on equity. Our analysis indicates that over the last 35 years, the average annualized return for companies in the index that have high free cash flow yield has equaled 13% from peer to only actually compared to a negative 1%, believe it or not for the companies that we index that have the lowest free cash flow yield. And this comparison is the same really for return on invested capital. So again, over the last 35 years, the average annualized return for somebody who's in the index that had the highest returns on invested capital has equal 12% as compared to a neutral side of the companies in the index that have low returns on invested capital. So clearly then at least over the long run high quality companies, significantly outperform lower quality companies. So how about the short run or even from a perspective of where we stand today? Well, first thing to recognize is that high quality small cap companies are actually trading at a historically low valuation relative to low quality small cap companies. And this has been the case for quite a while now, for example, at the beginning of 2020, the valuation of high quality companies as compared to low quality small cap companies equaled a little bit over 60%. So the relative relationship was about 60% since then that ratio has actually declined by 20%. This is the lowest relative valuation for high quality, small cap companies that we've seen over 20 years. So when you kind of put it all together, high quality, small cap companies offer higher free cashflow yields. They offer a much higher returns on invested capital. And finally, the last thing I perhaps would want to chime in on the strong performance of low quality, small cap companies in the initial stage of the market rally was actually not that unusual. So of our research shows that historically at the onset of bull market, rich traditional bear markets, indeed in fact, low quality companies tend to initially outperform. And that's perhaps due to the fact that when the markets are recovering, a lot of investors are willing to take on more risk. And so they're willing to allocate capital to more speculative, small cap companies. So for example, some research, we did show that in the last team shock their market declines and small caps, and that would be February, 2003 in February, 2009, low quality companies all performed high quality companies for about 14 months. On average, starting with the onset of the recovery. After that point, high-quality companies went on to outperform the gains momentum. They wanted to outperform low quality companies and performance actually lasted for at least three years or more. So if you think about where we are right now, we're about 16 months out from the market bottom that we experienced last year, essentially end of March of 2020. So right about that point in time, when at least historically high quality small cap companies should begin to help perform. And we actually saw some evidence that in the month in July, in July, high-quality small cap companies call performed locally small shops by about 6%. So if history repeats itself, that's obviously a big gift. We could be entering an environment where high quality falls out companies are set to simply outperform. And again, as you and I just discussed over the long run, we have clear and compelling evidence that high quality goods tend to do better.
Speaker 2:Yeah. I mean, that is a story I've heard before seen elsewhere about though, you know, in the early stages of a rally often it is that, you know, the quote, the junk that does very well early on, but then it gives away to the much more high quality companies, I guess what I'm kind of amazed by, uh, going back to what you were talking about a little while ago about, you know, the performance of the unprofitable companies versus the profitable companies within the small cap index. I'm surprised at how much junk there is, I guess, in that small cap index. I mean, and this is something that your team talked about a bit in the paper from last fall that I found fascinating that the changes in the index over time in the Russell 2000, that it has been trending smaller in size and, and towards, I should say more unprofitable companies as a percent of the index. Talk a little bit about, you know, what has been going on with that index over years and, and why, why has it been happening?
Speaker 3:Yeah, Steve, you raise a very interesting observation. So you're right over the last 10 years or so the percentage of loss-making companies within the small cap indexes had significantly increased again, for example, the percentage of loss-making companies in the Russell 2000 index today equals roughly 40% or so. And this trend is partially due, not fully, but partially due to the decline and overall public companies in the United States equity market. So I think P in the mid nineties, the number of publicly traded companies equal tobacco center. So that figure has actually declined to slightly under 4,000 publicly traded companies today. So essentially a small pool of public companies to pick from forces, the index providers to go down in market cap spectrum, if you will, in order to find new companies to add to their index. In the case of the small cap indexes, it really forces the index providers to add new really tiny companies. In many cases, they have market capitalizations that are well under 500 million or so oftentimes these are the new companies that have recently been IPO to last couple of years and their business models can be unproven, and they really struggle at least initially to a profit on a consistent basis. So recognize all this, we actually think is important for our listeners to see that passive investments in small cap companies, whether you obtain that through, let's say a mutual fund or ETF by definition, or I guess I could say by default would result in a really large exposure to loss making companies. And conversely, a passive investment would also result in a sub optimal allocation to high quality companies, which we obviously think is superior. So we would really advocate if you're going to invest in small cap equities as an asset class, we would really advocate an active approach, primarily because if you do incorporate an active approach, you can better control your exposure to high quality fall cap companies, which again, we think look very attractive at this point in time.
Speaker 2:Yeah, it's a, it is a really interesting development that, that what you talk about about the decline in the number of public traded companies. Obviously there's been a lot of mergers and acquisitions activity over the last couple of decades. So there's been very little antitrust enforcement to the sense of very few mergers got rejected by the government. So you, every time there's a merger, there, there goes one publicly traded company. And normally they were replaced by companies going public. But in recent years, you know, with the phenomenon of the unicorns or companies would stay private much longer and say lifecycle than was the case in the past, they were companies were kind of seeing that they felt there were a lot of negatives to going public in terms of the reporting requirements and public scrutiny and so forth. And many companies have simply chosen to stay private far longer than they, they would have in the past. So it's led to this shrinkage in the number of publicly traded companies, which has unintended consequences, I guess, or not that everything was really intended about it, but it's sort of perhaps consequences that people didn't think of at first in terms of, as you say, the sort of the blend of quality, high quality and low quality and things like a small cap index. So really, really interesting material. Well, I think we've sort of covered a lot of ground here. So Rick, I want to thank you for joining me here on the podcast listeners. If, again, if you've enjoyed this podcast or our previous podcasts, please give us a good review on whatever platform you're getting this podcast from. And we will be back with another episode soon.
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Speaker 4:The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment product information contained here in has been obtained from sources believed to be reliable, but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but it's subject to change. Any performance information referenced in this podcast represents past performance and is not indicative of future returns. Any projections, targets or estimates in this podcast are forward looking statements and are based on Epic's research analysis and assumptions made by epic. There can be no assurances that such projections targets or estimates will occur. And the actual results may materially be different other events which were not taken into account in formulating such projections targets or estimates may occur and may significantly affect the return or performance of any accounts and or funds managed by epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not. They are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of security selected for clients and not all securities selected for clients in the past year. We're profitable.
Speaker 5:[inaudible].