Extended Small Cap – Q3 2018 Commentary
We’ve noted in prior letters our view that the summer quarter can be a challenging one for the markets, particularly for the small cap stocks which are our focus. In the summer months, the market often looks for economic or policy direction, investors take their vacations, and volumes tend to be lighter leading many smaller and underowned names to lag or exhibit sometimes conflicting signals in share prices. Even under normal circumstances, these conditions are conducive to the market overlooking stock-specific stories at the margin. However, going into 2018’s summer, the market brought concerns regarding the pace of rising interest rates and implications for the broader economy.
Last quarter, we had looked forward to a better stockpicking environment following a valuation-challenged Q2; what we got instead was a market heavily skewed with risk-off sentiment, driven by concerns over interest rate changes and what that suggests for this cycle, even in the face of otherwise strong economic data. While the impacts from the slowly escalating trade and tariff disagreements also drove areas of specific weakness, we think that the primary determinant of the market’s direction has remained the underlying sentiment. Much like Q2, the small cap market was largely unwilling to discount economic strength vs. assuming the economic peak is now behind us. Multiples thus continued to compress for many economically sensitive companies. We can see the steepness of this risk aversion sentiment illustrated in the chart below from Credit Suisse highlighting plummeting risk appetite; as this index is actually global, it captures the effects first seen in leading edge risk areas like emerging markets that then migrated to domestic small caps.
Factors at Work in Q3
Within the context of these broad macro factors driving the markets, it should be unsurprising that valuation, much like Q2 and the full year-to-date, continued to struggle as a signal for equity returns. In addition, leadership continued to narrow and was represented by less favorable areas for our deeper-value style. Earnings season showcased less the company-specific results we sought, and was instead trumped by economic concerns, often resulting in multiple compression even with fairly strong results. One factor that struck us during the quarter was whether the substantial increases in earnings (over 20% in aggregate year-over-year) were being treated as more of a one-time phenomenon, benefitting from tax law changes, and were thus discounted as either not recurring or being supported by the otherwise strong financial data. As we’ll discuss in the outlook, we don’t think that tax changes were the only driving factor for strong results, which offers optimism for the quarters ahead. However, this poor sentiment was particularly evident in Q3 during the month of September as small caps overall gave back much of the year-to-date gains that they had held earlier in the quarter as that risk aversion rose. Like in Q2, market environments featuring these types of macro / factor-based return patterns, particularly where valuation is directly impacted as a differentiating factor, typically present challenges for alpha-driven value strategies and we felt that in Q3.
Small cap value stocks finished the third quarter at +1.60% for the Russell 2000® Value Index. Extended Small Cap Value returned +0.09% (gross of fees) -0.08% (net of fees) for the quarter. It was a challenging quarter for relative performance, although much like the prior quarter, conditions improved during August vs. July and September as the outer months were dominated by the rate-based and valuation conundrums discussed above. Attribution across sectors was mixed, with positive contributions from Health Care, Real Estate, and Information Technology unable to counter significant headwinds in Financials (banks, primarily), Materials, and Industrials. We again observed the valuation impacts described above in most all sectors.
We continue to believe that we are solidly in the third leg of our bull market economic framework. We see multiple signs of a solid economy (including PMIs, production, new orders, employment, and prices, all of which have contributed to some level of portfolio exposure in these economically sensitive areas) and think that a near-term end to the current credit cycle is unlikely. There is still a massive amount of money seeking investment returns powering the credit side of the market and providing ample liquidity for buybacks or M&A, which we expect to actually accelerate. We continue to see reports of heavy investor subscriptions for debt offerings to fund M&A transactions, again suggesting that the cycle still has legs.
We remain mindful of what the market is telling us about what it is willing to discount and spent much of the last quarter refining positions in the portfolio to benefit from this environment. This includes paying attention to broad exposures as well as seeking to emphasize even more company-specific opportunities and positive forward catalysts, especially where irrespective of economic expectations (or, at minimum, far less sensitive to them) and at attractive valuations (especially when those expectations have been meaningfully reset). We do not hold the view that 2018’s strong earnings growth is solely tax-related, and believe that by looking instead at pretax margins we can see the potential for small caps to show continued improvement. We likewise see the strong potential for valuations to matter more in the future and even for the yield curve, as an expression of future growth potential, to show some resilience in 2019. Debt, while elevated in aggregate terms, remains manageable as both a percentage of GDP for households and on a net basis for corporations, suggesting that the credit side of the cycle still has room. All of these things indicate to us that the market is digesting concerns as it has done more than once in the past several years and that we should be diligently looking for opportunities to benefit from companies with the potential to outperform. We thus remain encouraged, while at the same time mindful of the market’s temporary ability to misvalue ideas that should tend to work over the longer run. We therefore 1) look to see better potential for company-specific differentiation over the balance of 2018; 2) are pleased by the continued availability of solidly attractive investment ideas; and 3) see market conditions that remain favorable to small caps.
Differentiation: While macro factors again had significant impacts in Q3 of 2018, we still look to take advantage of additional company-specific opportunities being uncovered, particularly with the potential for a reversal of the valuation relationship to offer differentiation and a better stockpicking environment.
Investment ideas: We are still bullish on individual company prospects and still see opportunities to take advantage of them. The current pullback is providing the potential for some entry points as we look to improve quality unlikely. There is still a massive amount of money seeking investment returns powering the credit side of the market and providing ample liquidity for buybacks or M&A, which we expect to actually accelerate. We continue to see reports of heavy investor subscriptions for debt offerings to fund M&A transactions, again suggesting that the cycle still has legs.
Conditions favorable to small caps: We believe that there remain reasons to be optimistic about the economy and particularly for small cap stocks. The definition of the third leg of our framework still relies on economic growth; should we continue to see economic expansion, we think small caps likely benefit. We again note also that much of small cap returns since 2014 have been a function of strong earnings growth, not multiple expansion, which we think many investors haven’t calibrated, and would likewise highlight that small cap valuations while elevated are not extreme either relative to large cap valuations or in absolute terms.
As shown in our usual charts below, stocks are still very attractive on a cash flow yield basis, with small caps more so than large. We remain skeptical that the market would peak under these conditions nor so far ahead of where we’d anticipate a recession to manifest. Still seeing differentiation in company-specific stories and finding worthwhile ideas, we continue to persistently search both the investable universe and our research team’s ideas for good opportunities. We look forward to speaking with you in the near future, and appreciate your interest and support.
Michael Bertz, Ph.D., P.E., CFA®
Assistant Portfolio Manager