Small Cap Growth – Q3 2018 Commentary
“One ought never turn one’s back on a threatened danger and try to run away from it. If you do that, you will double the danger.”
– Winston Churchill
“Times and Conditions change so rapidly that we must keep our aim constantly focused on the future.”
What do Amazon, Square and Salesforce.com have in common? At one point in time, they were sitting in the non-earners bucket and plenty of investors complained they could not own the stock because they don’t buy stocks that lose money (effectively, turning their backs on them). Why do we bring this up? Frequently, we hear how today’s market compares a lot to 1999 and 2008 when non-earners were the only stocks working and therefore the market is poised to correct meaningfully to the earners bucket. The chart below is usually shown for those looking for a visual to match their theme. So considering we will own non-earners, we expect to get questions around why and should we be worried? Considering our use of CFROI® we understand any confusion on why we would own companies that are burning cash. However, our process revolves around finding inflections and rates of change inside each business model. This is why we believe you cannot just classify non-earners as a single, homogenous bucket. Non-earners are not all created equal! In fact, stocks like Square or Five9 come from this bucket. Why is that? In the case of Square, for years they posted extraordinary growth at significant losses in cash-flow, but underneath they were building a network and product base to cross sell and scale. Once they hit the inflection mark and their CFROI® crossed the discount rate, they now get credit for all that wonderful growth, and cash-flows can be re-invested in future projects with the potential to keep moving rates of return higher.
This recursive cycle is the basis of our investment process. We believe in investing for the future. Again, our focus is on the rate of change and inflection not the importance of how much money they have lost in the past but instead what their CFROI® will be in the future. Let us be clear, this does not mean the entire bucket of non-earners will be successful or that the segment does not have pockets of momentum that are being overvalued. In fact, a shake out of market sentiment for these names seems to be upon us and is well overdue in our opinion. Our growth models have a hard time justifying 20x revenue no matter how much cash-flow you generate in the future. In the end, this is all part of what we were hired to do, find the winners and buy them right. For us, it’s about looking to the future not at the past.
Source: FactSet Research Systems, Inc.
The KCM Small Cap Growth composite was up 9.21% (gross of fees) and 9.02% (net of fees) for the 3rd quarter of 2018 outperforming the Russell 2000® Growth Index benchmark, up 5.52%. For the quarter, Health Care, Information Technology, and Consumer Discretionary were our best performing sectors versus the benchmark. Our largest negative contributors were Communication Services, Financials, and Industrials. Our largest overweight’s were Information Technology and Consumer Discretionary while Industrials and Communication Services were our largest relative underweights.
Strong performance from the Russell 2000® Growth benchmark continued to be driven by Information Technology and Health Care. Digging in further, Software & Services and Health Care Equipment & Supplies/Life Science Tools & Services were the main components for the upside. This narrow market provided a considerable tailwind for growth managers who typically, in our opinion, make a large sector bet by overweighting Information Technology versus our more diversified approach. Meanwhile, the factors driving performance remained consistent—High P/E and Sales Growth. High P/E names were up 13% in the quarter while the lowest P/E bucket fell 1% with non-earners underperforming as well. The top 2 quintiles of sales growth were both up 8% plus in the quarter, while the other buckets underperformed. Our stock selection was strong across the board in the quarter. Additionally, value based factors continue to underperform and while we struggle to identify the trigger or the timeline for a shift from growth to value factors we believe inflation and the mid-term elections could be the catalysts to move investors.
As we enter the 44th quarter of managing small cap growth assets we can’t help but reflect on the incredible amount of economic turmoil, market volatility (we began in January of 2008) and even internal firm changes we have observed. We take satisfaction in the fact that our investment philosophy and strategy has evolved but has not changed through the many years and most importantly, since inception we have outperformed the Russell 2000® Growth Index . We also reflected as we wrote the first paragraph of this letter that our current (and future) investors are not here for our past returns but for the future returns. We look at our investments the same way. We fully expect more of the same with many unknown unknowns and we will continue to evolve as we follow our investment discipline. Thank you for the trust you have placed in us and we are looking forward to the next 44+ quarters.
Assistant Portfolio Manager