January 3, 2017 • John Coumarianos
Small-cap stocks spent the four weeks following the election of Donald Trump shooting the lights out. For Mark Balasa, co-founder and CIO of Balasa Dinverno Foltz in Itasca, Ill., the results have been eye-popping. His firm uses several Dimensional Fund Advisors mutual funds and Vanguard ETFs and as of December 2, his clients’ small-cap growth funds were up 15% while their small-cap value funds climbed 25%, with more than one-third of the gains coming after the election. Their outperformance hasn’t “violated the bands” of the firm’s asset allocation models, so Balasa is not rebalancing yet. “For us, consistency is important,” he says. “There are so many unknowns we don’t have the conviction to make changes.” Jim Callinan, who launched the Osterweis Emerging Opportunity Fund in 2016, doesn’t lack conviction. He believes that small businesses were among the biggest victims of Dodd-Frank regulations, which prompted banks to ignore small businesses. “As rates rise, banks may have the wherewithal to loan and take risk again. This stimulates even more economic activity,” Callinan says. “Loss ratios are incredibly low across the spectrum of bank size.” Callinan, who was Morningstar’s manager of the year in 1999 when he ran the Robertson Stephens Emerging Growth Fund, cites the example of Opus Bank, a small institution that tried to accelerate loans three years ago. Just one or two bad tech loans forced it to take a “hyper increase in loan loss provisions,” knocking its stock price to way below book value. “Small companies benefit most when corporations feel free to experiment with new projects and build capacity for these ideas if they work out,” he says. “Easing of regulation should help with all that.” Advisors should recall that small-cap value stocks were left for dead in 2000. As has happened with other sectors and segments in that situation at various times, small value then went on a tear. From 2000 through September 2016, the Russell 2000 Value index has scorched other indices, posting a 9.6% annualized return. The broader Russell 2000 has done well over that period too, producing a 7% annualized return. By contrast, the large-cap Russell 1000 has posted a 4.7% annualized return. In retrospect, 2000 was the time to buy small-cap stocks (as long as they weren’t in the technology sector). The result of such good performance over an extended period is that many asset managers who study asset class valuations think the small-cap segment of the stock market is expensive. Indeed, the Russell 2000 Value index has outperformed the Russell 1000 by around 500 basis points annualized since 2000. That’s much more than any long-term study can ascribe to the “small-cap effect.” Research Affiliates, the Newport Beach, Calif., investment firm led by Robert Arnott, evaluates 27 different stock markets around the world, including the United States, which it divides up into large-cap and small-cap segments. Currently, no stock market or stock market segment the firm evaluates is as expensive as U.S. small-cap stocks, which clocked in with a Shiller PE of 49. U.S. small-cap stocks are poised to erode an investor’s purchasing power for the next decade, albeit by a tiny amount, according to Research Affiliates. The expected real 10-year return for small-cap stocks is -0.01%. U.S. large-cap stocks have the second-worst prospects, according to the firm, with a likely 1.1% annualized real return for the next decade. Still, asset class valuations, even if they’re accurate, don’t preclude the ability of talented managers to uncover underpriced sectors and securities. It may be harder to uncover bargains now, but some managers are finding a few. For example, Chris Kiper and his team at Beverly Hills, Calif.-based activist hedge fund Legion Partners like some telecommunications names including Boingo Wireless (WIFI). Boingo is poised to benefit from increased mobile data traffic. Its small cell and distributed antenna systems (DAS) boost cell signals from existing towers to increase capacity inside buildings, helping the company capture revenue from wireless providers seeking to give their customers uninterrupted service. Specifically, Boingo has secured strategic locations—over 90 airports and over 50 DAS venues and military bases—where mobile usage is intense and existing cell towers can become overloaded. Boingo allows mobile phone carriers to “offload” the extra capacity during peak usage onto Boingo’s small cell network. The firm’s top locations include airports such as JFK International, Chicago O’Hare and LAX; sports arenas for the Utah Jazz and the Chicago Bears; and other venues such as the New York City subway system and the Lincoln and Holland tunnels connecting New Jersey to New York City. The stock is mostly undervalued because of the perception that the firm’s only revenue source is airport Wi-Fis—an increasingly free service. That means the market has underappreciated the extent to which the company’s revenues come from cell phone carriers paying Boingo for the use of its small cells, according to Kiper. Furthermore, the company’s free cash flow should increase after Boingo completes a multiyear cycle of capital expenditures in which it built out its military business. When it comes to market opportunities overall, Kiper argues that searching for cheap stocks is not as easy as it used to be. First, the market has moved up. Second, many funds now have the ability to run the same valuation screens at the click of a button. Quantitative funds have become very good at identifying broad swaths of cheap securities and buying them in a passive manner. And algorithms can buy small quantities of stock whenever shares are available. But Osterweis’s Callinan is finding some striking values in companies the broad market fails to understand. Take Square, the credit card merchant processor for Visa, Mastercard, PayPal and Apple. Started by Twitter CEO Jack Dorsey, Square now sells at between $13 and $14 a share. Before going public, the company raised venture capital funds at $20 a share. Square’s initial strategy was clearing transactions for very small merchants and charging a below-market interchange fee of 2.5%. But it has added a “loan business and instant deposits convenience for merchants” charging 7% fees and 14% interest rates. Callinan believes the company could earn $3.50 a share in the next four or five years. “The perception of investors is that Square is populated with programmers and marketers who know little about finance,” says Callinan. “In actuality, it is managed by many former Goldman Sachs and Morgan Stanley employees and is loaded with capital markets talent.” Another manager finding some value in technology and telecommunications is Steve Scruggs of Queens Road Small Cap Value Fund (QRSVX). In an interview with Financial Advisor, Scruggs said he liked Harman International (HAR), maker of audio equipment, mixing boards, electronics systems and lighting equipment. That was a few weeks before the announcement that Samsung would buy Harman for a 25% premium to its previous closing price on November 14. Harman’s audio brands include Harman Kardon, JBL speakers and Mark Levinson. The largest portion of Harman’s business is manufacturing “infotainment” systems for new automobiles. Harman’s automobile partners are Audi, Volkswagen, BMW, Mercedes-Benz, Chrysler, Toyota and Fiat. Scruggs thought this was a lucrative business, as consumers are demanding more sophisticated infotainment systems in their cars, and his shareholders were rewarded for his view. Scruggs prefers higher quality businesses than commodity producers, but he makes an exception for Cloud Peak Energy—a coal company with the cheapest extraction costs in his opinion. The company has access to low sulfur and ash coal, and has a lot of leases at good rates. The firm’s long-term contracts with utilities, along with its balance sheet, sustained it while coal plummeted over the past few years. Scruggs thinks that the firm just needs coal prices to rebound just a little bit, and it will be worth a lot more. Scruggs has held healthy amounts of cash at various times in the fund’s existence, and now is one of those times. The fund is bumping up against 20% cash. He stresses that this has never been a market call on his part, but more an assessment of value or a function of how many desirable companies his fundamental analysis is uncovering. He says most of the companies that meet a basic enterprise value-to-EBIT test now have serious problems in their balance sheets or long-term business outlooks. That’s typically the indication to him that stock prices are getting frothy. Over the past decade, that approach has helped the fund produce a 6.99% annualized return through September 2016. That compares well with a 5.78% return for the Russell 2000 Value index. Also, the fund’s volatility-adjusted performance among its peers has garnered a four-star rating from Morningstar. In the sprawling small-cap value space, many managers like Jay Kaplan of Royce Total Return are looking for quality while targeting dividends. That combination has produced one of the more stable small-cap funds, with a 15-year 14.8% standard deviation of returns compared with the 18.24% for the Morningstar small-blend category average. Additionally, the fund has notched a 9% annualized return for the 15-year period through November 10, 2016, a 50 basis point annualized victory over the small-blend category average. Kaplan is finding bargains in retail (Amazon won’t destroy all physical stores) and financials. He currently likes MidWestOne Financial Group (MOFG), an Iowa-based bank that recently purchased another bank in Minneapolis. Kaplan thinks the acquisition is taking some time to digest, but he is, nevertheless, happy about its prospects. Management is “working slowly and methodically to get costs aligned,” he reported to Financial Advisor in an interview. Management has sold some branches, so loan growth has been slower than expected and the agricultural sector in Iowa has been a little weaker and that’s hurting loan growth. But Kaplan thinks that will improve, and the recent selloff in the bond market, creating a steeper yield curve, should also improve profitability. Kaplan thinks the bank can produce a double-digit return on equity again, and that it represents the kind of high quality bargain emblematic of the Royce Total Return approach. On the growth side, Sudhir Nanda of the T. Rowe Price QM U.S. Small Cap Growth Fund (PRDSX) likes turf management company Toro. Using a quantitative approach that emphasizes free-cash-flow generation and growth and high returns on invested capital, Nanda says Toro scores well on his model, though it’s not as cheap as it used to be. In addition to its cash flow generation and prodigious returns on capital, Nanda likes how Toro’s management allocates capital—an assessment that can’t be quantified, but that Nanda fits into his process. The firm made what Nanda considers a wise acquisition of snow removal equipment firm BOSS. That gives Toro a more complete product profile spanning all the seasons of the year. Nanda’s quantitative strategy has guided the fund to a 9.9% annualized return for the decade ended November 14, 2016. By contrast, the Morningstar small-growth fund category average has been 6.9% over that time. The fund had given investors a bumpier ride than the average small-growth fund—its 10-year standard deviation of 18.9% is higher than the small growth category average of 1.1%. But the fund’s combination of return and volatility have placed it among the best funds in the category, evinced by its five-star Morningstar rating.
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