Mega-cap stocks have dominated equity market performance over the last several years. Overpaying for companies with expensive valuations does not align with our investment philosophy. Over time, as earnings multiples return to their historical averages, we expect the financial market to once again punish complacency and reward active stock selection.
The Case for Small Caps
Hi, I’m Kevin Barr, Head of SEI’s Investment Management Unit. Stock markets are showing a level of volatility that is extremely concerning to many investors. With that in mind, I’ve asked Steve Dolce, Portfolio Manager for SEI’s Small Cap Funds, to join me today. Thank you for joining me Steve. I’d like to start by asking you how the current market conditions are impacting our portfolios.
It’s no secret that mega-cap stocks (companies with market capitalizations of more than $200 billion) have dominated equity market performance over the last several years. And within the small-cap universe, a small number of highly priced software and biotechnology companies are having an outsized influence on performance.
From a fundamental analysis perspective, these companies are expensive and the biotech companies tend to be binary in nature—they either win big or fail. Also, we know that a third of the companies in the Russell 2000 Index have no earnings. As our portfolios are actively managed, our inclination is to avoid overpaying for these securities. Companies with expensive valuations or no earnings don’t appeal to us. We intentionally avoid most of those companies, seeking profitable firms with solid earnings, good cash flow and below- average debt levels.
This bias toward higher-quality companies selling at reasonable valuations has hurt our performance. Our value bias has also detracted from some portfolios. Despite this, we do not plan to alter our investment process. Paying too much for companies that offer too little does not align with our investment philosophy. Active management is about more than just trying to beat a benchmark. It’s also about balancing risk and return and making prudent investments.
If small-cap stocks are struggling versus large-caps and actively-managed portfolios are struggling against their benchmarks, should investors look to allocate their assets elsewhere?
I understand the appeal of chasing performance. Everybody likes to win. Still, I have to say that SEI, has always and will continue to believe that fundamentals matter. That’s not just in small cap. It’s large-cap, international, everything across our equity portfolios.
Over time, as earnings multiples return to their historical averages, we expect the financial markets to once again punish complacency and reward active stock selection. We also believe that more diversification is better than less, markets can behave in unpredictable ways, and that chasing performance is not a sound investment strategy.
One of the most appealing things about small-cap stocks is the current discount they offers versus their own history and versus large caps. They are 10% cheaper versus their own historical average and depending on the lenses you look at, SCs are at a 16% to 31% discount to large caps. That’s an attractive entry point. In fact, last time we were at these levels, it was all the way back to 2003.
Diversification aside, what else do small caps offer to investors?
Small-cap stocks are in a less efficient part of the market than large caps, providing opportunities for active management and offering potentially attractive investment returns. This can be seen in number of ways, including less analyst coverage, historically higher long-term total returns, potential for alpha generation by active managers and the results generated by factor-based investment strategies, all of which have worked better in small caps than lag caps.
In terms of analyst coverage, consider that the average number of analysts covering large-cap stocks is 22. For small caps, it is 8 and for microcaps (the bottom half of the Russell 2000) it is just 2. Reduced coverage increases the opportunity to find diamonds in the rough.
Everyone wants to find the next Netflix, Microsoft or Google—all of which started out as small companies.
Small-cap stocks are early-stage, potentially innovative and cutting edge companies that can grow significantly over time. You can also think of them similar to venture capital companies, just a little more mature. They have the potential to grow at a faster pace than their already-large counterparts, which generally makes it possible for these companies to grow in a meaningful way.
Is there anything else you’d like add?
It’s worth mentioning again that small-caps are selling at attractive prices, both relative to their own history and relative to large-caps. The valuation differential between traditional small- and large-cap indexes is rather stark, up to almost a third of the discount versus their larger cousins. Looking at trailing price-to-earnings ratios, investors are willing to pay $52.1 today for every $1 in earnings generated by largest companies in the S&P 500 Index but only $17.2 for every future dollar generated by companies in the Russel 2000 Index. Smaller companies have the potential to be nimble and able to grow quicker than large caps just due to the sheer size difference in the numbers alone. Apple needs to grow revenue by $26 billion if it wants to grow 10% next year, small cap tech companies on average only need to grow by $100-$150m. That’s a nice advantage to have.
Thanks for your insights today, Steve.
Alpha source: Our strategies are designed to capitalize on long-term drivers of market performance through exposure to persistent sources of returns such as mean reversion, trend-following and stability. We have refined our approach to identifying these alpha sources and the factor groups we employ as proxies to measure and capture their performance.
- Value Alpha Source: The investment manager seeks to benefit from investor overreaction—resulting from aversion to loss. Such groups of stocks revert to the mean, as fear over the perception of the investment’s risk dissipates.
Beta: is a measure of sensitivity to movements in the market. High-beta stocks are more sensitive to movements in the broad market. Low-beta stocks are less sensitive.
Russell 1000 Index: includes approximately 1000 of the largest U.S. equity securities based on market cap and current index membership; it is used to measure the activity of the U.S. large-cap equity market.
Russell 2000 Index: includes approximately 2000 small-cap U.S. equity securities; it is used to measure the activity of the U.S. large-cap equity market.
S&P 500 Index: a market-capitalization weighted index that consists of approximately 500 publicly-traded large U.S. companies that are considered representative of the broad U.S. stock market.
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