SBH Investment Summit
Fourth Quarter 2023:
Small Cap Value

Navigating Small Cap Opportunities Across Sectors

With continued uncertainty in the small cap space, Shaun Nicholson, Senior Portfolio Manager, provides insight on navigating volatility and finding opportunities in key sectors heading into 2024.

 

Key Takeaways

  • The Industrial sector stands to benefit from government fiscal funding such as the Infrastructure Spending bill, while Health Care sees excitement around GLP-1 drugs that are predominantly used to treat diabetes and are now also being used to treat obesity.
  • The rapid rise in interest rates has increased deposit costs for banks, but higher loan yields may help to offset this over time if economic growth is not impacted by emerging credit issues from customers facing increased debt costs.
  • The portfolio remains positioned in self-help companies that have the ability to run the business differently than in the past, though heightened focus on risks from higher capital costs may warrant adjustments depending on Fed actions and resulting market developments in 2024.

[Alexis Cann Ford] How you are navigating the ongoing volatility, especially within the Industrials and Health Care sectors. And additionally, what key trends do you anticipate will shape the future of these industries moving forward?

[Shaun Nicholson] When I look at the Industrial space, it has been through notable change over the last few years. There were supply chain issues post COVID and rapid inflation where companies were trying to raise prices fast enough to maintain their margins. As things have settled, volatility is turning away from those areas and into the true end demand for the products that the industrial companies produce. At this point, the volatility is really understanding where the global economy is going, and we think this is the biggest challenge within the Industrial space.

We believe there are secular drivers that are going to help these companies, particularly the fiscal funding that is now available resulting from the U.S. government passing the Infrastructure Spending bill. There is also the Inflation Reduction Act (IRA) bill, the CHIPS and Science Act, and funding for rural broadband. All those combined are close to a trillion dollars of spending in the U.S. that will help industrial companies manage some of the demand challenges (or forecasting that demand challenge going forward). Time will tell where the economy goes, but volatility overall is settling down into more the true end demand side versus those factors that came out of COVID.

Health Care is a unique space. The companies there were also touched by inflation challenges that emerged post-COVID and by supply chain challenges. Today, the Health Care group is seeing excitement around certain drugs coming to market. In particular, GLP-1 drugs that are predominantly used to treat diabetes are now being used to treat obesity and weight loss. I think some market participants are assuming that this could be a savior for the health care system in terms of the success rate of those that would no longer need all the services they might have needed in the past if they became healthier by losing the amount of weight that this drug can cause.

This drug is very new in the Health Care space, and we are not sure what it will create from the backdrop of health care service demand. This is something no one knows since it is very early, and this has caused volatility in terms of trying to determine the uptake of the drug and its success rate.

[Cann Ford] Another contributing factor to volatility this year has been the Fed’s rate hiking campaign. We have seen rates increase by more than 5% since last year, and they currently stand at their highest levels in 22 years. How has this impacted the banking industry, and do you believe the full repercussions of these rate increases are still unfolding?

[Nicholson] I believe the impact has been on the cost of funding for banks. When you look at how banks fund their loans that they lend out to customers, it is mainly through deposits. What we have had for a long time is the very low cost of deposits. Given that the Fed raised rates so fast, up to that 5% level, we have seen people wanting more for those deposits. This has resulted in banks competing with Treasuries in terms of yield to provide customers. Banks have had to absorb that higher cost of capital in terms of the impact on their net interest margins.

Now on the other side of that, to offset this, they are going to the market with higher loan pricing. If you look at where loan pricing was a year ago, it was around 4% to 4.5% on average. Today, loans are at 8% to 9%. I believe that impact will help the banks recapture some of that lost margin that they have had to deal with from the Fed hikes. However, a credit issue could emerge as customers have to now pay higher interest costs on debt which could slow down loan demand and impact the growth of the economy.

I believe the full impact of rate increases has not been absorbed by the market; this should come over the next one to two years. But in the interim, most people are hoping the Fed starts to cut rates sometime in 2024 which will alleviate some of that stress. That is still uncertain at this point given where inflation is relative to the target that the Fed is trying to achieve.

[Cann Ford] Given the trends and factors we have discussed today, how are you positioning the strategy and what areas of risk as well as opportunities are you watching as we approach year-end and look ahead to next year?

[Nicholson] The portfolio’s positioning is not much different than it has been in the recent past. We have tried to understand the true end demand across industries coming out of COVID, with the supply chain issues and inflation. There was a lot of over-ordering across many different areas because people were uncertain they would have the product.

Now, as we are settling into what the true demand is, there is too much product out there. We are positioning the portfolio into those companies that have “self-help,” as we call it—the ability to run the business differently than in the past and that’s usually through a different go-to-market strategy, getting out of markets that are commoditized, and pivoting the focus and resources to areas that have much better growth characteristics, as well as better profitability and return on invested capital (ROIC) characteristics.

From the risk standpoint, we are clearly watching the higher cost of capital, as we talked about with the banks. If you go to the market now, you are going to pay more to borrow money. If you have debt that is going to be refinanced, you are also going to be paying a lot more. And so that higher cost of capital has to be absorbed and offset within these companies. Therefore, we are paying more attention to that side of the risk equation than we would have a couple of years ago when rates were low. We have tried to stay away from levered companies and if we do have exposure to companies with leverage, they have a very solid strategy to deleverage the balance sheet through their own actions.

We have maintained an overweight to Industrials and underweight to Financials, and do not see a tremendous amount of change with that position. As things develop and we move into next year, there will be more information on the Fed and that will determine some of the market structure and where the portfolio may have to move from a position standpoint.

 

Additional Resources:

Small Cap Value Strategy

Domestic Equities Insights

 

The opinions expressed in this video are solely the opinions of Segall Bryant & Hamill or an unaffiliated third party. You should not treat any opinion in this video as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinions. The opinions expressed in this video are based upon information considered reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this video does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The opinions and statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this video. For illustrative purposes only.

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