SBH Investment Summit
Fourth Quarter 2023:
Small Cap Core/SMID

Russell 2000® Quality Concerns: Is Active Management the Answer?

Despite near-term headwinds in the market and economy, SBH is finding opportunities in high quality small and SMID cap companies. Jeff Paulis, CFA, Senior Portfolio Manager, provides insight on the Russell 2000® Index degradation, why active management matters, and his 2024 market outlook.

 

Key Takeaways

  • Our analysis shows that, over the last 20 years, the top half of the Russell 2000 has retained quality while the bottom half, especially the lowest market cap quartile, has seen concerning degradation across factors like return on invested capital (ROIC), cash flow margin, and profitability.
  • With the declining quality profile of the Russell 2000, we believe that active managers can capitalize on stock selection by building higher-quality small and SMID cap portfolios.
  • While SBH’s portfolios remain oriented towards high ROIC companies, an inflection to more attractive reward-to-risk ratios and potential Fed easing could accelerate a rotation into improving ROIC opportunities.
  • We expect to see ongoing earnings weakness and economic challenges in the first half of 2024, with the potential for a market rebound in the second half if the Fed decides to cut rates.

[Carolyn Goldhaber] It has been well documented, especially recently, that the quality profile of the Russell 2000® Index has notably declined over the past two decades. With lower quality companies now making up a greater portion of the index, in your view, what are the key drivers behind the degradation?

[Jeff Paulis] We just authored and published a study on the changes in the quality factors within the Russell 2000 over the last 20 years. If you would like to see that and have not, please reach out to your SBH contact or go to the Segall Bryant & Hamill website here. The punchline is that the top half of the Russell 2000 has remained largely consistent from a quality perspective over the last 20 years, but the bottom half, specifically the fundamentals of the fourth quartile or lowest market cap companies, has really degraded over the last 20 years according to the data. The analysis looks at return on invested capital (ROIC), free cashflow margin, and the number of profitable companies. The key drivers of the degradation we have seen in that index over time have been five factors that we would point to.

The first would be the migration of higher ROIC or improving ROIC companies to higher market caps. Those companies have appreciated and moved out of the index, so you are left naturally with just lower ROIC businesses. The second would be higher quality companies that have remained in private ownership and have not wanted to become public or publicly traded stocks for whatever reason. Third, higher quality private and public companies have been bought by private equity and strategic buyers which has kept them out of the public markets. Some of those bigger companies, as well as low interest rates, have attracted companies to buy these higher quality companies looking for growth post the Great Financial Crisis period when the economic recovery underwhelmed. They looked for these higher quality private and public companies to add to their portfolios to drive growth. Low interest rates also drove less mature companies to enter the public markets earlier. There has also been an increase, particularly in the 2021 timeframe, in the number of special purpose acquisition companies (SPACs), which was a quick way to bring companies into the public markets. And those ended up being lower quality companies and many of them are in the Russell 2000 today.

[Goldhaber] What are the implications of this shift for active, small and SMID cap managers?

[Paulis] We believe that the real implication is that there has not been a better time to be in active management in the small and SMID cap space because of how the index is composed, being lower quality, particularly at the lower end of the market cap range. Higher ROIC companies typically outperform lower ROIC companies over time. So, if you have an index that is now lower quality than ever, it is reasonable to believe active managers could potentially have a higher probability of outperforming the index more so now than before.

[Paulis] And there are great companies in the small and SMID space—there always have been, always will be. In the top half of the Russell 2000, as we show in the paper, these are good companies and they have been over that duration of our study. They have stable ROIC, stable free cashflow, improving free cashflow margins, and are largely profitable. Our job is to find those companies and invest in them so they can create value in our portfolios.

Our job also is to identify these lackluster businesses, the lower ROIC companies, and stay away from them. We have seen, in the lower market cap area of the Russell 2000, a real degradation in the fundamental quality of those businesses as we have discussed. We generally have stayed and will stay away from those; we believe this has contributed to our outperformance over past market cycles. In the interest of time, another implication (I won’t get too much into the cost of capital environment we are in now, which is way different than what we have been in for the last 15 years) but should rates remain high, that only further supports our case. I would refer you to the document that we published; it is only about two pages long with charts that help illustrate what has been happening over time and gets at the nature of this question.

[Goldhaber] While your portfolios remain oriented towards high ROIC companies, you have mentioned being ready to accelerate your shift towards improving ROIC opportunities as earnings weaken. What factors would cause this rotation in your portfolio?

[Paulis] We have been weighted more towards higher ROIC companies for several reasons. The philosophical fit is better with what we believe in, but we have also had this slowing economic backdrop amid the rising rate environment and rising cost of capital, which puts disproportionate pressure on lower ROIC and levered companies, just to name a few factors. The list of risks in the economy and for the companies we invest in has continued to grow over the last couple of years which has caused us to make this shift towards higher ROIC companies. Those risks that we identified are now playing out in real time. We have been expecting earnings to weaken throughout 2023, and that has started to happen. Every quarter through 2023, we think the environment, and therefore the revenue and earnings of small cap companies, has become weaker.

We have seen the Russell 2000 and the Russell 2500 earnings expectations continually revised lower for 2023 and 2024 as we have moved throughout this year. As those earnings have weakened, we have seen the market and individual stocks move lower in reaction to that. And as those stocks move lower, what we call the upside/downside ratio or the reward-to-risk ratio, has become more attractive, particularly as we look out over our evaluation period of about 18 months plus or minus. So that risk-reward improvement would be one factor that we are looking at. Stocks have come in, have become cheaper, taking a longer-term timeframe in our analysis. The risk-reward is starting to be there as the market pulls back as earnings have come in.

If a stock meets our philosophical criteria, ROIC, niche market, competitive advantage, strong management team, and attractive reward-to-risk ratio, we will initiate a position. What will really help from an improving ROIC company perspective is the Fed backing off its interest rate raising campaign; this would cause the economy to start to strengthen again instead of weakening, which is what we have seen now for several quarters. And that would create a more favorable backdrop for these companies which would also cause us to accelerate our shift to those improving ROIC businesses.

[Goldhaber] What is your outlook for the market heading into 2024 and what factors will you be closely watching?

[Paulis] We think 2024 is going to be a tale of two halves. The first half we believe will be a continuation of what we have seen in the second half of 2023, that is, somewhat of a difficult environment. Then we will likely begin the rebound process in the second half of the year because the Fed is cutting rates in response to more weakness than they expected in the economy. We think the first half is going to be difficult for several reasons, many of which we are seeing now. Earnings will continue to decline in the small cap area. Earnings have been cut for small caps since late spring, early summer of 2022. That continues all the way through today and we do not see that stopping for another few quarters. There is a lag effect of the Fed tightening that remains in the pipeline.

There is typically a lag between the Fed takes action and when you see that result in the economy and in company fundamentals. That is still tightening. We believe things do not get worse from that. Also, international demand, just in Europe and China, as a general picture has remained soft. The geopolitical events and the impact that that can have on confidence (which we saw with Russia and Ukraine and now given what is happening in Israel) dampens both consumer and business confidence. The U.S. political dysfunction and the 2024 election cycle has already begun creating uncertainty with companies which could be a risk factor. Then there have been rising energy prices, dwindling savings, and student loan payments starting back up in the October 2023 timeframe which have all put a bit more of a weight on the consumer. And then there is the unknown of a surprise occurring with every tightening cycle; something happens where there is a large negative surprise (e.g., maybe we saw it in March with what happened in the bank crisis, we do not know). But history tells us that something breaks in every tightening cycle. Will something occur again in 2024? We are not sure, but there could be an event based on history. We believe these are going to be headwinds for the market throughout the first half of 2024. This likely results in the labor market weakening and will likely provoke the Fed to begin cutting rates at some point. We do not know if will be early or late in the year, but we feel the Fed either changes its tune or begins to cut rates in 2024. This should help drive optimism that an economic recovery can begin. Therefore, the market should begin to stabilize and to move higher up from its lows once there is a visible sign for that to happen.

 

Additional Resources:

SBH Domestic Equities Strategies

Domestic Equities Insights

“You’re Killing Me, Smalls”

 

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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