SBH Investment Summit:
Small Cap Equities

What Fundamentals Will Help Drive Small Cap Companies’ Success?

The impact of restrictive monetary policy and higher inflation this year has created a difficult backdrop for financial assets, especially equities. While we haven’t yet seen a significant impact on the economy from higher rates (given the lag effect of rising rates), there are some warning signs flashing. Despite the potential challenges of an economic slowdown next year, we believe opportunities remain in small cap stocks.

Brian Fitzsimons, CFA, Director of Small Cap Growth Strategies, Jeff Paulis, CFA, Senior Portfolio Manager, and Shaun Nicholson, Senior Portfolio Manager, discuss what market drivers they see going forward, potential opportunities in 2023, and how they are positioning their portfolios.

 

Key Takeaways

  • The significant rise in companies’ cost of capital has made strong free cash flow and effective capital allocation decisions more important now than in the past decade.
  • Companies that can take advantage of U.S. reshoring trends may be better positioned to offset a recessionary hit in 2023.
  • The compression in valuations has been very meaningful in small caps this year, particularly for growth stocks. We believe active management will allow us to take advantage of these valuation disconnects across the small cap landscape in 2023.

[Alexis Cann] Hello everyone and welcome to another session of our SBH Investment Summit. My name is Alexis Cann. I’m a member of the Institutional Relationship team at SBH and joining me today for a discussion on the U.S. small cap landscape is Jeff Paulis, Senior Portfolio Manager and Lead PM for small cap core and SMID cap core, Shaun Nicholson, who is the Senior Portfolio Manager on the small cap value strategies, and Brian Fitzsimons, Director of Small Cap Growth Strategies at SBH. Thank you all for joining today. I’m excited to get your thoughts on the small cap environment. I know it’s an area that’s always very top of mind for our institutional consultants and clients. With that, let’s get into our first question. Looking back at this year, 2022, what surprised you the most across the small cap market and the broader economy in general?

[Jeff Paulis] I would say the biggest surprise for us in 2022 was twofold. I would say first it was the significant positive performance of energy names, and second, the degree of the collapse in valuations in longer duration growth stocks driven by the rise in interest rates. I’ll let Shaun and Brian dive deeper into both of those topics in just a minute. But the outbreak of the Russia and Ukraine war magnified both issues due to the impact of commodity prices. But when you combine the war’s impact on energy prices, in particular, with continued problem areas like global supply chains and the related product shortages that we saw with continued labor shortages which have driven wages much higher, you really have a recipe for accelerating inflation throughout most of 2022 to 40-year highs. That acceleration in inflation forced the Federal Reserve’s (Fed) hand, and you’ve seen that aggressive response from the Fed in monetary policy over the course of 2022. And as those rates rose, evaluation multiples fell particularly in longer duration companies. And with that, I can turn it over to Shaun and Brian so they can discuss both of these points in a little bit more depth.

[Brian Fitzsimons] I’ll take the valuation compression side of the discussion as it’s been very meaningful especially on the small cap growth side this year, really going into the year we had Fed Funds rate that has increased materially, sitting at three and three quarters to 4% today up from effectively zero at the beginning of the year. Those higher discount rates that have been put into the valuation work of companies has meant lower stock valuations. I think the real surprise has been the magnitude of some of those moves this year given the move in rates, growth companies with greater future cash flows have struggled and lagged peers and those reinvesting in businesses with limited current free cash flow, given the fact that they’re building brands, building services, building products, those stocks have even struggled more, areas like technology software, which has typically been defensive in a down market has been one of the areas leading the market lower given this this valuation compression. So, it’s been quite a surprise in the market. Growth stocks have taken the overall brunt of that valuation compression, but we do believe that we are, we’re through the worst of it at this point. Let me pause there and turn it over to Shaun for some comments on the energy side.

[Shaun Nicholson] Thanks Brian. The energy space has been the best performer within the market this year. It’s funny, the majority of that did occur though in a very short period of time, post the invasion of Ukraine by Russia, oil prices spiked, energy stocks went up materially, but they’ve stayed at a pretty high level. When you look at the value space, energy as part of our benchmark was about five and a half percent coming into the year; at the end of June, it was near 11%. So, it’s clearly the significance of that move underpinned by that volatility and energy globally. It’s been something that I think has been a challenge across any product that has been underweight the space. But what’s more interesting when you step back year-to-date, the price of oil’s only up about 10%, but energy equities are up anywhere between 60 and some up a 100 percent. So, there has been a big dislocation on a full year basis at this point of energy equities relative to the price. It’s something going into ‘23 that will be very interesting to watch.

[Cann] Let’s talk about what else you’re watching as we look ahead to next year. What do you see as far as what’s going to drive the markets going forward? Are there areas of risk that you’re concerned about or, what potential opportunities are you watching for next year?

[Paulis] I’ll jump in here and talk about what we see as the risks and then I’ll turn it over to Shaun after that so he can end with more positive news than I’m going to discuss here. I think one of the biggest risks that we see is really the lagged effect of interest rate increases on the economy and corporate, essentially corporate earnings. As many are probably aware, monetary policy works with a lag. So, we believe that we really haven’t seen much of an impact yet from higher rates in the economy. At the same time, you have some warning signs flashing from yield curve of inversion in several key areas to what is now a sub 50 ISMPMI index to the ISM new orders index that’s at its lowest point since the outbreak of COVID. We’ve heard more cautious and subdued corporate commentary as well. You also have, digging down a level, very soft housing data as higher rates have clearly impacted the housing market already. That tends to be one of the first sectors that is impacted in a downturn. You also have had signs of slowing in areas like Consumer Retail as the lower end consumer has been under pressure from things like inflation as well as higher gasoline prices and energy prices in general. More recently we’re starting to hear and see signs of weakness spread to other areas including transportation, particularly trucking so far. Container rates have meaningfully plummeted from a year ago and semiconductor demand has also weakened. All these areas, even whether that be housing, retail, transportation, semiconductor, are what we call early cycle, which means that they typically see the weakness in the economy first. So, the dominoes have essentially started to fall similar to past cycles in some respect as far as the weakness starting to pervade itself from sector to sector. These concerns are really being confirmed in forward earnings estimates. Whether you look at the S&P 500 Index or the Russell 2000 Index. When you aggregate the earnings, they’re declining and so earnings estimates peaked in the June 2022 timeframe, and they’ve been trending lower ever since. We don’t see much that can stop that trend over the next few quarters. We’re seeing more and more companies both large and small miss earnings estimates, revise their forecast lower and with higher interest rates still working their way through the tightening pipeline. As I talked about in the first question, we think forward estimates will continue to fall for the next few quarters, which is going to make it difficult for the market to keep rising like it has. And with that, I can turn it to Shaun to give you the positive view or the offsets that we see.

[Nicholson] There’s definitely some things that have been implemented going into 2023 if it is a recession that have not been present in other recessions actually going into those recessions. A couple of government programs that you may be familiar with. The infrastructure bill, that was really passed earlier this year. It’s a 44% increase in spending on an annual basis for the next five years. That spending is going to start hitting in 2023 and that’s going to be a meaningful driver of some of the industrials that participate in the infrastructure space. On top of that, you have the IRA, or the Inflation Reduction Act, that also has helped funding some new investments here in the U.S. particularly around supply chain. Lithium gets a lot of attention there in terms of bringing more lithium production into the U.S. Also there’s the CHIPS Act, in order to drive semiconductor investment here in the U.S. All that is correlated around a reshoring theme that’s emerging based on the geopolitical environment we’ve seen over this year, in particular with China and zero COVID lockdowns that emerged and have continued in many respects. The reshoring theme in order to eliminate some of that volatility, is going to be a 2023 story for many areas of the market. So, we are trying to position many of our companies around these trends that are going to, in a sense, help offset that recessionary hit through 2023.

[Cann] That’s a great segue to the next question of just how you guys are positioning your portfolios to help minimize some of these risks and take advantage of the continued volatility. Brian, we could start with you if that works.

[Fitzsimons] I think there’s a few key things that we’re looking at today and I’ll hit on a couple of those. First, given what we’ve seen from inflation the prior discussion we were talking about on the valuation side of things, strong, free cash flow generation is a characteristic that we find incredibly important especially on the small cap side. If we continue to see inflation remain stickier than expected and rates end up going higher, having current, strong, free cashflow generation is really important from a valuation support side of things. That’s going to be one of the key elements that I think is prevalent on the small cap side. Another item is when you look at the balance sheets, we need to see strength in balance sheets within the companies that we’re looking at investing in. It will help them navigate through what is likely going to continue to be a challenging environment and even potentially more economic weakness in 2023. The impact from weaker cash flows as you go through that environment and you combine that with the fact that now we’re talking about higher interest rates, so it’s no longer just a liquidity concern or evaluation concern when it comes to balance sheets, but it’s real financial impact as you have to start to look at refinancing with existing debt that’s coming due over the next 12 to 24 months or higher interest rates with variable debt. So, you’ve got an impact on cash flows that has now become very real as we’ve moved away from this zero-price environment. The higher capital costs overall we think is something that is an important part of the equation, so strong, free cash flow generation, along with balance sheet strength. And then the other element is having a long-term focus towards investing and that really helps from being able to take advantage of valuation disconnects where fundamentals are better than what the market is pricing in, and we think will be more resilient. On the small cap growth side, we’re looking at fundamentally stable growth. This is trying to create more consistent growth in cash flow per share and on the small cap value and core side it’s continued focus on return on invested capital. Those are a couple areas that we continue to be focused on, we think will be important in the year ahead.

[Paulis] I’ll have similar things to say to Brian. For us on the core and value side, it’s all about return on invested capital and by nature free cash flow as Brian mentioned, including for us both free cash flow growth but also free cash flow improvement. At the end of the day, we’re firm believers that free cash flow is really the primary driver of equity value creation. This is particularly true and important in rising high interest rate environments. Brian touched on some of the reasons for that but I also would add that with the 2-year near 4 ½% and the 10-year fluctuating between 3 ½% and 4% now, investors for the first time in years have alternative investment options to equities. I’d say it’s important to note that the rise in rates also results in a higher cost of capital for companies, which Brian touched on. So free cash flow and free cash flow yields, the ability to sell fund and just making appropriate capital allocation decisions and investments are much more important now than they have been for the past decade or even post the Great Financial Crisis. So as Brian mentioned, on the core side we’re positioning our portfolio and have been for companies that generate high return on invested capital, that generate strong free cash flow, and have good balance sheets. All of these are going to help weather any type of economic slowdown that we’ve been discussing here today. Also, will generally help our companies weather the higher rate environment that we have now. I would close by saying this is a time that active management can really shine, investment managers, including ourselves, typically prefer companies with solid fundamentals or high quality attributes, including things like as we’ve discussed multiple times already, free cash flow, high return on invested capital, strong balance sheets. If you take a look back from the Great Financial Crisis up until about 2021, long duration stocks did very well and you saw performance scenarios like low or negative ROIC stocks, including areas like biotech. We had the Meme craze at the beginning of 2021, and we had the SPAC craze. All of these were rooted in the low level of interest rates and many of these types of companies can only fund themselves when capital is cheap and abundant and that is in the process of changing, some would argue that it’s already changed. And so, a lot of active managers including us shy away from the types of companies that are fundamentally challenged from an ROIC perspective or a competitive position perspective that were just dependent on low rates. If rates stay higher for longer, or at minimum just don’t revert to where they were post pandemic or post the Great Financial Crisis, we think that active management should continue to have the wind in its back here for some time.

[Cann] Great, to wrap up our conversation, we have one final question, but this has been great so far. When thinking about an overall asset allocation, why do small caps still make sense to have as part of an overall portfolio just in helping clients reach their long-term goals?

[Nicholson] I’ll take that one. When you think of the small cap universe, diversification across small cap core, growth, and value and just an overall portfolio, small caps bring a nice diversification element. When you think of from a risk standpoint, a lot of the problems are emerging outside of the U.S. and small caps historically have a much more domestic oriented business model. I think from a risk perspective, it plays a nice role having more of a focus in the U.S. There was a fact that that came out from Evercore ISI that was quite interesting. Small caps are the only asset class since the 1930s to outperform inflation every decade. So when you kind of step back and think of the inflationary backdrop that we’ve been in and that we’ll likely stay in for a little bit longer, small caps still seem like a very logical place to have part of your portfolio invested in.

[Cann] Great, well that is all we had prepared to cover today. Shaun, Jeff and Brian, thank you again for joining. I hope those that have tuned in have found this to be helpful. And if there are any questions around what we covered today, please don’t hesitate to reach out to your contact at SBH. We’re always available and happy to discuss further and we look forward to seeing you at the next summit.

 

Strategy Profiles:

Small Cap Growth

Small Cap Core

Small Cap Value

SMID Cap

 

Small Cap Videos:

Transcending Volatility in Small Cap Growth

High ROIC + Niche Market Advantages

The Benefits of Investing with a Return on Invested Capital (ROIC) Focus

 

Additional Resources:

Small Cap 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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