Fund managers put on their small caps
Ed Beal is a senior investment manager on the UK and European equities team at Aberdeen Asset Management. Here he talks about the UK-focused Dunedin Smaller Companies Investment Trust, which started in 1927 and counts among its clients several grandchildren of the original investors.
'Our goal is to select small-cap names with the potential to outperform' – Linda Csellak, head of Asia-Pacific equities for Manulife Asset Management
Linda Csellak, who began her Asian equity career in 1995, is head of Asia-Pacific equities for Manulife Asset Management. She also manages the Manulife Global Fund – Asian Small Cap Equity Fund. Her small-cap career includes four years with a specialist Hong Kong-based small-cap boutique fund and six years at Credit Agricole Asset Management (now Amundi).
Jon Eggins, portfolio manager for Russell Investments, has been responsible for Russell’s small-cap US equity funds since 2011. He takes care of all aspects of the portfolio management process including manager selection, portfolio construction and monitoring. Here he talks about the long-only US Small Cap Equity Fund.
How do you define a small cap?
JE: We define the small-cap universe as stocks represented by the market capitalization range of the Russell 2000 Index. The index is reconstituted annually, and the range as of the latest reconstitution was from $129 mn to $3.3 bn, with the median at $594 mn.
LC: A firm with market capitalization of around $3 bn or below.
EB: We tend to say we will not invest in anything that is bigger than £1 bn ($1.66 bn) at the time of investment, or less than £100 mn. But we have done – I remember when [specialist electrical firm] Acal was less than half that, so we are prepared to do it if we find the right opportunity.
How would you describe your investment style?
EB: This trust is fairly conservative in what is a fairly conservative house. The focus is on investing in ‘quality’ companies. We regard ourselves as the owners, or the agents of the owners, [and] we will not change what we do in pursuit of short-term performance.
JE: In the relatively inefficient US small-cap market, we believe skilled manager stock selection is the most reliable source of value-add and, as a result, the fund seeks to emphasize this return source.
LC: Our bottom-up stock selection process focuses on fundamentals, and our goal is to select small-cap names with the potential to outperform regardless of the market cycle or macro trends.
What’s your average holding time?
LC: Two to three years – but we have a disciplined approach to our holdings, particularly in more volatile sectors.
EB: We talk about a three-to-five year investment horizon, and we back that up by saying that across our small-company portfolios in the UK, turnover last year was 15 percent, which would suggest a six-year average holding period.
'The price you pay for these firms is crucial' – Jon Eggins, portfolio manager for Russell Investments
JE: The fund employs a variety of different investment strategies and a range of holding periods.
What are your investment criteria when choosing a small cap?
LC: We look for companies with sustainable growth, ample cash flow and trustworthy management teams. We also like companies that are well positioned in their respective industries and have a strong competitive advantage. Pricing – and mispricing – is the key, as we are looking for undervalued stocks. Our ideal holding is a stock that undergoes a significant rerating over time. Once it becomes a more highly valued mid-to-large cap, we can take profit and reinvest in a less recognized and less expensive company that can possibly provide a higher risk-adjusted return.
EB: Overall, Russell uses a valuation business cycle and sentiment framework to make dynamic changes to the underlying equity strategies through time.
JE: We put a lot of store in the management team and its demonstrable track record or otherwise, [and] we are prepared to take cyclical exposure when appropriate. You also want the right balance sheet to add to the business model. We have a company called Dignity, which provides funeral and cremation services in the UK. I don’t mean to be flippant but we’re pretty confident demand for that business will continue. It’s probably got leverage of four or even five times EBITDA, which we think is fine for that business. Put that in for a general retailer, for example, and we’d run a mile.
Does a company need to be profitable before you invest?
EB: Yes, you want profitability – that definitely fits with where we see ourselves and where we pitch ourselves in the risk spectrum.
JE: We prefer to tilt the aggregate portfolio toward higher quality. Just because a company is not making money, however, it doesn’t follow that it’s a bad investment. The price you pay for these firms is crucial and we feel some managers are especially skilled at identifying the true undervalued gems among stocks that may not be profitable just now. One of our money managers describes his process as finding cigar-butt stocks at cigarette-butt prices.
What are your current likes?
LC: We are particularly bullish on South Korean small caps, which are attractively valued. While our exposure to the market underperformed during 2013, with several of our holdings losing substantial ground due to a combination of external factors such as tax law changes and rebalancing by fund managers, we now find ourselves well positioned with a slate of promising value stocks with structural growth potential. We are also positive on Hong Kong and beginning to see value emerge in selective South East Asian small-cap names after an extended period of volatility in 2013. Thailand is a good example, as the current political unrest has created some attractive buying opportunities.
JE: We view 2014 as a year with some valuation risks, underpinned by solid business cycle and sentiment dynamics. We also believe the active management opportunity is strong in 2014 as macro influences decline, stock correlations fall, valuation gaps remain, and rising interest rates are likely to continue pressuring areas that active managers typically avoid. The stock-picking opportunities in the energy sector, housing market and tech sector remain vast, and for many active managers continued M&A activity could boost excess returns. We like what’s happening in US micro-caps, [which] offer the potential for significant security mispricing that skilled active managers can exploit. One of the micro-cap strategies in our fund had an especially strong year mostly due to focusing on the inefficiencies between the equity and debt markets.
'We put a lot of store in the management team' – Ed Beal, senior investment manager on the UK and European equities team, Aberdeen Asset Management
EB: We’ve put these portfolios together from the bottom up, rather than the top down, so people spend most of their time looking at businesses and doing analysis on companies. We base our decisions on our own in-house analysis rather than third-party analysis. So the view on interest rates, oil prices, commodity prices or the recovery in other parts of Europe finds its way into the analysis of the firm, rather than being a top-down view that’s imposed on the portfolio. We have sector underweights and overweights but they are a function of the portfolio, not the other way around.
In terms of IR, what could small-cap companies do to make themselves more attractive?
LC: Small caps are often reluctant to deliver bad news: I often remind management that investors prefer companies that under-promise and over-deliver and to first sound out existing shareholders to gauge views before issuing equity. In general, we prefer focused firms with one main business segment but, for more diversified firms, it’s important to keep the story simple and clear, focusing on what makes the company different and why the investor should buy the stock. In this vein, I would never underestimate the impact of IR presentation materials.
JE: We like IROs who engage with knowledgeable small-cap managers and seek out their insights on capital allocation decisions.
EB: Corporate contact is the lifeblood of our investment process and we welcome contact from companies offering us corporate access. We meet everything before we invest in it, and then meet it at least twice a year. There aren’t many black-and-white issues in investing but that’s one, [as] we [don’t use] consensus numbers.