Small cap Interest rates Macro USA Equity Fundamental equity Podcast

Why small caps are looking big again

Thomas Mucha, Geopolitical Strategist

Andrew Heiskell, Equity Strategist

2024-08-15T12:00:00-04:00 | S3:E8 | 23:48

The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.

Episode notes

Small-cap stocks have experienced a historic rotation in response to recent macro jolts. In the latest episode of WellSaid, equity strategist Andy Heiskell joins host Thomas Mucha to discuss his outlook for small companies in this environment.

2:00 – The role of a global equity strategist
3:40 – Small-cap stocks’ recent rotation
5:25 – Regime change is a process
7:05 – Potential drivers of small caps' relative outperformance
9:00 – Small caps and the economic cycle
10:50 – Characteristics of higher-quality small caps
12: 20 – Identifying today’s small-cap opportunities
14:25 – The growth of private equity
18:00 – The impact of geopolitics and national security
21:00 – Lessons learned

Transcript

ANDY HEISKELL: And small companies have outperformed because they’ve grown faster than large companies. And so, this happens because, they’re smaller companies. And there is, through cycles, this creative destruction where the smaller companies end up being more nimble to be able to adapt new technologies, to be disruptive to the incumbent companies, which ultimately leads to faster growth.

THOMAS MUCHA: Vladimir Lenin once reputedly said, “There are decades when nothing happens, and there are weeks where decades happen.” The events over the past few weeks have upended US markets, the outlook for the economy, and potentially, the entire political and geopolitical landscapes. July’s cooler inflation print, rising odds of a September Fed rate cut, the assassination attempt on Donald Trump, the historic shakeup for the Democrats in the 2024 presidential race, and there’s still a long way to go until November. Now while it’s not clear that these events will have decades-long consequences, of course, the effects will surely be felt for quite some time. This is a massive topic, so we’re gonna touch on these things briefly, but focus on a market segment that has had a historic rotation in reaction to these macro jolts. And here of course, I’m talking about small cap stocks. I’m joined by Andy Heiskell, Wellington’s global equity strategist, a former portfolio manager, and a 23-year veteran of the firm. Andy, welcome to WellSaid, and thanks for helping us break all of this down.

ANDY HEISKELL: Thanks for having me, Thomas.

THOMAS MUCHA: Obviously. Andy, there’s a lot to unpack. But first explain what you do as global equity strategist, and who you work most closely with.

ANDY HEISKELL: So as Wellington’s global equity strategist, I have two really complementary functions. First, I work internally. Think sort of, as sitting horizontally across our public equities business. And we have 25 equity investment teams. And I work day to day with them, helping them to navigate all the complexities of investment markets. Helping to answer questions, identify trends, and probably most importantly, to discover new opportunities. And then secondly, complementary to this, I work externally with our clients and our partners, and I guess unsurprisingly, helping to answer and address the same questions and trends. And I say these are complementary, because the questions and issues that we’re trying to debate, and trying to answer internally are exactly what our clients and partners are trying to answer and debate as well. And so, those conversations that we have internally are very informative for me in helping to lead those conversations I have with our clients, and then those external conversations I have simultaneously are very helpful in terms of helping to instruct that conversation internally.

THOMAS MUCHA: What you just said is an exact mirror of my role. I’m meeting with those same 25 investment teams. I’m meeting with a lot of these same clients, and I do think there’s a really nice symbiotic relationship between the internal and the external piece of it. All right, Andy, now onto the specifics of today’s conversation. And let’s start with the dizzying events that I just mentioned, seen through the lens of the stock market. So please, explain to us what happened, why did it happen, and why did small caps rebound so dramatically?

ANDY HEISKELL: Yeah, this rotation between small caps and large caps in recent weeks really has been historic. It really was triggered beginning on July 11 when we saw the surprising low CPI print, which is important for small-cap stocks. We’ve seen this really significant negative correlation between small-cap stocks and interest rates in the markets in recent years, really cause small companies have become more exposed to higher interest rates. Small companies have higher leverage. They have a lot of floating rate debt. And have been more pressured by the Fed rate actions and higher interest rates. So the CPI has come in lower, it’s increased expectations that the Fed will be cutting interest rates into the back half of this year, alleviating some of this pressure on small companies. And then you combine those together with some positive economic data, retail sales, GDP. And then lastly, the increasing prospects of Donald Trump and Republican sweep, combined together have really caused a lot of investors sort of on the wrong side of positioning and sentiment. And so these have all combined together to really create this historic reversal that we’ve seen.

THOMAS MUCHA: You’ve been doing this a long time. Have you ever seen something so dramatic in your 23-year career?

ANDY HEISKELL: It happens at times, but it usually happens exactly these moments, where sentiment and positioning, really sort of tilted towards one side of the boat. Everybody’s in one trade, and the trade recently has been really around the Magnificent 7, the large-cap stocks, AI. And a lot of investors have been caught offsides here.

THOMAS MUCHA: Yeah. Well, on the topic of the Mag 7 trade, you’ve been saying that for some time that on the other side of this, when the biggest tech names end their run, you anticipate a prolonged period of outperformance by small companies. Do you think that an inflection point is under way? Or could this be more of a blip that hints that the market is prime for reversal? But it’s still early?

ANDY HEISKELL: I would describe it as an inflecting point. We discuss a lot internally about regime change, whether it’s regime change around the economy, or regime change around the market. And I like just to reiterate that a regime change is a process. It’s not an event, right? And so what we’ve seen here recently is an event. And so really the process takes time. And so if we think through the key components of regime change, have to go what we discussed earlier, have to do with sentiment, positioning, valuation, which had been on the side of small caps here recently. But the last component, which is probably the most important ultimately, is around fundamentals. And this is where small companies have been, as I said, particularly impacted by higher interest rates and the Fed policy. And so, just this last year alone, we’ve seen earnings go down by over 20 percent for small companies. We’ve seen revenues go down six percent. And this is in the midst of a GDP that’s been growing nominally five, six percent. So pretty striking adverse economic, and earnings impacts for small companies. So to see, really, a true reversal, we need to see this true reversal in terms of the fundamentals. We need to see the closing of the earnings-growth gap between the large companies and the small companies. And that will take time.

THOMAS MUCHA: Weeks, months, quarters?

ANDY HEISKELL: I would say quarters and years. And our anticipation is that we’ll start to see some of this gap close into the back half of 2024. But really probably accelerate into 2025.

THOMAS MUCHA: So to take the other side of that, why shouldn’t investors assume that the structural dominance of these massive, powerful companies will continue? You know, what’s the argument here for small caps, really?

ANDY HEISKELL: So I’ll caveat by saying that we do view favorably a lot of these large companies. They are outstanding companies. They are world-class, they’re growing more quickly than the market. They’re delivering tremendous growth and profits, free cash flows. They have low debt. There’s a lot of attributes to love about these mega-cap companies. But that being said, I think there’s really two important attributes here that we need to take into consideration. The first is the law of large numbers has not been suspended. And I get legitimate questions at time where people ask, like, well what if these companies that are bigger than average continue to grow faster than the average company? And I pause, and I say well, how does that work, right? If you’re bigger than average, you can’t grow faster than average forever, right? Eventually, the only outcome of that is you’d have one company left. So, that law of large numbers still remains in place. I’d say that the other law that we need to keep into consideration is the law of creative destruction. Over a long period of time, like a hundred years, small companies have outperformed large companies. And small companies have outperformed because they’ve grown faster than large companies. And so, this happens because, they’re smaller companies. And there is, through cycles, this creative destruction where the smaller companies end up being more nimble to be able to adapt new technologies, to be disruptive to the incumbent companies, which ultimately leads to faster growth.

THOMAS MUCHA: Yeah, that makes sense. And I like your point, it’s not an either/or here between large and small caps, right? There’s a wide array of options here from an investment perspective. Now, let’s dig into this a bit. If you look at historical chart of outperformance and underperformance relative to large caps, the inflection points marking changes in leadership are pretty sharp; they’re fairly unmistakable. So what are some past examples of catalysts that benefited small caps, and what should investors be looking for this time around, apart from what you said earlier about interest rates?

ANDY HEISKELL: Historically looking back, again, over long cycles, small companies tend to outperform early economic cycle. So they’re clearly viewed as early-cycle stocks, early-cycle sectors. And what I mean by this is after recession, you typically have a period of accelerated economic growth where these small companies are disproportionate beneficiaries; they’re winners there. And I think the complication that investors have been facing the last four or five years, is that the cycle has been anything but normal, right? We had a downturn, a recession because of pandemic. And subsequent, we’ve had rebounds that have been sparked by really aggressive monetary and fiscal policy. And then we’ve had worries about a subsequent downturn. So we’ve been really vacillating back and forth, I would argue, between sort of mid- and late-cycle for the past four or five years.

THOMAS MUCHA: Yeah, it’s weird out there.

ANDY HEISKELL: And we haven’t had a true, sort of early cycle period other than maybe for a quarter or two in 2020. And so there really hasn’t been the normal opportunity for investors to engage or reengage with small-cap stocks. And I think at this moment in time, a lot of investors are waiting for this signal, this bell to be rung to say it’s safe to go back into the water. I’d argue that we might not have that this time. That because of this sort of disruption of the normal cycle, it might play through a bit differently. We’re not going to have maybe the sharp rotation that we’ve seen in cycles past. But rather, again, it will be this process that lasts, or takes several quarters, or maybe even a couple years, of an improvement of the relative profit growth of small companies. And as that comes through, that will be the driver, I think of the closing of this relative gap of performance between large and small.

THOMAS MUCHA: You know you mentioned small caps being more nimble. Do you think management of small caps can be more nimble in managing the economic uncertainty resulting from the pandemic that you referred to?

ANDY HEISKELL: I think the key important point here is that there’s an increased bifurcation of quality of small companies. And what I mean by this is there are a growing amount of small companies that are very economically vulnerable. They’re highly indebted, have high leverage, have floating rate debt that are very sensitive to the impacts of higher interest rates. I think these companies have less flexibility. And those are the parts of the market that are very vulnerable. But I think the important component here, is that there’s a growing bifurcation in the quality of small companies. That yes, on average small companies have more debt, have more leverage. But that debt and leverage is highly concentrated in a small percentage of small cap companies. So half of the debt, interestingly, of small companies, is concentrated in only 15 percent of small-cap companies. So highly, highly concentrated. Conversely, 35 percent of small companies have no debt at all. So those are the companies that have the flexibility to be able to be adaptable. And so, in our research process, it’s a matter of trying to identify those winners and losers, the vulnerable, and those that have that ability to take advantage.

THOMAS MUCHA: Yeah, you have to know where to look.

ANDY HEISKELL: Yes.

THOMAS MUCHA: Let’s move to the topic of alpha and beta, and small caps are generally attractive for active investors given the breadth of the opportunity set, the lack of analyst coverage that you sometimes have and so on. Now, those characteristics though, Andy, also make it a challenging area for idea discovery. So what are the best practices for identifying these opportunities and capturing alpha within small caps?

ANDY HEISKELL: There’s no silver bullet here. Really to identify opportunities in small caps is a lot of hard work. And it’s a lot of hard work from the bottom up. And so you really need to dig in and identify the companies. There’s not a model you can run that’s just going to give you the winners and losers. And so really, it’s a matter of having a bottom-up fundamental process to know the companies, to know who the winners are, to know the sectors, to know all the intricacies, to be able to identify.

THOMAS MUCHA: So it’s an ideal time for active management.

ANDY HEISKELL: Yes.

THOMAS MUCHA: So this leads me to an obvious follow-up, Andy. So where are some of the most interesting opportunities in small caps today that are generated from this bottom-up process that you just described?

ANDY HEISKELL: Yeah, today the most interesting opportunities are in those sectors that really have the most number of companies, that really are the most complex. And also the ones that I say would be the most vulnerable to the technological change and opportunity that exists in the economy today. So this would be areas like biotech, fintech, even within technology itself, where you have a large number of companies that will be highly disrupted, where you have significant winners, but you also have significant losers. You also have an extraordinary amount of technological and technical complexity. So if we think of a sector like biotech, right now there’s over 150 biotech stocks in the Russell 2000. These are very small companies, very complex companies, very complex technologies, with a very bifurcated outcome in terms of, they’re either going to be tremendous successful or they’ll be dramatic failures. And so there’s only one way to go about to identify those winners and losers, is to know the companies one by one by one, to identify them and figure out who the winners and losers are. And so these are the sectors really that present the most interesting opportunities today.

THOMAS MUCHA: How has the growth of private equity affected public markets small cap investing? Because a lot of what you just mentioned is also existent on that side of the equation, so what’s the impact here? What’s the intersection?

ANDY HEISKELL: Yeah, this has been a really dramatic impact. I’d say, modestly positive, but in some regards has been pretty significantly negative for public small companies the last couple decades.

THOMAS MUCHA: Why do you think that is?

ANDY HEISKELL: So let’s put a few numbers to this, I mean this is really fascinating. But if we look back 20 years ago, in the United States, there were 5,000 listed public companies. And there were less than a thousand companies owned by private equity. Roll forward to today, there’s actually over 10,000 companies currently owned by private equity, and there’s only 4,000 public companies. So we’ve seen this tremendous shift from public to private. So what I say is, that’s a positive and a negative. Well in some regards, the positive is that private equity has been a big buyer of public companies, right? They’ve been taking companies private. And if you’re a shareholder, you’ve typically been taken out at a premium, so that’s been good. But on the negative, as more companies sit in the private space, as a public market investor, it just reduces your opportunity set. And we have seen in some cases, companies staying private longer and longer. The classic example that we all know about is Uber, right? Uber didn’t become a public company until it had a US$50 billion market cap. So if you’re a public small-cap investor, you never had a chance to invest in Uber. So that is a negative, but I think what’s quite interesting right now is as we’ve seen this tremendous growth of private equity, that increase from 1,000 companies privately owned to 10,000-plus companies privately owned, we have to think forward. What happens to these 10,000 companies, right? Private equity has long-term committed capital. But in many cases, they don’t have permanent capital, right? So these 10,000 companies need to find some exit. There needs to be a monetization event. And historically, the monetization event for private equity has been either to sell to another private equity firm, maybe sell to a strategic buyer, an industry buyer, or to sell to public markets. So if we look at these 10,000-plus companies owned by private equity, a good portion of them will need to eventually find their way into public markets. And think about the ratio of this: 10,000 private companies, only 4,000 public. So as a public market investor, I’d argue that the supply/demand characteristics, or the supply/demand dynamics will be increasingly coming in our favor. And that as these companies are listed in public markets, small-cap investors can be discerning in terms of identifying the best companies at the best price.

THOMAS MUCHA: Sounds like this is a long-term horizon trend, right? Do you agree with that, like over years?

ANDY HEISKELL: Years, many years. And I would argue it took two decades to get to this current position. And it’ll probably take another decade or two decades to find where the equilibrium is in how this plays out.

THOMAS MUCHA: So Andy, you know we can’t avoid my favorite topic, geopolitics and markets. So while I have you here, in our fractured, and I would argue high-risk geopolitical environment, a number of mega caps, whether in tech, in AI, semiconductors, legacy defense, defense/innovation, other strategic sectors, now they’re being seen by their respective governments, Washington DC included, as national security assets. So much so that maybe the idea of antitrust regulation might seem almost quaint. So, let’s cast this forward in the political context, how does Democratic versus Republican leadership change that structural trajectory in your mind, and the effects on small caps?

ANDY HEISKELL: I would say it’s an increasingly muddled situation, where we’re seeing a blending of some national security and populism between both sides of the aisle. And if we thought like historically, we would say, well the Republicans are more in favor of business. But today, we see this growing trend towards populism across both parties. I completely agree with your premise, that there is a national security aspect to these large mega-cap companies that is increasingly important for geopolitical reasons. And because of that, I do agree with this notion that there will be probably some sector-like protection for the part of these companies that is most strategic and most important to national defense, within the specifically areas around AI. But I would also say on the other side of this, that that aspect of populism will be I think increasingly looking at the consumer sides of these mega cap companies. So I think you could actually see a really interesting situation where there is protection of these companies on one aspect, but also an increased sort of focus of regulation and anti-trust on the other parts of their businesses.

THOMAS MUCHA: That’s interesting, you don’t hear too many people conflate great-power competition with rising protectionism through that lens. How do you think that the impact of the election might change that direction?

ANDY HEISKELL: Again, I think that’s one that probably more conflicting than what we would have said historically, because of this notion of populism that’s rising into play. I do think that, again, the aspect that will be drawn most into question or the biggest scrutiny, is most potentially around the consumer sides of these businesses, where it’s viewed that these companies have growing market power over consumers, in a way that is adverse to the political and consumer interests.

THOMAS MUCHA: Are there any sectors in the national security context that you think favor small cap? And here I mean like emerging technologies. There are a lot of small companies working in AI. Defense innovation. We have all sorts of changes in military doctrines, those tend to be smaller companies. Would you agree that the opportunity set for small companies is growing, given the intense focus on national security?

ANDY HEISKELL: Yeah, I definitely agree with that. And we think about where are the key components of national security interest? That lies around AI, it lies around computer chip technology. It lies around energy production, biotechnology. And these are all the key areas, we go back to thinking about where there’s opportunities, that you have winners and losers, you have disruption, you have a lot of like complexity within technological change. I think that the key technologies, the key companies in the small-cap spectrum across these areas will be the key components that will be the beneficiaries of this national political interest.

THOMAS MUCHA: And this is a global trend too. It’s not just US small caps, right? These are global small caps.

ANDY HEISKELL: Definitely, yes.

THOMAS MUCHA: All right, Andy. Now, you’ve been here for 23 years. You’ve seen Wellington grow from a small company to a relatively large one. You’ve certainly become a leader at the firm. So what have you learned on this journey about yourself, and about what good companies need to do as they grow?

ANDY HEISKELL: I’d say the most important thing I’ve learned is that careers are not linear. And I think the same thing is true for a company as well, and the growth trajectory of a company. And that there’s economic cycles. But there’s also aspects of opportunity and disruption that happen. And to be able to adapt to that sort of nonlinearity requires, I’d say a curiosity and a flexibility.

THOMAS MUCHA: Well you certainly exhibit those characteristics, Andy. Thanks again for joining us here on WellSaid. Once again, Andy Heiskell is Wellington’s global equity strategist.

ANDY HEISKELL: Thank you, Thomas, this has been great.

Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced August 2024.

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