Between 2014 and 2016, large-cap stocks drove the U.S. equity market higher, while the vast majority of stocks greatly underperformed. But this pattern has changed in a big way since the election of Donald Trump as president, argues John Reese, a bottom-up quantitative manager who is the founder and CEO of West Hartford, Connecticut-based Validea Capital Management LLC.
"It was not specifically due to Trump's election. Even coming into 2016, based on median trailing 12-months price-to-earnings ratios, small and mid-cap stocks were historically cheap relative to large-caps," says Reese, manager of the $339-million National Bank Consensus American Equity. "The trend of large-caps outperforming was very long in the tooth and some valuations were at extreme levels. At that point, mean reversion was inevitable, though history shows that periods of overvaluation or undervaluation can last for many years longer than you think."
The valuation gap is attributable to a combination of a slow-growth economic environment and a period of very low interest rates. That pushed investors toward large-caps that were perceived to be extremely high-growth. Equally important, says Reese, most of the benchmark performance was concentrated in the top 50 stocks.
"In fact, there was one period in 2015 when the entire positive gain of the S&P 500 was concentrated in just the top 10 stocks," says Reese, noting that investors favoured stocks known by the acronym FANG: Facebook, Amazon, Netflix and Google.
Essentially, it needed a trigger event such as Trump's election to tip the scales. "It was not the election by itself, but the fact that small stocks had been so extremely undervalued," says Reese, whose firm relies on computerized investment models to pick stocks based on the methodologies of famed investors such as Benjamin Graham and Warren Buffett. "It was long overdue. But you can't predict when the trend will reverse."
Reese believes that expected lower taxes and less regulation will be a boon to smaller companies. In addition, he argues that small-caps tend to outperform when interest rates are rising, as they have already done so, in response to expected infrastructure spending.
"Rising interest rates are not harmful for small-caps," says Reese. He points to a March 2013 study of data going back to 1979, by Fidelity Investments unit Pyramis Global Advisors, which found that U.S. small-caps outperformed large-caps when rates were rising. "Small-caps tend to use less debt than bigger companies and are less affected by rising interest costs. Second, when interest rates are rising, it's usually because economic growth is picking up and small-caps typically grow faster in these periods."
Rising rates tend to push the U.S. dollar upward and make local companies less competitive overseas, although Reese believes small-caps will be less affected because their revenues tend to have less foreign exposure than large-caps. "It's devilishly complex to calculate the impact of a stronger dollar. It's not just that revenues will go down, should the dollar gets stronger. Some companies can benefit because they can buy raw materials a whole lot cheaper. It has to be looked at on a company-by-company basis."
A bottom-up stock-picker, Reese holds about 45% of the fund in small-caps, followed by 25% mid-caps, and 30% large and so-called mega-caps. Using his computerized models, he selects about 100 names from a universe of 3,000 liquid stocks. Given the heavy tilt in the universe toward small-caps, the composition of the fund is not surprising, says Reese. From a sector viewpoint, financial services represent the largest portfolio component at 19%, followed by 17% consumer cyclical and 13% energy.
"Our fund remains all-cap," says Reese, whose firm manages about US$550 million. "We are not striving to pick small or large-caps. The individual models select the stocks. But relative to where the market is at any one time, the models will find the best values," adds Reese, who rebalances the fund five times a year.
While Reese will be rebalancing the fund this month, he continues to favour names such as G-III Apparel Group Ltd. (GIII), which makes clothing for brands such as Calvin Klein and has a market cap of US$1.2 billion. "Our Benjamin Graham strategy gave this a 100% score," says Reese, who adds that the company is financially secure and trading at a discount to its intrinsic value.
Another favourite is Transocean Ltd. (RIG), a mid-cap company that operates drill rigs around the world. "The stock was hit very hard by a plummeting oil price," says Reese. "Big oil companies backed off on offshore drilling." Reese calculates that the stock, which the fund acquired in June, is also trading at a discount to intrinsic value.
All strategies will spend some time in the cellar, Reese argues, and his is no exception. Over the past year, however, there has been a reversal of the poor performance of National Bank Consensus American Equity in 2014 and 2015. "That's a strong indication to us that we have not only benefited from a tailwind, but we're going to benefit hugely from the mean reversion that happens to long-term successful strategies," says Reese, adding: "The rotation into small and mid-caps is likely to continue."