Small and Mid Cap Investing in Volatile Markets
Small and Mid Cap Investing in Volatile Markets Matt Weatherbie and George Dai hosted a portfolio update with clients in the Alger Weatherbie Specialized Growth strategy. To kick off the call, Brad Neuman, CFA, the firm’s director of market strategy, shared his views on the markets and the economy. Brad Neuman : Thank you all for joining us in what is no doubt an extremely busy time. This is Brad Neuman. I’m director of market strategy at Alger and I'm joined on the call by Matt Weatherbie, chief executive officer and co-chief investment officer of Weatherbie Capital, as well as George Dai, co-chief investment officer of Weatherbie Capital. The format for the call is that I'm going to go over five macroeconomic points and then we're going to move into a Q&A with George and Matt. At the end we are going to take questions from you all on the line. First off, I want to set the stage for what's happened. Things are moving pretty fast. In our view, the stock market has already priced in a recession. We say that because of the U.S. stock market. The S&P 500 is down 34% peak to trough. That decline exceeds the average that we've observed around recession since World War II, with that average being 22%. In fact, it would put it as the third worst decline. Right now, we're down about 23% from the peak, having lost over $20 trillion of wealth in global equity markets. Under the covers, growth is outperforming value significantly by about 1,000 basis points depending on which benchmark you look at. In terms of characteristics or factors that are driving the market, quality is generally outperforming with better balance sheets outperforming those companies with higher leverage, and companies with stronger profitability outperforming those with lower margins. Please note this transcript is from a call on March 26, 2020 and it has been edited for clarity and brevity.
MATTHEW A. WEATHERBIE, CFA Chief Executive Officer Co-Chief Investment Officer Weatherbie Capital, LLC
H. GEORGE DAI, Ph.D. Senior Managing Director Co-Chief Investment Officer Weatherbie Capital, LLC
Economic estimates have been shifting wildly, but in the U.S. there seems to be settling for low to mid-single digit decline in the first quarter of 2020, down double digits in the second quarter of 2020, followed by a strong second half rebound that some people have occurring in the third or fourth quarter. Interestingly, the last time GDP was down double digits in the United States for a quarter was the first quarter of 1958 during the Asian flu pandemic, which killed over a million people globally, and 100,000 people in the U.S. Interestingly, over the next three quarters, GDP increased 3%, then 10% and then 10% again. As one of the first data points that have come in to show just how severe this downturn is, initial jobless claims were filed this morning. They come out every Thursday measuring how many people are looking for assistance from the state because they've lost their job. 3.3 million Americans filed for jobless claims in this past week. To put that in context, the old peak was 665,000 in the global financial crisis in March 2009. So, that would represent alone a two percentage point increase in the unemployment rate just last week. I want to talk about sentiment. At Alger, we measure sentiment with a couple of different metrics. One, we like to look at it is the VIX index, which is the implied volatility in S&P 500 options. Some people refer to this as the fear index. Generally it ranges 10 to 20 in a normal market; above 20, say 20 to 30 shows some increased anxiety; 30 to 40 is investors being pretty, extremely anxious; and over 40 I would characterize as panic. It occurs statistically less than 2% of the time. That VIX recently hit a record, even higher than the Global Financial Crisis. And it's currently sitting close to 60, so extremely elevated, showing a lot of anxiety in the marketplace. Another metric we look at is a money market funds, how much cash is on the sidelines. And with investors liquidating a lot of risky, risky assets and piling into cash, those money market funds have surged to about $4 trillion, up over 20% from last year, with the highest weekly inflow that we've ever seen last week, with nearly $100 billion. And that total $4 trillion is up about, at the peak, similar to the peak of the Global Financial Crisis. I want to contrast that with what we see as confidence from executives. Typically we see insider net selling, but right now we're seeing strong insider buying. We're seeing hundreds and some weeks even thousands of
executives buying. In fact, we're seeing the highest insider buying on record, even higher than the Global Financial Crisis. So, in contrast to very skittish investor sentiment, executives seem more confident in their fundamentals of their companies over the longer term. And I point out that historically, there've been historically strong returns after a VIX registered very high levels. In fact, historically, when the VIX has been over 40, the one-year and three-year returns have been 32% and 58% respectively. The next point I want to make is on stimulus. Obviously, there's a lot of stimulus entering the pipeline, both on the fiscal and the monetary side. The key thing to note is that it's much, much greater than it was in the Global Financial Crisis. On the fiscal side, with the Senate having passed and the House about to pass the fiscal bill, the headlines show it is $2 trillion, which compares to the $8 billion stimulus in the Global Financial Crisis. But in reality, we believe the Federal Reserve will be able to leverage some of those funds and turn it into something that's more akin to a $4 trillion stimulus. Of course, that's a very large number relative to $20+ trillion economy. On the monetary side, the Federal Reserve has announced open-ended quantitative easing, buying treasuries and mortgage-backed securities, corporate bonds, and even some ETFs. They've been doing about $600 billion a week over the past week, which is faster than the average that they were doing per month in the Global Financial Crisis. So, a lot of quantitative easing from the Fed. And the European Central Bank for its part is purchasing about $240 billion this week and on track to do €1 trillion in quantitative easing by the end of December. In terms of the virus, we're very focused on the individual country curves. We think that the stimulus is great from a market and economic standpoint, but it's not sufficient to really restore confidence. Investors need to see some kind of deceleration or an ability to project the transmission of the virus. So, we've already seen the transmission slow significantly in some eastern countries, like Korea and China. And we're watching the western countries that are ahead of the United States, like Italy, very closely. So far through today, the new cases in Italy seem to have peaked on March 21st, but of course they're volatile. And that's going to be, I think, a key for the market going forward. We'd expect the United States cases to continue to accelerate because we are at least a week and a half behind Italy.
Finally I want to touch on macro valuations. Our preferred method of valuing the stock market is looking at implied equity risk premiums, or how much investors demand inequities relative to bonds. The higher they demand, the cheaper stocks are. And one simple way to look at this is to look at the earnings yield on stocks as compared to the yield on Treasury bonds. And historically, stocks have yielded, depending on what time period you're looking at, 100, 200 basis points more than bonds. Currently, if you look on a trailing basis, stocks are yielding 550 basis points more than bonds, so much more than double the average over time. And pretty close to where we were in the Global Financial Crisis, which touched a little over 600 basis points. So relative to bonds, we think stocks are fairly attractive though we acknowledged that earnings will take a big hit here and take a little while to come back. But nevertheless we view stocks as pretty attractive relative to bonds. And particularly within stocks, we, of course, favor growth equities. Our confidence is pretty strong and its driven by five points. Number one, growth equities are much less cyclical in our view than value stocks. We've gone back to the past two recessions and shown that growth companies tend to be able to keep their earnings flat or even grow them modestly, while value companies have seen earnings decline on average about 40%. Secondly, growth stocks have more exposure to the digital or virtual economy, whereas value stocks have a little more exposure to physical or tangible goods, like autos and equipment which is more impacted by the border closings and the lack of free flow of goods across the world. Thirdly, value stocks are more adversely impacted by the low interest rates that you see in this crisis and in most economic crises as bonds go up and interest rates go down. That hurts the large financial weighting in value stocks. Whereas you could argue that growth stocks, and in particular the small growth stocks that Weatherbie is going to talk about, are longer duration assets and may even be helped by lower interest rates. Fourth, growth stocks generally have better balance sheets than value stocks. We think strong balance sheets are really important to help weather the storm and emerge on the other side of the crisis and thrive and take share.
And growth stocks are generally much more innovative, which we've written a lot about. And you can read more about on the alger.com website under Insights. And lastly, I want to mention we think it's a pretty great time for skilled active managers because the correlations between stocks within the S&P 500 are the highest that we've seen on record and our data goes back to 1995. So, it's possible that some very high quality companies have gone down, alongside with some lower quality companies and that might be producing a very good opportunity set for skilled, active managers. Alright, let's move into the Q&A portion with the Weatherbie team. Matt, let me start with you. You've been a portfolio manager for a long time and during your career you've been through many financial and economic crises. Can you help us understand how you're feeling about this portfolio in light of the current crisis? Matt Weatherbie : Brad, we've seen the VIX exceed 40, a historically high number for a number of days in a row now. And most recently it's been over 50. So, fear is rampant. I have seen these market crises before, including 1987, 1998, 2000 to 2002, which included 9/11, 2008, 2009 and most recently, the fourth quarter of 2018. That experience can help us to put things in perspective. In the current pullback, first we saw a lot of what we consider to be low quality companies decline. Next, the best higher quality companies, the ones we seek to invest in, are also being thrown overboard. We believe that Weatherbie 50 – our portfolio, are still excellent businesses. Evidence from some economists suggest that we may now have entered a recession due to COVID-19. A great majority of stocks have fallen sharply in this waterfall market decline. We believe that when they bottom out, the highest quality companies should recover the first and strongest, just like 1987, 2009 and 2018, which this downturn reminds me of. We believe the Alger Weatherbie Specialized Growth strategy is a portfolio of such companies. Brad Neuman : Great. Thank you. Can you also maybe discuss the portfolio positioning and any subtle shifts you've made recently?
Matt Weatherbie : Well, first and foremost, we are not changing our investment philosophy or process in any way; because we are not reinventing our playbook. We are using our tried and tested strategies honed over 25 years. Proactively, we are looking for opportunities and George, please add your thoughts. George Dai : As Matt indicated, the global economy is likely to be in recession, according to some leading economists. We are adding at the margin to our highest quality positions, and we have experienced similar situations before. And for example, in the 2008-2009 period, our portfolio companies held up better than the broader market. There were category leaders with strong competitive positions, solid balance sheets and therefore rebounded more quickly after the market bottomed. And we believe that this will be the same this time around. Brad Neuman : You've historically invested in innovative, smaller growth companies with a preference for services companies and somewhat mundane industries. Is the portfolio still positioned this way? Matt Weatherbie : Absolutely. What we refer to as diversified business services remains a cornerstone of the Alger Weatherbie Specialized Growth strategy research process. You're right, these can be in some more mundane industries, but, in our view, these companies all generally feature strong growth metrics, healthy balance sheets and great management teams. A good example in our Weatherbie 50 top 10 is Casella Waste Management. This is a solid waste services provider has an environmentally friendly business model that leverages technology in impressive ways. Whether the economy's doing well or poorly, people generate waste. Collection and disposal of that waste is part of the critical infrastructure of our economy. Casella is a leading waste player in the northeastern United States, implementing sound business practices to collect that waste and dispose of it or recycle portions in a way that's good for the world and for the communities that it serves. Casella is also implementing new technology to speed pickup times, improve route density and keep its equipment up and running efficiently. Add to that, the particularly favorable industry dynamics at the present time with its high demand for landfill access with limited supply in an industry that's ripe for consolidation with a stable competitive landscape, you can see it's pretty clear why this is a core position in the diversified business services dynamic growth area of our Weatherbie 50 portfolio.
Brad Neuman : That's an interesting example. It seems like you've done a very good job this year at protecting capital relative to the benchmark. But with your stocks still down, do you feel quality companies are being sold alongside worse-positioned companies such that some of your portfolio holdings are especially attractive here? George Dai : Our Weatherbie Way of investing has been practiced over multiple decades and withstood many turbulent times before. We own 50 of what we believe are the best smaller cap quality growth companies in the United States. And due to their sustainable competitive positions, they are driven by their own internal growth engines. Therefore, these companies, to a greater extent, control their own destiny and are less impacted by the macro environment. One good example is Chegg, which is an education service company. Chegg provide study aids to tens of millions of college students in the world in the form of Chegg Study, Chegg Tutoring, Chegg Writing and Chegg Math. Everything is driven by technology and it's 100% delivered online directly to end users. With widespread closures of colleges in the United States and in some other countries due to COVID-19, colleges are rapidly implementing remote learning and online instruction. There'll be much less face-to-face instruction and the demand for Chegg services could potentially increase. This is a good example that some of our companies may not only do well in normal times, but may also potentially benefit from an otherwise adverse situation such as COVID-19. Matt Weatherbie : Yes. We believe experience counts. Brad, I've seen a half a dozen of these crises in my career. We at Weatherbie Capital are a very experienced team of investment professionals, folks focused exclusively on smaller cap growth investing. We average 12 years of working together at Weatherbie Capital. When the COVID-19 pandemic finally reaches maximum impact and its spread is curtailed, we want our holdings, what we call the Weatherbie 50, to be positioned to snap back properly. As mentioned previously, historically that has been the case with our portfolio. For example, in 2008-2009, when our portfolio company earnings flattened out, doing much better than the average company, and then re-accelerated quicker and faster. Brad Neuman : Matt, do you have any final thoughts before we move on to Q&A?
The Alger Weatherbie Specialized Growth strategy was incepted in 1996 and our investment philosophy has not changed. Our investment process, with minor tweaks, also remains the same. Our investment team is intact. We are not reinventing the playbook we have used for 24 years at Weatherbie Capital. Instead we will rely on it in this period as we seek to make our client's portfolios stronger and better. Brad Neuman : All right, great. Thanks so much, Matt and George. Operator, can we open it up to questions from those folks on the line? Speaker Question : The U.S. is looking really strong with all this stimulus being poured into it right now. But we have the resource for that and we see Europe has some of it. But the rest of the world is going to be stuck with coronavirus for a while. How's it going to affect this recession, so to speak, throughout the year? Because I keep hearing about this major snapback and I'm not seeing it. Brad Neuman : We have some templates to look at for this. We were looking a little bit at what's happened in China. And there are also some tentative historical examples, nothing to the extent where the whole economy has been shut down, in the past. But I mentioned one pandemic example from the 1950s. But more recently, China does seem to be getting back to business. Now, obviously, the way China addressed the virus is different than some – than we have in some of the western countries will. But nevertheless, it's probably a little instructive to look at it. Nike reported just the other day and they talked about some significant growth week over week. And actually some of their stores are back to the same levels that they were at before the crisis. We look at a lot of macro indicators and in China that's moving in the right direction. I'd agree with you that for two main reasons, a lot of countries can't respond with the same kind of stimulus that the U.S. did. Number one, they don't have the same governance and strength of a central bank in terms of the history and the preparedness for such an event. And secondly, nobody else has the reserve currency. And to be able to print as much as you want without having a problem and pump that money into the economy, you need to have a very strong or reserve currency. And the U.S. has that.
over the world. We mentioned the European Central Bank, you're seeing even a lot of fiscal stimulus in Europe, which was frowned upon before. So, you are seeing on a global basis. And listen, I think everyone agrees that 3.2 million people just lost their jobs and it's faster to fire those folks than to hire them back. So, the U.S. economy is not going to go back to work in a heartbeat. It's going to take some time. Speaker Question : I had a question about the centerpiece of your portfolio, which seems to me is small to mid-size innovative companies that have been disruptive through their technology and process prowess. I just wondered if, with this disruptive nature of the recession piece here, at least the couple of quarters setback, if those companies will lose a step in their momentum and potentially their enterprise customers will scale back and look to do in-house solutions. I wonder if you have any perspective on that. Matt Weatherbie : We believe that the current challenging economic environment will increase the need for the kinds of innovative solutions that our companies with disruptive technologies, as you call them, provide. So, we think after the initial significant downdraft in the economy created by the coronavirus 19, once the economy begins to stabilize and the business confidence begins to return, we believe our companies are set up to show very strong re- acceleration and growth. George Dai : We do believe that, together with you, the U.S. is probably in a recession and it's probably going to take some time for us to get out of this hole. However, if you look at some of the holdings that we have, now, these are the companies that provides the technology that oftentimes cannot even be duplicated in the previous physical world. I'll just use one example. A company called The Trade Desk, which is one of our top 10 holdings. Now, this is a company that provides programmatic technology platform for the advertisements to be bought and to be sold. And this is the technology leader that significantly not only disrupt the marketplace, but actually accelerates and add value to the end users. So, when we eventually get out of this crisis, this company is going to be positioned in an even better situation in our opinion. The value proposition that this company provides will be even more recognized by its end users. We believe there's just simply no way for companies to go back to the in-house solution. And we have many situations like this.
I'd agree that the U.S. is in a better position than many other countries, but I think you're seeing stimulus all
Speaker Question : You mentioned several names like Chegg, Trade Desk, Casella Waste. So when you do get this huge volatility, are you concentrating the portfolio in some of your more high conviction names; and when you are buying, are you doing it in smaller batches and are you using some sort of maybe open orders way below the market, knowing that this volatility is creating opportunities that maybe shouldn't exist? Matt Weatherbie : Yes, at the margin is part of our playbook, which we've tested over past crises in a 25 year history at Weatherbie Capital is in times like this to upgrade – at the margin, upgrade what we believe is the already high quality of the portfolio. So, again, we're not making any radical changes in the portfolio, but at the margin, yes, we're allocating more capital to our highest conviction names, as you indicated. In terms of trading on a day-to-day basis, we don't have any particularly exotic trading strategies of putting in orders well below the market and things like that. But, we have a full-time trader at Weatherbie Capital, we're very experienced at trading small cap growth stocks in my opinion. Speaker Question : Given your approach of only investing in companies at $2.5 billion in market cap or less at initial point of investment, are you seeing some opportunities for new additions out there of great Weatherbie potential companies that perhaps you've missed over the past year or so? George Dai : Yes, we do. At Weatherbie Capital, when we buy, we buy below $2.5 billion market cap. So, we stay true to our investment strategy. Yes, this market meltdown is unpleasant. However, it does create opportunity for us to buy, otherwise, those companies whose market cap exceeded $2.5 billion. So, right now in fact, we are in the middle of the campaign to find some of these high quality companies with strong fundamentals, but now at 30%, 40%, 50% discounts. So, we are like a kid in a candy store, in a sense. So, that's I guess the pleasant part of this unfortunate situation. Speaker Question : I've got a question on being able to take advantage of new purchases. In relation to your position to add to quality positions, how are you doing as far as money on hand relative to what's coming in versus outflows, and are you trimming back some positions in order to take advantage of others that are more attractive to you?
Matt Weatherbie : We generally run a small cash position of 5% or less, so we don't change the cash level in our portfolios dramatically and we have recently been running in the 4%-5% range. So, there has been cash on hand generally to fund new purchases or increase the weightings of the highest conviction names without selling other names. But we wouldn't hesitate to sell our lower conviction names if we thought that were the right thing to do. On an overall basis, our cash flows have been quite stable and with no dramatic either increases or outflows in recent weeks. Speaker Question : Certain companies are going to be impeded by what we're witnessing. Some companies, maybe their long-term prospects are unimpeded. And I look at the portfolio and I recognize, some names of Planet Fitness, the Canada Goose, and those companies, that may be impeded for a period of time, whereas Everbridge or XPO Logistics, maybe companies like that, nothing's really changed. Or maybe it benefits companies like that. So, I would imagine when you guys are doing your weightings what's going on, what are you trying to figure out? Matt Weatherbie : Yes, we take into consideration whether companies are temporarily helped by this crisis, such as Everbridge or companies that are – whose business models are temporarily disadvantaged, like Planet Fitness and Canada Goose. But we believe the market decline has been so swift and severe that it is already priced in the temporary dislocation in, for example, Canada Goose's business model, wherein we believe on the other side of this, such as is already occurring in China where their stores are reopening, Canada Goose has an open-ended opportunity to continue to grow its brand for many years to come. Likewise Planet Fitness. It's a balancing act and we know our companies really well. We believe and we factor all of those things into account when creating our position sizes. Brad Neuman : No, I don't have anything to add. The flows into this strategy year to date have been positive.
Brad Neuman : All right, great. Well, listen, thanks everybody so much for joining us. And thanks to George and Matt for taking the time. I think the takeaway from this call is that the opportunity set has potentially expanded. There's a lot of room to potentially even improve the portfolio or find new and interesting companies to add to the Weatherbie 50. And again, with the backdrop of very high correlations, or the highest correlations that we've seen across stocks that that’s potentially really good for stock pickers, like the Weatherbie team. Thank you all.
The views expressed are the views of Fred Alger Management, LLC (“FAM”) and Alger Management Ltd. (together with their affiliated entities “Alger”) as of March 2020. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and may not represent the views of all portfolio management teams. These views should not be interpreted as a guarantee of the future performance of the markets, any security, or any funds managed by Alger. Weatherbie Capital managed the strategy during the financial crisis of 2008-2009, but did not take over management of the Alger Weatherbie Specialized Growth Fund until 2017. Risk Disclosures : Investing in the stock market involves risks, and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as their prices tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political, and economic developments. A significant portion of assets will be invested in technology and healthcare companies, which may be significantly affected by competition, innovation, regulation, and product obsolescence, and may be more volatile than the securities of other companies. Investing in companies of small and medium capitalizations involve the risk that such issuers may have limited product lines or financial resources, lack management depth, or have limited liquidity. Assets may be focused in a small number of holdings, making them susceptible to risks associated with a single economic, political or regulatory event than a more diversified portfolio. Past performance is no guarantee of future results. Investors whose reference currency differs from that in which the underlying assets are invested may be subject to exchange rate movements that alter the value of their investments. Important Information for US Investors : This material must be accompanied by the most recent fund fact sheet(s) if used in connection with the sale of mutual fund shares. Fred Alger & Company, LLC serves as distributor of the Alger mutual funds. Important Information for UK and EU Investors : This material is directed at investment professionals and qualified investors (as defined by MiFID/FCA regulations). It is for information purposes only and has been prepared and is made available for the benefit investors. This material does not constitute an offer or solicitation to any person in any jurisdiction in which it is not authorised or permitted, or to anyone who would be an unlawful recipient, and is only intended for use by original recipients and addressees. The original recipient is solely responsible for any actions in further distributing this material and should be satisfied in doing so that there is no breach of local legislation or regulation. Certain products may be subject to restrictions with regard to certain persons or in certain countries under national regulations applicable to such persons or countries. Alger Management, Ltd. (company house number 8634056, domiciled at 78 Brook Street, London W1K 5EF, UK) is authorized and regulated by the Financial Conduct Authority, for the distribution of regulated financial products and services. FAM and/or Weatherbie Capital, LLC, U.S. registered investment advisors, serve as sub-portfolio manager to financial products distributed by Alger Management, Ltd. Alger Group Holdings, LLC (parent company of FAM) and Fred Alger & Company, LLC are not authorized persons for the purposes of the Financial Services and Markets Act 2000 of the United
Kingdom (“FSMA”) and this material has not been approved by an authorized person for the purposes of Section 21(2)(b) of the FSMA.
Important information for Investors in Israel : This material is provided in Israel only to investors of the type listed in the first schedule of the Securities Law, 1968 (the “Securities Law”) and the Regulation of Investment Advice, Investment Marketing and Investment Portfolio Management Law, 1995. The Fund units will not be sold to investors who are not of the type listed in the first schedule of the Securities Law. The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. Note that past performance is no guarantee of future results. Comparison to a different index might have materially different results than those shown. The following positions represented the noted percentages of assets in the Alger Weatherbie Specialized Growth strategy as of 12/31/19: Chegg, Inc. 5.85%; Casella Waste Systems 4.69%; Planet Fitness Inc., 3.28%; Trade Desk Inc., 3.24%; Everbridge Inc., 2.79%; Canada Goose Holdings Inc., 1.51%; XPO Logistics Inc., 0.62%; and Nike Inc., 0.0%.
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