Small Cap Investing in Volatile Markets
Small Cap Investing in Volatile Markets
Amy Zhang, CFA Executive Vice President Portfolio Manager
Amy Zhang, CFA, who recently celebrated her five- year anniversary at Alger, hosted a portfolio update with clients in the Alger Small Cap Focusstrategy. To kick off the call, Brad Neuman, CFA, the firm’s director of market strategy, shared hisviewson the marketsand the economy in light of ongoing volatility.
it’s been since the European crisis in the 3rd quarter of 2011. And insider buying in small cap companies is the highest on record going back over 20 years according to InsiderScore. The second point on monetary and fiscal easing: clearly there’s been a lot of monetary easing. In fact, this month will mark the largest drop in the federal funds rate, according to our data, in nearly 40 years. The pace of quantitative easing is actually faster than QE3, which drove the stock market up significantly in the fall of 2012. The Fed has a few more tricks up its sleeve. It talked today about being able to buy corporatedebt like many other central banks can, and potentially even in the future, though they didn’t mention it. They may be able to buy equities like the central banks do in Japan. So, we don’t think it’s wise to count the Fed out just yet. The European Central Bank, today, was reported to be readying some help to help lower the Italian spreads, which is what the market’s worried about today. Treasury yield, which is the most since 1982. We think that that’s likely reflective of the market’s optimism regarding some kind of fiscal stimulus. The president talked about over a trillion dollars in stimulus, $500 billion of which would be in checks directly sent to citizens. We think that this is probably the right way to approach and give aid in this type of pandemic environment. Also, on the fiscal side, yesterday was a historic day in bond yields. They increased 32% to the 10-year
Please note, this transcript is froma call on March 18, 2020 and it has been edited for clarity and brevity.
Brad Neuman (BN): The first point I want to make on the macro-environment is regarding sentiment. The stock market is down in the U.S. about 30%, peak-to- trough. We believe that’s pricing in a recession. We’ve looked back over the post-war era, at all the recessions that the U.S. has experienced, and the average peak-to- trough decline in the S&P 500 is about 22%. Over $20 trillion of wealth has disappeared in global equity markets year to date. So, pricing in a recession. What’s interesting is that although investors are extremely anxious—and I say that with good evidence. The VIX or fear index, which is the implied volatility on the S&P 500, recently hit a record high, higher than the Global Financial Crisis. And money market funds in the United States are up to $3.8 trillion. That’s up 20% year over year, and about as high as the Global Financial Crisis. There is a lot of cash on the sidelines and a lot of fear in the marketplace.
What’s interesting is that we can contrast that with executives at companies actually buying their own stock. Insider buying market-wide is about as high as
The third point is why we’re optimistic about equities and how we look at it right now. A lot of people are running away from equities and they’re moving into cash or other safe havens like bonds. Now, when we look at equities, not only do we see dividend yields that are far in excess of Treasury bond yields, you know, over 100 basis points and the widest in over half a century, but we see the equity earnings yield. In other words, the inverse of the P/E, the equities earnings yield exceeding Treasury bond yield by as much as it has since the Global Financial Crisis, about even to the Global Financial Crisis. So, you’re getting paid about 600 basis points more in equity earnings, in terms of a yield, than you are on the 10-year Treasury, about 7% versus 1%. And we’d note that earnings have grown in every 10-year period over the half-century. In fact, the average is about 7% annually which is about 90% over a 10-year period. We really like equities as opposed to other asset classes, even in this environment, because of the very strong likelihood that earnings grow over a 10-year period and the fact that the dividend yield and the earnings yield far exceed what you get in safe havens such as Treasuries. The fourth point is growth versus value stocks. Growth is dramatically outperforming value for the Russell 2000 indices. The Russell 2000 Growth index is outperforming the Russell 2000 Value index by about 500 basis points year to date. We think that there are structural reasons for that, and cyclical as well. Some of the reasons we think that growth is outperforming is: one, because growth stocks are less dependent on the economy. They have their own secular growth drivers and rely less on overall economic growth. Two, they have less exposure to interest rates. Obviously, there are a lot more financials in the value part of the stock market. And as interest rates fall, that’s worse for value stocks than it is for growth stocks. You could argue it’s a benefit to growth stocks.
Third, growth stocks are much more innovative, which we’ve written a lot about. I invite you to look at the Insights section on Alger.com for more of our work there. And lastly, growth stocks generally have much better balance sheets, less leverage, less debt than value stocks, and that’s really important in a crisis such as this so that these companies can control their own destinies. The last point I wanted to makewas regarding active management, which I think is a good segue into handing it over to Amy. Active funds have historically outpaced passive indices, theS&P 500, by about 100 basis points during recessions. But one thing I thought was very interesting is that correlations amongst S&P 500 stocks, and stocks across the stock market, are the highest on record back to 1995 we had data. And what that means is that the stock market is basically throwing the baby out with the bath water. It’s saying, “Sell all stocks in light of this pandemic.” We think that that sets up a really good environment going forward for active managers who are good stock pickers because it’s not correct. Weare optimistic that the environment going forward, once this pandemic subsides and stocks are able to differentiate themselves, that stock pickers will really come out on top. Brad Neuman (BN): Amy, 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 the Alger Small Cap Focus Strategy portfolio in light of the current crisis? Amy Zhang (AZ): Yes. I’ve been managing the same strategy for over 17 years, being a portfolio manager, and also as an investment professional, I’ve been through many crises including: 1998, 2002, and 2008, and this crisis is different. But on the other hand, also, our portfolio is very different from our peers. I want to move to the Q&A with Amy.
We invest in high growth, high quality companies that are less economically sensitive, as Brad alluded to. They can control their own destiny. Also, our companies generally have very strong balance sheets with very low debt. I use the analogy of motorboats versus sailboats. Motorboats are the companies driven by innovative, fundamental drivers versus sailboats that are very much more economically sensitive. To that extent, we, think they’re well positioned we can weather the storm of market volatility fairly well.
which is something we look for, and I know they have the capability to do COVID-19 tests.
The stock has performed strongas a result because even with COVID-19, we will need to have flu testing. And now recently they just announced they are going to produce test kits for COVID-19. And going forward, the next flu season, they are going to do a test—a combination test that can test both flu and COVID-19 for the next flu season on their platform. Clearly those are idiosyncratic drivers. Whereas, of course, they also have very strong fundamentals. BN: Wow. Talk about being at the right place at the right time. That was certainly a good holdingand has benefitted performance. And speaking of performance, the strategy has performed strongly relative to its benchmark YTD. Why do you think it’s done well? AZ: I believe the performance is a testament to our unique strategy, which is resilience. We have had an attractive upside/downside ratio for two years. But just as I mentioned before, it’s really about investing in what we believe are exceptional growth companies that also have high financial quality because liquidity and cash are king. And as they are less economically sensitive and they can—more defensive. but also have idiosyncratic drivers, which will really stand out in this market. AZ: This is a crisis and we are not taking this lightly. But just like any other crisis, where there is crisis there’s opportunity, and I think that the impact on the markets and our portfolio is going to be temporary. And we are working very hard on risk/reward and stock selection as we are looking for companies that are trading below their intrinsic value. There will be a light at the end of the tunnel and we want to be well-positioedn for a bounce- back, which will happen. BN: Any final thoughts, Amy, before we move onto Q&A?
BN: Okay. Great. Can you discuss the portfolio positioning and any subtle shifts that you’ve made recently within the portfolio?
AZ: Since the beginning of the year, I felt like the COVID-19 virus could spread to the U.S. And also, I felt this should be the year for health care. To that extent, I positioned the portfolio in a very defensive way and in a more recession-resilient sense, looking for company specific drivers that are idiosyncratic, that will not be affected by macro. I raised more cash because now we have approximately 5% to 10% cash, which is big for our strategy. But it’s very important to have some dry powder in this market to take advantage of volatility based on risk/reward potential. BN: It sounds like you were being very proactive. You’ve historically invested a lot in innovation, primarily in the technology and thehealth care sectors. Is the portfolio still positioned that way? AZ: Yes. Our largest sector weight is currently health care. But I trimmed some tech because I think tech is relatively more cyclical than health care. And we want to invest in companies that are part of the solution to COVID-19. One example of the health care companies that’s one of our top holdings is Quidel Corporation. Quidel is a diagnostic testing company that has a very broad platform, but really specializes in respiratory testing and the bulk of that is flu testing.
BN: Thanks a lot, Amy. Operator, we’ll now open up the phone lines for questions, please.
But importantly, we had the premise that this is going to be a strong flu season. And there’s always optionality,
Speaker Question: In reference to the oil war that’s taking place between Russia and OPEC. And based on where oil pricing is going and what the effect it’s had on the energy sector, do you think the market’s already taking that into account? You were alluding to the fact that the recession is being filtered in, but is the energy crisis being filtered in as well? AZ: Well, this is just my own personal opinion. I feel like that could be a more negative impact. The ripple effect is that oil is highly correlated to high yield. And it’s going to spill over to investment grade like it always has. So, I think high yield is already feeling that, I think, as of last week. I think investment grade is feeling the impact. I say, “leverage kills.” No matter what. I know that sounds harsh, but leverage does kill. If a company has strong balance sheet, they will survive this storm. That is why our portfolio is very well positioned in my opinion. This is not a time to have exposure to energy financials, or banks. Banks are going to be impacted because all banks have energy exposure, just depends on how much. To that extent, that’s why I don’t like to invest in companies that cannot control their own destiny in terms of sector, because they’re either going to be subjected to oil prices or energy companies, no matter what, and nobody can predict that precisely. To that extent, it could get worse. And that’s why I’m glad that we’re very well positioned in that situation, in that potential situation that could get worse. BN: I wanted to add on to the oil comment, just quickly. We recorded a video on this recently. And just to put some numbers around what Amy said, in high-yield index, the energy sector, it is or was about 11% of the total, whereas in the equity markets, it’s a low single- digit percent, 2% or 3%. It’s not someaningful toU.S. equities and global equities around the world. Obviously, it’s a larger share outsideof the U.S. than inside of the U.S., and it will certainly weigh on earnings.
I think that this level of oil, the futures are starting to price in the lower, somewhat of a lower long-term level of oil and that’s going to cause somebankruptcies. We think it will, first and foremost, effect the fixed income market. It’ll effect the servicers which, you know, we don’t have much or any exposure to. And probably the majors will hold up the best. Ultimately, once we get through the capital spending standpoint, it will be somewhat stimulative for the U.S. consumer. We think that gas prices will drop well below $2 a gallon. In the near term it’s certainly negative for global earnings and high yield. But longer term, once we get through some of the pain, it could be somewhat stimulative. Speaker Question : Worst case scenario, people are advocating for a 30-day or 60-day shutdown around the country. What kind of impact will that be for the portfolio’s holdings? AZ: As I mentioned before, that’s why the portfolio is positioned in our largest sectors. Within health care, we generally own diagnostic company, testing companies, and many others. Andalso medical devices companies. But medical devices companies clearly are more economically sensitive, right? Elective surgery is going to be, sort of, pushed back. The kind of medical devices companies we own are also very mission critical. We long-termholdings for people that have diabetes; they still have to use insulin pumps. Again, being part of solution rather thanbeing part of the problem. It’s also going to impact technology. For example, software companies. A lot of user conferences are canceled or pushed back, so that’s why our tech position is much less than health care, for that reason. I wanted to position that way early on, but the key is to be proactive. But, clearly, it’s going to impact Q1 even Q2 earnings, especially for software companies. Or just any tech companies.
And industrial companies, we own very, very little. They’re going to be impacted in a huge way, I think. So, I think we are very well positioned that way. Consumer is very tricky. One of our top holdings is Wingstop. They sell chicken wings, but that means the bulk of their business is takeout. They are ramping up on digital and delivery. It’s actually being part of the solution, whereas if you own any other restaurants, you’re going to be clearly impacted. So, in consumer space, we are very selective.
AZ: As Brad pointed out, we’ve seen a lot in our individual companies; there are a lot of CEOs buying; which is clearly positive. I always appreciate that, but that’s not the only factor. I take it seriously, but it’s not like I’m jumping to buy just because a CEO bought. But at least it’s sentiment in a sense that they believe in their business and we also, of course, ask if company’s going to exercise buyback programs. The one thing we don’t want is companies to borrow money to buyback shares. We want them to conserve cash, which they know my sense of how important cash is important for them. So, I’m advising themnot to make big acquisitions if they needmore cash. And then too, cash is king for companies. As long as they have more cash then it will help themover the long term. Speaker Question : I was wondering if after the market correction, if you’re looking at sectors you normally would not being looking at? But due to valuation, it looks so appealing to you? AZ: Me and my team like to stay with our own competencies so we are not going to invest in utilities. I’d rather have cash. I don’t sector rotate. On an absolute basis, I feel good about bouncing back when we get through this crisis. Speaker Question: I think we would all agree that earnings for the 1st quarter and 2nd quarter will be significantly down. At what point do you see things starting to turn? And I know it’s hard to pin it down, but at what point do you see earnings starting to turn, which might drive the markets back in an upward position? AZ: Well, let me answer that first and then I’m sure Brad will add. For us, it’s really company-specific because this strategy is always about stock selection. Our forte is really individual companies. Of course, as a portfolio manager, I think about companies in a holistic way, whether they serve markets that’s diversified enough and the correlation with each other is not very strong. And also in terms of risk considerations. But not all companies’ earnings are going to go down.
In a recession, everything goes down. The key is to go down less.
Speaker Question : In terms of the overall portfolio structure, how many names are in the portfolio?What is your cash position right now?
AZ: We currently have 49 names. Generally, I’m keeping cash from 5% to 10%.
Speaker Question: What will be the process for you to allocate some of that cash for opportunities?
AZ: We stress test our portfolio holdings a lot. We’ve been talking to every single company. It’s been very helpful because no matter how well we know a company, it’s very important to get their current thinking. We ask a lot of questions toadjust our assumptions because everything has changed. And in terms of short term and intermediate term, we focus a lot on bull/base/bear case scenarios. Now, we’re moving more towards uber-bear. Uber-bear assumptions are much lower than before. Not theworld is coming to an end, but factored in, for example, a 30 to 60-day shutdown and maybe more. I feel the key is to have the ammunition and also be well prepared. So, we’re going through this in a very rapid and intense way. Speaker Question: What are your thoughts on some of the companies announcing buybacks at some of these depressed prices?
For example, companies likeQuidel or Everbridge. I know we hear a lot of rhetoric, but when people say earnings are going to go down, or going to be negative, they just refer to the S&P 500. But we’re not investing in S&P 500 companies, right? We believe a lot of companies that we invest in, even software companies, are still going to grow. They will have selling activity, but they’re still going to have positive earnings. Our job is to see what is priced in. That’s why we talk to every single one of our companies now, right?And we look at our models. We separate companies that have earnings risk and then don’t have earnings risk. Then the companies who have earnings risk, we want to see how much is that priced in? Then it’s really about positioning. We’re not going to sell everything that’s going to have a soft Q1, right, because it’s just going to be a bump in the road. There’s a lot of stress testing going on for us now, so it’s really company by company. And it’s very hard to say how long it will last, right, but eventually it will pass. BN: I’ll just chime in from a broader market perspective. I think consensus right now is that the first half earnings to clients materially and GDP, and then some people are looking for a bounce-back in the second half of the year in terms of GDP. From my perspective, I would not comment on when the bounce-back would be. My view is that when the markets get comfortable that virus transmission is slowing and therefore the end is forecastable, the attention will shift from how bad earnings are this year and they’re going to be, I think, pretty bad in the 1st and 2nd quarter to what are more normalized earnings in 2021. I don’t think it’s exactly about when GDP starts coming back, but I think it’s about when there’s more ability to look forward in time. And what we’re watching on that, what I’m watching on that, is the individual country curves of virus transmission.
You’ve seen China, Korea, and a couple of other countries flatten that curve and Italy is one we’re watching very closely. There may be some tentative signs that that exponential growth is slowing. And I think what the market just needs to get comfortable with is exponential growth starts to slow, becomes linear, and flatten off and then the shift will be towards 2021. Earnings were $162 last year and they’re going to drop to some number in 2020. The question is: how do you value the stock market? What earnings number for 2021 do you use? Speaker Question: My question is more on the general market as a whole. You know, small caps have underperformed for the last year-and-a-half to two years and have been underperforming in general as the market has gone down here. What do you see as a catalyst for small caps starting tooutperform and what is that time frame? AZ: Small caps have underperformed large caps since the end of 2013, right? So, I think a lot of this perception, because when people think about small caps, they think it’s riskier. It’s not in my opinion. They think about, you know, lower financial quality. But also, small caps as an asset class have become much more attractive because they are more U.S.- centric. When you look at any bounce-back, nobody knows when exactly it’s going to bounce-back. You could look at 2008 to 2009 when there was a very sharp rebound. I think small caps will benefit tremendously because I will still want to be more U.S.-centric at this point because I think the damage this coronavirus has done to Europe and to China, the economic activity is a lot much more than U.S. In the U.S., we’re still in the cutting edge of innovation. We are a service economy and we are not manufacturing driven.
To that extent, the most innovative companies are still doing well. It’s just a temporary bump in the road. But it’s not permanent in the fundamentals whereas, some more economically sensitive industries will have more of that impact. As Brad mentioned before, growth versus value. I believe in that. With these low interest rates, the interest rates may even go lower, that long duration aspects will do well. One of the longest duration assets in equity is small cap growth. To that extent, I think small cap growth will be the first to come out. We don’t know the timing. But eventually those should be the assets that will outperform. BN: I would give you three reasons why I think small caps will outperform. One, Amy mentioned, they’re more domestically focused and I think the U.S. is in a better position to address the virus, certainly than Europe. Two, if you look at recessions, small caps actually tend to do better than large caps in recessions. And the reasons why is because as the market starts counting that we’re coming out of a recession, towards the end of it, small caps lead the way. So, small caps typically trough and go up faster towards the end of a recession, or would inside of the recession, than large caps. And it’s conceivable that we’ve already entered a recession here and small caps will lead the way out. The third thing is small cap valuations are pretty compelling to large caps. I’m lookingat the Russell 2000 P/E relative to the S&P 500 P/E and the premium is now about 14% on a forward basis. That compares to a 40% premium over time and this premium of only 14% is the lowest in nearly 20 years. So, small caps look cheap, they’re more domestically focused, and they typically leadon the way out of a recession. So, I look for them, you know, in thenext 12 months to outperform.
tactically in the portfolio going forward and then talk about its moat as well?
AZ: It’s certainly, in some ways, part of the solution in terms that they do masks, they do disinfectants. But they also have some challenges. Part of it is that as we anticipate they will temporarily suffer as colonoscopy elective surgery is pushed out. They also have some internal challenges. But, on the other hand, they’re still very well positioned. They generate a lot of cash flow. So, to that extent, it’s not of concern. Speaker Question: Could you give some indications about any liquidation pressures that you’re getting at the present time? AZ: We have not had liquidation pressure because I think we have a very diversified client base and strong distribution team. So, I think we have built a business that’s very diversified and also very resilient. I think people should stay the course because the worst is trying to sell low and buy high. I firmly discourage people to chase performance. BN: All right, we’re going to end the call here. We really appreciate everyone dialing in and taking the time. At Alger, we want to be transparent. We want to give you the resources to help you and we want you to know that we’re here for you through this difficult time. Good luck in managing through this and remember that we’re here for you. Take care.
AZ: Yes. Thank you for all your support, we greatly appreciate it.
Speaker Question: Can you talk a littlebit about Cantel and its cash flow position, how you see it positioned
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