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A Time for Quality in Small Caps


The Good News 

Looking back 50+ years, valuations of Small Cap stocks relative to Large Caps are historically attractive and at levels not seen since early 2000.

Small Cap / Large Cap Relative Valuation

Source: Furey Research Partners. Past performance should not be taken as a guarantee of future results. 

 

Significant Challenges & Key Considerations

Quality has been deteriorating for years

  • The percentage of Russell 2000 companies with no earnings has risen significantly over the last decade.
  • Additionally, quality has deteriorated, as leverage ratios have been increasing.

Percent of Russell 2000 Non-Earners

Source: Strategas. Past performance should not be taken as a guarantee of future results. 

 

Leverage Ratio Spread - Small Caps Less Large

Source: Furey Research Partners. The leverage ratio represents Net Debt/EBITDA. Past performance should not be taken as a guarantee of future results. 

 

Cost of Capital In Perspective

Historical Influence

For the past 10+ years, abundant access to cheap debt has helped prop up an array of non-earning, low-quality small-cap companies—zombies, if you wish—and largely eliminated any performance differential between such companies and their high-quality counterparts. That may be set to change.

Russell 2000: Profitable / Unprofitable Relative Performance IndexSource: Furey Research Partners. Past performance should not be taken as a guarantee of future results.

 

Implications Moving Forward 

With the decade of abnormally suppressed interest rates over, the cost of capital is on the rise across the cap spectrum, and nearly 50% of S&P 1500 debt matures in the next five years when refinancing will be much more expensive. The impact of higher financing costs on low-quality companies with limited earnings could be severe.

 

Russell 2000 Weighted Average Cost of Capital (WACC)

Source: Furey Research Partners. Past performance should not be taken as a guarantee of future results.

 

Looking Into the Next Decade

Should the next decade more closely resemble a period of a normalization in interest rates and historical volatility among small caps, a higher quality focus could become increasingly important, as quality among Small Caps has eroded over the past decade.

  • Going forward, as the Fed normalizes policy, a higher cost of capital environment will likely shape the contours of the investment landscape for years to come.
    • This comes at a time when quality among Small Cap companies has eroded over the past decade.
  • The last time relative valuations were as attractive (early 2000) and the interest rate environment was more normalized (a period much like the one we may be entering), The London Company’s Small Cap portfolio generated meaningful excess returns and substantially lower levels of volatility over the ensuing decade.

 

Small Cap vs Russell 2000 Peer Group Ranking

Source: eVestment; Peer ranking based on eVestment US Small Cap Core Equity Universe. Past performance should not be taken as a guarantee of future results.

 

 

We believe our Small Cap portfolio is well positioned to capitalize on attractive relative valuations while avoiding the pitfalls associated with low-quality Small Cap companies.

  • Companies with sustainably high and improving returns on capital provide downside protection and have outperformed over the long-term
  • Attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as tangible competitive advantages in a higher cost-of-capital environment.
  • Pricing power allows companies to pass through inflationary costs.

 

Small Cap's Quality Metrics

Source: FactSet. Past performance should not be taken as a guarantee of future results.

 

A Long-Term Quality Value Approach to Small Cap Investing

Long-Term Quality Value Approach to Small Cap Investing

Learn More about our investment philosophy.

 

Small Cap Annualized Returns

Performance shown should, under no circumstances, be construed as an indication of future performance. All are encouraged to read and understand the disclosure notes found below.

 

 

Our Investment Process

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