The Capital Cycle Podcast - US Small Caps: One Size Fits All

Episode Date: November 29, 2024

Are we any nearer to the end of a long cycle of small cap relative underperformance in the US? Presented by Edward Chancellor with Robert Anstey, Portfolio Manager North America.For more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Hello, this is Edward Chancellor here with the Capital Cycle podcast. And with me is Robert Anstey, US portfolio manager at Marathon Asset Management. And we're going to talk about small caps, but we're not going to talk about it in the conventional way that people think about small cap as an investment category. Robert's written a piece for the latest global investment review on small cap, the prospects, some of the small caps in his own portfolio. But I think we should give the big picture first before we dive into the details, which is that the markets today highly concentrated in large cap stocks. Ned Davis' research produces data on market concentration, which when I last looked at a few

months ago, I think the top 10 US stocks had a share of total market capitalisation of north of 30%. The top 50 stocks had a share of total market capitalisation of closer to 60% of the market. And we've been through these periods of concentration several times in the past during the famous nifty 50 boom of 1972, 73, when small caps. stocks and value stocks were beaten down. And within the living institutional memory of marathon, we saw something similar in the late 1990s with growing concentration in mega-cap tech stocks and media and telecoms and value very cheap. And now we're sort of back in the same situation today, which offers some investment opportunities. But first of all,

you open your piece talking about humans' propensity to categorize things and how this informs your own analytical approach. I think it's something which is, you know, humans have always done. We try to make sense of this complex world that we're in. And basic psychological process that we use is categorization. We group things together. This enables us to conserve energy, to be cognitively efficient. You know, you think about categorization in a sort of pyramid structure. So if you had a small group at the top of the pyramid and then a very wide group or category at the bottom of the period, basically, you know, the broader the category, the more simplistic, the analysis and in a world which still remains complex. So, you know, you think about financial

markets. There's categorization all around us, you know, from. the bricks, the Mag 7, thematic investing, electrification. And of course, one of the broadest categories of all is, you know, these asset classes, we talk about small cap versus large cap or midcap. And actually, the reality is that, you know, what does small cap mean? Well, it depends where you are in the world, right? If you're small in the US, you're probably quite large relative to companies elsewhere in the world. So we try and simplify a complex world. And I think as a contrarian investor, I think it's

important to kick against that because actually investing is complex and businesses are complex. And your argument is that one shouldn't approach investment opportunities from the perspective of their market capitalisation, that you are looking for a different way of categorizing an attractive investment. Correct. Yeah, we're following the capital cycle. So we're following the flows of capital in and out of industries, countries, regions, and management's capital allocation ability. Now, you might say, we sometimes refer to this as more of a horizontal view of the world as opposed to a vertical view. You know, a vertical view would be, you know, you have sort of sector specialists who dive into the sort of minutiae and, you know, create their Excel spreadsheets in great detail.

And they build that case for investment for a sort of inside out view. Whereas a horizontal approach to the world, you know, we're looking across industries. What's happening with evaluations in one industry very high? And that's attracting capital. And in another sector, maybe valuations alone, capital's exiting. And so the capital cycle teaches us to sort of look at things in a sort of more horizontal view, really, of the world. A sort of outside view, if you like, if, you know, Daniel Kahnman would put it that way, I think. And although we're basically issuing categories, we can't deny large-cap U.S. stocks have done

staggeringly well over the last, what, 15 years or so, but in particular over the last eight years or so. And small-cap value have disappointed. And then you've got this very nice data, which I wasn't aware of, where you're comparing relative performance and valuations of the large-cap S&P index against the relatively smaller cap, S&P, small cap, S&P 600. Yeah, I mean, you know, so the first thing to say is that we've had this large cap outperformance cycle. It's been 13 years. If you put that in historical context, you know, since 1927, you know, Farmer and French,

you know, did a study that showed that small caps on average have outperform large caps by 285 basis points per annum. So that's a 100 year history. But what you find within that history is that it goes to these very long cycles where small caps outperform, then large caps outperform, then it goes backwards and forwards. And it's interesting you reference those periods right at the start of this, you know, the nifty 50 and then the not dot com boom because actually in 1974 after the nifty 50, small caps went on a nine year stretch of outperformance. And after the dot-com bubble burst, it was a 12-year period of outperformance. I think small cap value outperformed the broad index.

I'm saying something like nine points a year for eight years or so, up until about 82. And the mega-caps disappointed. The nifty 50 went down 50% during that period and disappointed at least for the next 10 years or so. So I think many of, you know, the listeners won't be aware of the data that you're showing here. Yeah. So I chose the S&P 600 deliberately rather than the Russell 2000. And that's because the S&P 600 only includes profitable companies, whereas the Russell 2000, which is the more commonly used small cap benchmark in the US,

contains approximately 40% unprofitable companies. So if we just look at the profitable small cap, You know, and this data, by the way, is pre the recent Trump bump. But we find that, you know, S&P small cap 600 is on a price to sales ratio of about one, whereas the large cap benchmarks three times sales. You find on a price to cash flow basis, small caps are on 10 times cash flow, the large caps are on 19. It's quite stark in the differences.

In fact, that relative price to sales ratio, for the small cap benchmark is at a greater than 20 year low. So we're 13 years into a large cap cycle, and you've got small cap valuations on price of sales at a greater than 20 year low relative to large caps. That's quite a big difference. Yeah, and most people would be thinking, well, that's because large cap has much stronger expected earnings per share growth,

but you're saying that ain't so. Well, the consensus, if you can believe it, and to be honest, I really don't believe these numbers, but the consensus has higher earnings growth for small caps than large caps next year. But I think the market discounts that I don't believe it. I think there are lots of good reasons why small caps traded a discount. And what I'm not arguing is that investors just sort of pile into small caps. As I said, if you pile into the Russell 2000, you're piling into 40% unprofitable companies.

But what this data shows is that there are a lot more undervalued companies. companies further down the market cap spectrum than at the top of the market. Before we get into detail on one of your stock portfolio holdings that you discussed, why do you think it is that we're in this near-trough devaluation of small-cap relative to luxury? There's several reasons, really. I think small caps are more economically sensitive. You know, that's true.

And I think the markets have been acting in a sort of late cycle type manner where they're worried about growth. So they'd prefer to the safety of large caps. By the way, that was what happened in 1973 or four. If you remember, there was a sort of US downturn in 1970, all the super spec, the sort of meme stocks that that day crashed. And the investors sought comfort in the mega caps. And that's when they marked down. Makes sense.

Make sense. And then another reason is that small caps on average carry more leverage than large caps. That's true. The other reason that people have talked about is the rise of private markets. So there are over 1,200 unicorns, a unicorn having a market cap of a billion dollars plus that are in private hands. And so the argument is that good companies are staying private for longer and not emerging into the public markets, whereas in public markets, we've had this sort of equity shrinkage now for 20 years. And I think those are all valid.

But if I took a sort of contrary position to that, I think as a public market investor, it'll be a buyer's market when those unicorns eventually come to market, which they'll have to. Private equity funds can't keep swapping between each other indefinitely. They're going to have to have an exit strategy at some point. And it'll be a buyer's market. And venture capital is making heavy drawdowns on their institutional clients. largest ever this year without actually putting much back on the market. Anyhow, you're not arguing you should load up on small cap per se on the category small cap.

Correct. And that's the whole point about the categorisation. This is not an argument, you know, just let's go pile up on this asset class because there are plenty of expensive small caps. There are plenty of small caps that are unfrocible, plenty of small caps with indebted balance sheets. I think the point I'd make is that high valuation, in large caps will tend to mean lower long-term returns. It also means that high valuations, those high valuations from a capital cycle view will attract more capital.

Which they're doing in the field of big tech and AI, and the converse is true. So the low valuations that you can find in some of these small caps means that people are just ignoring them. That's not where the capital is. Wall Street has followed the money, as it always does. But I'm finding that, you know, I have now a third of my holdings have fewer than five analysts covering them. It's astonishing.

Yeah, so they're neglected stock. Neglected. And so you list your niche exposures across a number of different areas? You know, it's something which does not lend itself well to easy categorization. When I'm asked to describe my portfolio of 30 holdings, you know, because they're in industries ranging from regulatory compliance software, used automobile wholesale platforms, ceramic materials, rural broadband, dental manufacturing and ski resorts. It's not easy to sort of package those up into an ETF, I'm afraid. But they conform to the Marathon Capital Cycle philosophy because a niche almost by definition

is a business like Warren Buffett's moats that doesn't attract a huge amount of new capital. Each one of the companies held in those areas has, a unique supply-side story. And that's what we're looking for ultimately. So let's do a deep dive on the company that you chose to highlight in your note, which is BioRad Laboratories. BioRad is not actually that small, if I'm honest. It's about $9 billion enterprise value in terms of the world. It's actually quite a sizable company. But it operates in the life science industry about half the business is life sciences and half is diagnostics. And the capital cycle thesis in this industry is this is an industry that has consolidated over many years. And I've owned companies in

the past, Beckman Coulter, Millipur, they've all gone. And you have these two very large companies, Danaher and Thermo Fisher, that have been consolidating the industry. And yet, Birorad is a company that has remained steadfastly single, which I find interesting. It's a family-owned business. The Schwarz family founded it, and the current CEO, Norman Schwartz, is the son of the founders, and he's been the CEO for 20 years or so, I think. But, you know, this company, although the industry is consolidated around it and it's remained single, it still has leading positions in about 80% of its business lines.

It's got recurring revenues are about 70%. So it's got some very attractive businesses. So it's managed to sort of innovate even in the face of much larger competition. And I think one of the characteristics of life sciences or life science instruments is that if a scientist publishes a research paper about some scientific process, they will often cite the instrument and the assays that they've used in that test. And then what you find is that other academics or other drug developers,

they want to replicate those results, they will use the same instrument. So you can have these actually quite strong positions in niche areas. And one of the areas that they have some quite a leading position at the moment is a very cutting-edge technology, which is called Droplet Digital Polymerase chain reaction. instruments. We'll abbreviate that to DDPCR. But what those do is they enable the amplification of

DNA and RNA with very high specificity. And they're a leader in that. They've been gaining share. And these instruments, you know, they're being used for liquid biopsy, biopharmaceutical production, pathogen surveillance, all kinds of things. So biurad is, you know, it's been able to maintain leading positions. It's not good in all its business lines. It's never black and white like that. It's gray areas as well. But you point out that its profitability has recently been relatively disappointing compared to competitors, all the big names like Thermo Fisher. Yeah. So what I think the interesting thing about this is that the company's operating margins are about 1,000 basis points lower than peers. And you think, why is that? And actually,

if you delve back into history, I think it wasn't particularly. well run for a number of years. But then prior to the pandemic, Biarrad was actually outgrowing peers with higher incremental margins. So there's nothing structural about the business, which means its margins can't be similar to peers. In fact, it's gross margins the same level as peers. And all their newer products are at higher gross margins. So I think as these newer products grow and outpace the market, the margins should improve. And you're saying that those low operating margins that are to do with problems related to the pandemic period?

Well, I mean, there's different things going on. So the whole industry actually is in a downturn at the moment. And this is why I think it's attractive. Because in the pandemic, what happened was, you know, pharmaceutical companies, countries just loaded up on instruments and equipment. and we're basically two years into a downturn where they bought all those instruments in 2020, 2020, 2021, they're not really chewing through them yet. So we're two years into a downturn, and that has kind of depressed the whole sector. So I find this is a very interesting time to invest now because you're basically paying attractive prices within this industry, and in particular with Bayerad, it's hugely discounted.

And then this stock has a jewel in the crown that perhaps is not being properly valued. Yeah, so this is one where if you just look at the data on the surface, you think, oh, it doesn't look very good value. But what the data on Bloomberg or whatever system you're using doesn't tell you is that this company owns more than a third of Sartorius, the European company. Sartoros is considered by many to be a sort of jewel in the crown within European biopharm of processing. It's a market leader. And the Schwartz family knew the Sartorius family 20-odd years ago, and they took a $100 million stake in Sartorius,

because Sartorius was very good at mechanical separation technologies, I think filtration, whereas Biod was good at sort of chemical separation. So they thought the two companies would sort of fit well together. Anyway, to cut a long story short, that $100 million, investment is now worth $5 billion, which is half the enterprise value of Bayerad itself. And if you subtract that and deferred taxes, Bayerad's core business is trading on a single-digit multiple of EBITR, whereas, you know, Danaher and Thermo Fisher are in mid-20s multiple of EBITR. It's absolutely astonishing.

Why does Wall Street not like this? I mean, it's not a very widely followed company. Bracket firms don't follow it, probably because there's no deals. But the negatives are, you know, the family controls. So Wall Street doesn't like that. They want them to monetize this asset and engage in some financial engineering. But I think the CEO having met with him, I think he is very passionate about this business and feels a sort of weight of history on his shoulders. And he wants to create long-term value. And we're happy to be alongside him in that. Very good. Well, I hope you find more outliers in the US small-cap area. Thank you, Robert, and hope to see you again soon.

A pleasure as always, thanks, Edward. Thank you for your time today. I hope you will listen to the next edition of the Capital Cycle. This communication is provided for information purposes only. Please refer to Marathon's website and the Global Investment Reviews for further information, including important disclosures.