Small-cap investing: Harnessing opportunity with an active approach

As active managers in the small-cap equity space, we view this special niche of small-caps as full of pockets of inefficiencies and areas of opportunities that the market at large might easily overlook. Yet in the current market run-up, when many investors are flocking to passive investing, we think some are not taking the time to differentiate small-caps from other parts of the capitalization spectrum — and as a result, they seem to view small-caps as just another asset class to be captured through passive funds.

By doing so, we believe these investors may be missing out on an important advantage of actively managed small-caps: the ability to capitalize on those natural inefficiencies.

Inefficiency creates opportunity

What makes small-caps prone to pockets of inefficiencies? One reason is that fewer equity analysts tend to cover small-caps and generate research1 making the small-cap space less homogenous than the larger-cap space. But the key to uncovering opportunities can lie in the fundamental research that is applied to small-cap companies, something that's essential to our team. On our research-driven active team, for example, we carry out a highly targeted and disciplined security selection process, offering an opportunistic, research-based alternative to simply "buying the market" via index funds. Our focus on research means that companies have to exhibit the right mix of attributes in order to “earn” a place in our portfolios — and potentially give an edge that following a benchmark can't provide. What does this edge look like? We see it as taking the form of a repeatable stock selection process that delivers consistent performance.

Markets that are out of bounds

Given the extended stretch of impressive returns that equity markets have currently been experiencing, it's understandable to us that some investors may view small-caps as natural candidates for passive funds. Small-caps posted strong returns in 2016, as seen in the chart below. In fact, the entire US equity market gained momentum after November's presidential election and reached new highs early in 2017 on positive expectations of the new administration.

But even when markets are riding on strong momentum, it can be worth exploring how inefficient market segments such as small-caps may offer opportunities to build positions that are based on something more meaningful: sound fundamentals. That's where the investment process we follow can make a difference.

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Small-caps versus the broad market: A year of outperformance

Small-caps versus the broad market: A year of outperformance

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Data: Standard & Poor's; Russell Investments. Both via Federal Reserve Bank of St. Louis. Index values are set to 100 on Jan. 1, 2016. Daily observations.

Past performance is no guarantee of future results. Chart is for illustrative purposes only.

Emphasis on free cash flow is a barometer

In the day-to-day management of our small-cap portfolios, we rely on rigorous research to focus on companies that we believe exhibit strong fundamentals — with strong free cash flows chief among them.

Our focus on free cash flow creates a strong demarcation point for us, fencing off those companies we are interested in from those we are unlikely to pursue. It is such an important measure that even when a company's shares retreat, if cash flows are still robust, we keep in mind that the market could be overreacting to something other than fundamentals. And in such cases, we stay committed to long-term investing and avoid a reflexive exit of the position.

In one recent example, shares of one particular holding — a distributor of laboratory supplies — declined by more than 10% during the fourth quarter of 2016, after the company reported a slowdown in organic growth rates and provided revenue guidance that was on the low end of the range provided in the prior quarter. We nevertheless maintained a positive view of the stock, partly because of the company's continued ability to generate healthy cash flows, and partly because our fundamental research revealed a company that continued to maintain a solid business model. The company's shares saw renewed support in the following months, and they remain within our portfolio.

Another example involved a distributor of packaged goods and food products to convenience stores. The company's shares felt pressure after it lost a customer during the third quarter of 2016. Even though the market treated the company's shares unkindly, our research supported our positive opinion of the company's prospects. Furthermore, despite the loss of a significant customer, the company's customer pipeline was still in net positive territory. The company's shares have oscillated somewhat in the ensuing months, but on the whole, our thesis on the company — and its suitability as a portfolio holding — has remained unchanged.

Wisdom gained from experience can be a factor

In both cases above, our research suggested that the companies were running solid businesses and were probably being oversold. The free cash flow measure offered confidence in this view and in the likelihood that the companies would ride out the volatility. But the two examples also show that it's not simply a matter of collecting research — it takes experience to be able to identify a company's long-term potential.

The length of tenure on our team means that we've experienced complete business cycles together, and over time we've come to recognize themes that tend to emerge at certain stages. Those themes can factor into our views and opinions. Today, as we make our way through the mid-to-late stage of the current cycle, one such theme involves indebtedness. If we see companies start to aggressively increase the use of leverage, we will become more cautious because their shares are likely to feel pressure as the cycle matures and makes its way to the contractionary phase.

Return on invested capital (ROIC): A key metric

Among the core lineup of financial measures that we look at, an important one is ROIC. This indicator can show how effectively a company is investing its capital, whether in hard assets, research and development, or other areas. If a company’s ROIC is underwhelming, suggesting that the company is investing capital unwisely, we will likely downgrade our opinion of the stock.

Research underlies decisions

Our research-driven approach means that stock-by-stock analysis is at the forefront of everything we do. Our reliance on research can also inform our sector-level views. The consumer sector provides a good example in which our regimen shapes our daily work. Our current assessment paints a picture of a sector that is dealing with a conundrum: Consumer confidence measures are on the rise, yet several areas of retail, especially traditional mall-based retailers that are losing market share to online services, are up against considerable headwinds. (Indeed, Commerce Department data show that sales at department stores have been declining for much of the past two years.)

Based on inputs like these, our portfolios are underweight retailers, and we intend to continue this underweight in the near term.

It all comes back to risk control

One important goal of our day-to-day work is to produce portfolios that have a distinct bias toward quality holdings. This focus on resilient, stable companies speaks to our emphasis on risk control, and maintaining a strong element of risk awareness is crucial to us as active managers. In fact, we see it as a direct consequence of putting research at the center of our investment decisions.

Through research, we can focus on the attractive qualities of portfolio candidates, looking for elements such as healthy free cash flows, strong balance sheets, good ROIC, and shareholder-friendly deployment of capital (consisting of share repurchases, repayment of debt, and consistent or growing dividend distributions). Through this process, we seek to attain a quality bias that can provide ballast during periods of market weakness, particularly when facing unknowns and uncertainties such as those challenging markets today.

1The number of analysts covering the average large-cap company is approximately 18, compared to only 6 for small-cap companies. (Data: FactSet, as of Dec. 31, 2016. Based on the number of analysts that have published a rating on companies within the Russell 1000® Index and the Russell 2000® Index).

The views expressed represent the Manager's assessment of the market environment as of March 2017 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.


Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.

The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index, representing approximately 10% of the total market capitalization of that index.

The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.

Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.

Frank Russell Company is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company.

Diversification may not protect against market risk.

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