Dig Deeper: Quality in The Small Cap World

The views expressed below are those of Anchor Capital Advisors, LLC (“Anchor”) as of the date written on the last page of disclosures and are subject to change at any time. They are based on our proprietary research and general knowledge of said topic. The below content and applicable data are in support of our views on said topic. Please see additional disclosures at the end of this publication.

In the past few years, Anchor Capital has observed that the quality of many companies in the Russell 2000 Value Index has weakened. We view the decline in quality as a result of companies with negative earnings, flat to declining profitability ratios, and higher leverage. This decrease in quality increases the risk of investing in the passive index.

We believe actively managed portfolios are better suited to handle specific company and market risks associated with investing in small caps. We also think active portfolios are more able to manage downturns in the markets due to their disciplined focus on positive and growing earnings, stable and improving profitability ratios, and strong balance sheets and cash flow.

The bottom line: an investment should compensate for its risk. By neglecting to look under the hood and passively investing in an index, an investor may be exposed to a greater level of risk than one is suited to.

NEGATIVE EARNERS AND VALUATION

As depicted in Exhibit 1, the percentage of non-earning companies in the Russell 2000 Value Index is approximately 30%. History indicates that small, unprofitable companies skew towards high volatility, higher risk, and potentially greater underperformance.i

Therefore, in our opinion, it is more likely that an actively managed portfolio which values earnings should exhibit lower risk and potentially outperform a passive investment over the long term.

Quality Characteristics of Anchor SCV vs. Russell 2000 Value charts

When valuation metrics are reported by the indices and other financial reporting companies, negative earners are often removed from calculations of certain metrics. For example, the Russell 2000 Value Factsheet reports “Price to Earnings (P/E) Ex-Neg Earnings” as 15.8x in its characteristics section, as of March 31, 2019.

Vincent Deluard, head of global macro strategy at INTL FCStone, suggests summing the market caps of all companies in the index and summing the earnings all companies in the index to incorporate negative earners and get a more realistic P/E.ii By this calculation, the index was trading at 49.7x earnings on March 31, 2019.

By this same adjusted P/E of 49.7x, the earnings on yield on the index (the inverse of the P/E ratio, or 1 divided by 49.7) was 2.0% compared to 2.42% for the ten-year U.S. treasury as of March 31, 2019.iii In theory investors prefer a higher yield than the risk-free rate (the U.S. treasury) when they invest in riskier assets, such as small cap stocks.iv

PROFITABILITY RATIOS

Low profitability measures for the index, such as Return on Assets (ROA) in Exhibit 1, are further indicators of weaker quality companies, in our opinion. Profitability ratios such as ROA can show how well a company is utilizing its assets to generate earnings.v Although a low ROA can stem from  many things, a low or declining ratio may be a negative sign for a company.

Debt levels in the index and Anchor Capital small cap value charts

 

LEVERAGE

We have also noticed that in this prolonged low interest rate environment, leverage for companies in the index has trended up. We believe that growing debt on a balance sheet increases the chance of risk, especially in market downturns. Avoiding excessive leverage is a form of risk control for us.

DISTORTIONS

When money flows into ETFs, it distorts the markets by rewarding lower quality companies, ignoring valuations, and increasing stock correlations.vi

As Michael Kretschmer, CFA, Chief Investment Officer at Dutch investment firm Pelargos Capital put it in an interview: “Price discovery is to capitalism what free speech is to democracy… buying equity ETFs indiscriminately rewards public companies regardless of corporate performance. Capital market participants would then need to question whether there is still truth in price.”vii

Given the issues we’ve highlighted with the index, we believe that over the long term a higher quality, lower beta, active strategy will outperform a passive investment in the index while reducing investment risk.

ANCHOR’S APPROACH

At Anchor Capital, we are aware of the benchmark holdings and weights, but we are not beholden to them. We do not take benchmark weights into consideration in building our portfolios – unlike the investments of passive ETFs.

Anchor employs a fundamental bottom-up investment process seeking to invest in quality companies at attractive valuations. We conduct thorough research to attempt to identify quality companies with stable earnings, high returns, and low debt levels. Historical price performance indicates that these types of companies outperform over the long run. Our portfolio construction process strives to provide consistent relative outperformance with less downside risk over a full market cycle, which is more than we can say for passive investing.

Valuation is of utmost importance when balancing risk and reward. As University of Rochester’s Robert Novy-Marx said, “One common recurring theme is the strong relation between quality and value. The two are quite similar, philosophically. Quality can even be viewed as an alternative implementation of value—buying high quality assets without paying premium prices is just as much value investing as buying average quality assets at a discount.”

Anchor believes that by adhering to strict valuation discipline, we can add a measure of risk control that the index is currently neglecting. In our opinion, our actively managed portfolios, due to their disciplined focus on positive and growing earnings, stable and improving profitability ratios, and strong balance sheets and cash flows, are better suited to handle company and market risks, as well as to manage downturns in the markets.

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