The Excitement, Danger, and Unknown of Small-Cap Investing’s Comeback


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SouthernSun Asset Management has waited years for a market as promising as this one for its little-known stocks.

Phillip Cook, the co-chief investment officer of SouthernSun Asset Management, has lived in Tennessee, Alabama and Florida. If nothing else, those places have taught him one thing: “Americans cannot stand a minute without air conditioning.”

“If you’ve ever owned a home and had the frustration of problems with your HVAC, you have zero patience for it,” Cook said in late July. “You have to get it fixed immediately, especially if you live in a place like Memphis, where the heat index is 105 right now or whatever.”

Sometimes a simple observation like that leads to a great investment. In SouthernSun’s case, a longtime holding in HVAC parts distributor Watsco has helped the firm earn strong returns in recent years, showing that niche fund managers can thrive in a market dominated by major indexes and the megastocks driving them. The Memphis-based money manager made one of its key wagers in 2020, betting on itself by buying back its independence from Affiliated Managers Group.

Stocks such as Watsco can be hard to find.

Cook and his colleagues had the germ of an investment thesis: It’s getting hotter and more Americans are moving to scorching places like Arizona, Texas and Florida, so demand is growing for new air conditioning systems and maintenance services.

But SouthernSun, a small-cap manager with about $900 million in assets, needed to figure out how to get exposure to the business of heating, ventilation and air conditioning. Companies familiar to the firm, such as Carrier with its $45 billion market cap, were too large.

SouthernSun began a long research process: poring over financial statements, subscribing to industry magazines and news websites and hitting the road.

For years, Cook and his colleagues attended HVAC conferences to meet executives, employees and customers. SouthernSun started focusing on a couple of publicly traded companies that make small parts for HVAC systems but decided not to invest because of their exposure to other industries. It wanted a pure play.

After countless trips and meetings, a common denominator emerged: Everyone the firm spoke to kept talking about something called Watsco. Whatever it was, it mattered in the HVAC universe, yet there was no trade show booth to be found. “Watsco is not even at the show because they’re a distributor, but I kept hearing their name,” Cook said.

What SouthernSun learned is that most HVAC part makers don’t sell their components through their own network. Instead, they use third-party distributors to reach the workers who install systems in new homes and show up at front doors to fix old ones. Regulations often require the use of distributors, insulating those networks from someone like suddenly entering and taking over the market.

Watsco, which was founded in 1945 and had $7.2 billion in revenue in 2022, is among those distributors and became one of about two dozen companies in which SouthernSun is invested in. The firm started buying shares in December 2018 and its now the fourth-largest holding in one of its strategies.

“That’s a cool part of our process,” Cook said. “It might take years of getting to know people in a particular industry, to find where in the value chain we can invest and really do well. That was kind of fun to be a part of seeing the fruit after years of doing homework. Now we’ve owned it for a number of years and it’s done really well.”

Shares of Watsco (ticker: WSO) are up 56 percent this year and 145 percent over the past five years. The S&P 500 is up 14 percent this year and 58 percent over the past five.

Not every research rabbit hole results in an investment, but most are worthwhile. “It’s not a waste of time. Well, sometimes it is a waste of time. But you’ve got to be willing to go and have a conversation with somebody that wastes your time to find the right conversations,” Cook said.

During the past decade, fewer investors had that willingness as other strategies and passive funds delivered better returns. But higher interest rates and a possible recession mean there is no longer a rising market tide lifting all stocks. Some will fare better than others and choosing the right ones is what SouthernSun is all about.

Small-cap companies, generally defined as those worth between $250 million to $2 billion, are more numerous than mid and large caps. There are about 1,750 in the U.S. and several thousand globally.

The vastness of the small-cap universe gives it an air of unknown, excitement and danger. Compared with large caps, few research analysts, portfolio managers and regulators follow them. Short bets against them tend to be too risky for hedge funds. The share prices are volatile.

Small caps had an uninspiring run from 2012 to 2022, when historically low rates fueled a long bull market led by big tech. The stocks lagged the S&P 500 index by 2.27 percent annually on average. However, the future could be different. Small caps look cheap and, according to research by Schroders, have historically outperformed large caps during recessions and recoveries, returning an annualized 9.9 percent compared with 4.9 percent.

Small-cap stock-pickers are having at least a moment this year. Three in four active small-cap funds were beating their Russell benchmark in the third quarter through Oct. 10 and 52 percent were ahead year to date, according to Bank of America global research. Only 37 percent of large-cap and 35 percent of mid-cap funds can say the same for 2023.

“In small caps, a manager can have an information advantage that leads to alpha for its investors,” said Darrell Crate, founder and managing principal of Easterly Asset Management. “Wall Street does not cover small caps. Wall Street analysts, they’re stretched thin, and the work you need to do on a small-cap company is plentiful.”.

Crate was previously the chief financial officer of AMG, the publicly traded company that buys stakes in investment firms.

“To be a small-cap manager, you have to have strong private equity skills as well as public market skills because you need to be able to look at the business strategy, then you need to be able to assess if the management team has the ability to execute on the strategy,” Crate explained. “In the large-cap universe, there’s already a vetting mechanism for high-quality managers.”

Unlike large-cap managers who must understand market psychology and momentum, small-cap specialists can focus on fundamental analysis and identify good companies, making it easier to differentiate skill from luck, Crate said.

“These gems that folks can find, they can harvest returns that outperform peers for many years. So veteran teams matter in a small-cap universe,” he said.

Chas Burkhart, co-founder and CEO of Rosemont Investment Group, a firm that invests in asset and wealth management firms on behalf of Markel Group, likes small-cap managers for the same reasons.

“Small cap, micro, small-mid — any strategy or set of strategies that have clear capacity limits that are not likely to be overrun by asset gatherers, that can be compelling for the better performers,” Burkhart said. “They can build firms or strategies of several billion [dollars] and sustain pretty high fees and have profitable businesses.”

He counts SouthernSun as one of those firms Rosemont was invested in the asset manager from 2010 to 2014, when AMG bought the stake. “Southern Sun was clearly one of the best and we had a very good experience with them and still maintain a very strong relationship,” Burkhart said. Terms of SouthernSun’s deals have not been publicly disclosed.

Michael Cook, Phillip Cook’s father, who founded SouthernSun in 1989 and remains CEO and co-CIO, recalls researching small-cap companies being different back then. He would fill rooms with hard copies of earnings reports and spend days reading them for insights. Now, that information is at the fingertips of investors moments after it’s released by companies, alongside all the databases and tools available to the contemporary portfolio manager. But the investment philosophy and dedication to spending a lot of time on research and travel remains the same.

SouthernSun is not full of Luddites, but the firm says returns on new data for investment professionals are diminishing, even making the process of determining an attractive price for a stock more complicated than it needs to be, especially for long-term investors. “People fool themselves, because they have more data and more information and stronger quantitative computing skills, that we have better outputs,” Phillip Cook said. “No one has figured out how to predict the future, and that’s what these models are based on.”

Artificial intelligence might provide good signals, but never the same ones as a portfolio manager walking around a trade show. If SouthernSun didn’t do that, it might never have considered Watsco.

The firm has had a solid track record for many years, though its glory days from 2010 to 2014, when it and another manager were highlighted for running “2 out of 2,862” akin mutual funds in the top quartile of performers five years in a row. SouthernSun’s small-cap strategy has returned 10.18 percent compared to its Russell 2000 benchmark’s 8.96 percent through Aug. 31. On an annualized basis, the strategy returned 17.85 percent over the past three years and 9.48 percent over the past five compared to the Russell 2000’s 8.12 percent and 3.14 percent.

“That’s a really good duo and Phillip Cook is a very worthy successor,” Burkhart said. “It’s a bunch of high-quality people. They’ve had some bad patches where they’ll be out of favor. But overall, over longer periods of time, I think they proved to be very astute investors. It just, of course, depends whether or not as a client you hang in there for a long enough period of time to benefit from their skills.”