Declining valuations in the small-cap arena could be setting up an attractive opportunity for investors, according to a report released Monday by GMO.
Drawing on historical data, the asset manager argued that quality small-cap stocks — defined by GMO as small-cap stocks that are in the highest quartile of GMO’s “quality” metric, which blends profitability, stability, and leverage — will continue to outperform the broader small-cap asset class with stronger returns and lower volatility.
“Since 1976, small-cap quality has outperformed the small-cap asset class in the U.S. by 1.8 percent annualized and [the] all-cap U.S. market by 2.8 percent annualized,” the paper stated. “These more predictable, long-term winners are very often undervalued by the market, buried under the buzz of stocks long on narrative but short on fundamental stability.”
According to GMO, companies that meet its quality standards “exhibit high margins, high returns on capital, low debt, and stable fundamentals.” It says that while often undervalued by the market, these stocks are more predictable and safer long-term winners.
“[More] of the small-cap universe is set up to fail, and less of it is set up to succeed. Investors tend to overpay for shares of weaker and more volatile businesses, perhaps lured by overly optimistic projections or lottery-ticket-like chances for sizeable payoffs should these companies succeed,” the paper stated.
By using fundamental research in a “quantitatively defined quality universe,” the manager has screened the asset class and reduced its investable universe of 2,800 U.S. stocks by more than 90 percent. Fewer than 200 names meet the firm’s threshold, which is determined by its proprietary systematic screens, and the firm’s strategy for the asset class now has a high-conviction portfolio of 40 names that avoids excess exposure to one sector or an economic trend.
Leveraging research to pick or screen stocks is nothing new. So why haven’t other investors followed suit?
Part of the problem lies in the behavioral aspects of investing, in which people are drawn to “lotto ticket” stocks that offer extremely high returns — and high volatility — but, on average, can’t sustain attractive returns. According to the paper, the small-cap arena is fraught with speculative stocks that have “challenged” financials and offer empty promises. “Twenty-four percent of U.S. small-cap stocks by market cap weighting produced negative earnings over the last 12 months, while only 5 percent of the total U.S. market had negative earnings over the same period.”
GMO states that this has been an ongoing issue in the small-cap universe, and the firm contends that part of the solution lies in maintaining an active strategy approach.
“You want to learn everything you can about the management team, because more than ever it’s riding on them and they have more direct control over the smaller companies,” said James Mendelson, a portfolio manager at GMO. “You want to be extremely confident that you’ve identified the competitive moat and sized up all the threats to it, and [determined] whether or not it is going to be able to maintain and grow over time as the company prospers.”