(This article is from the the Spring 2014 publication of Natixis Global Asset Management’s Market Insights.)
Active management trumps passive in the US small cap universe.
It is an article of faith for many investors that passive performs better than active. That is, the median active fund manager will underperform the benchmark after costs. Evidence is provided by numerous reports, surveys and papers. To cite just one, 69 per cent of US large-cap value equity funds underperformed their benchmark over the ten years to the end of December 2012.
But, as we know, statistics can mislead. Yes, active strategies in totality underperform, but narrow your focus to subsets of the investment universe and the picture can change.
Consider US small cap value managers. A full three-quarters of them beat their benchmark over the longer term. To put it into perspective, between 2000 and 2012 the median large-cap growth manager returned just 2.45 per cent a year before charges, while the Russell 1000 large-cap index was up 2.94 per cent annually. The median U.S. large-cap growth manager clearly underperforms their broad benchmark. But in the US small cap value universe, the median manager returned 10.37 per cent a year to investors after fees, while the Russell 2000 was up just 6.21 per cent. In other words, US small cap value managers substantially outperform the broad US small cap index.
Let’s look at why US small cap value managers buck the trend and outperform the index, and other equity classes, on average.
US economic prowess
First, the US economy is simply more innovative and capable of creating value over the longer term than any other. The US market is large, diverse, transparent and serves an economy that has a strong entrepreneurial culture and that benefits from significant financial, human and natural resources. Despite regularly-voiced doubts about the US economy, for the last 20 years US equities have outperformed non-US equities in absolute terms and have outperformed by even more on a risk-adjusted basis.
Small is beautiful
Second, small cap outperforms large cap in most markets due to three broad factors:
1. Smaller companies often have an entrepreneurial culture, which provides incentives for people to flourish and innovate.
2. Smaller companies have higher growth rates because they start from a lower base.
3. Trees don’t grow to the sky. That is, big companies struggle to find ways to grow fast, if at all.
Dearth of research
Third, the small-cap universe is inherently inefficient. Many research houses and investment banks focus solely on large caps because, in general, they can access more reported information with longer time series on larger companies, they provide greater liquidity for investors and, importantly, they generate more commissions for the banks themselves. This leaves a gap which can be exploited by researched investment firms. “The typical small-cap company is followed by six sellside analysts and some have no sellside coverage at all,” says Seth Reicher, president of Snyder Capital Management, an affiliate of Natixis Global Asset Management. “This compares to a median of 19 and 27 analysts for large- and mega-cap stocks respectively.”
In addition to the limited quantity of coverage, the quality tends to be low too. Because many banks have swept out their ranks of experienced, highly-paid analysts, small-cap research is likely to be assigned to less experienced investment professionals, who are less able to distinguish between high and low quality companies.
Value trumps growth
A further factor contributing to the persistence of outperformance in US small caps is value. Over the long term, a value style of investing consistently outperforms a growth style. The value universe is, by the Russell index definition, composed of less expensive stocks in terms of price-to-book value and lower expected long-term growth rates. These factors have important defensive qualities too: less expensive stocks, with slower anticipated growth, have less opportunity to disappoint. Additionally, they also have more room, when successful, for multiple expansion and thus appreciation.
Quality control
The systematic advantages of US small caps can be enhanced further through the selection of high-quality companies. As a rule, high-quality companies outperform low-quality companies, all other things being equal. As defined by the Leuthold Group, corporate quality can be regarded as:
1. High Return on Equity
2. Low leverage
3. High earnings consistency
Put simply, better companies with better management perform better. And there is no other way of finding out which companies have better management than by meeting managers.
Beating the median
While beating the benchmark is often the aim of an investment strategy, investors in active strategies often seek to benchmark fund managers against each other. That is, they wish their chosen manager to outperform the median manager in the relevant sector.
Snyder believes two principal investment skews can lead to outperformance against the median US small cap value manager. They are: time arbitrage and a high free cashflow focus.
“With very little exaggeration, about 80 per cent of market participants have time horizons between two seconds and two months.”
Time arbitrage seeks to exploit the general market desire to harvest returns over very short time horizons. “The focus of most market participants is to make money yesterday,” says Reicher. “With very little exaggeration, about 80 per cent of market participants have time horizons between two seconds and two months.”
He points out that 50 per cent of the volume of trades on the NYSE are executed by high frequency traders whose time horizons are measured in nanoseconds. A further 30 per cent are hedge funds or quant managers who turn over their portfolios hundreds to thousands of times a year. Finally, just 20 per cent are long-only managers and even many of these have short time horizons.
The result is a market characterised by hyper-efficient overreaction to news events and one which fails to fully discount fundamental opportunities beyond around six months. This leaves opportunities for investors with longer investment horizons. “Our favourite stock is one with a solid business where we anticipate a positive event for the company a year out, but which has just disappointed on short-term earnings,” says Reicher. “You buy and hold it for nine months and as long as you are right on the fundamentals, you make money. Markets are not efficient in the short-term, but they tend to be in the longer term.”
Inefficiencies are also created by the way that different companies manage their cashflows. With investors hungry for yield, stocks that report strong earnings and provide high dividends are extremely attractive to investors and have become highly rated (read expensive) as a result. However, in order to win the popularity contest, these companies have to pay considerable additional taxes on their higher earnings, which reduces their ability to spend and grow.
“We prefer companies that have greater opportunities than just returning their money directly to investors and the government, and instead use it to invest profitably, and with high returns, for tomorrow,” says Reicher. “The market often penalizes capex, but we don’t for companies with a proven ability to properly allocate capital wisely because we know we will get benefit of this investment eventually.”
Anyone for darts?
Despite all the academic and anecdotal evidence to the contrary, active management can beat passive systematically. With 75 per cent of small cap managers outperforming, investors have to be unlucky or undiscerning to pick an active manager who underperforms the benchmark. As Reicher notes: “You can throw a dart while blindfolded at this group of fund managers and still have a good chance of outperforming.” Investors who want to outperform the peer group, however, might want to hone their dart-throwing skills.
Download the publication including sources and footnotes » Media Insights – Spring 2014