Perkins CEO, CIO, and portfolio manager, Jeff Kautz (pictured) offers three reasons why now is the right time to invest in defensive quality small cap value stocks.
Lower-quality, highly leveraged stocks have led the bulk of post-crisis market gains. Increasing volatility during 2014, however, may have marked the start of a rotation favouring higher-quality stocks in the small cap value segment. We believe a more accurate description for these securities may be “defensive quality,” as these stocks appear well positioned to benefit from changing market dynamics based on their attractive defensive attributes and stronger long-term return potential.
REASON 1: AN (OVER?) EXTENDED LOWER-QUALITY RUN
Lower-quality stocks have generally outperformed higher-quality securities since markets bottomed out post crisis in March 2009, with the exception of a brief period of higher-quality outperformance in 2011 during the European debt meltdown. This almost six-year run marks the second-longest period lower-quality stocks have outperformed since the 1980s.
While lower-quality stocks usually lead higher-quality securities as the economy recovers from recession, this exceptionally long rebound has to an extent likely been artificially supported by an extremely accommodative Federal Reserve and historically low interest rates. Investors have been willing to purchase more speculative equities under the assumption that the Fed is ready to bail them out should the economy turn down again. In addition, with cheap credit readily available, there has been less negative stigma associated with leveraged balance sheets. With the Fed now apparently ready to start winding down its extraordinarily loose monetary policy, the balance may finally start to tip back in favour of higher-quality securities. Top- and bottom-line growth, consistent free cash flow generation, and smart balance sheet management may become increasingly important to help secure value creation moving ahead.
REASON 2: HIGHER VOLATILITY AND LOWER CORRELATIONS
In 2014, through November, small cap value stock performance decoupled from large- and mid cap value stock returns for the first time in seven years. The Russell 2000 Value Index managed to remain in positive territory with a 1.5% total return as of November 30, 2014, but it experienced four draw-downs of 5% or more. In contrast, the Russell Mid Cap Value Index and Russell 1000 Value Index, each of which is based on the value segment of their respective market caps, climbed more than 13.9% and 12.8%, respectively.
Correlations within the small cap segment have also declined. Higher correlations during broad market momentum can make it difficult to differentiate performance through bottom-up stock-picking. Conversely, as individual securities move less in tandem, investors generally have greater opportunity to outperform through skilled stock selection.
Furthermore, higher-quality stocks tend to outperform lower-quality stocks during periods of elevated volatility, given that these companies’ balance sheet strength and earnings stability provide important defensive attributes that can help protect on the downside.
REASON 3: FOCUSING ON DOWNSIDE PROTECTION OFFERS GREATER LONG-TERM RETURN POTENTIAL
Even though small cap value stocks lagged in 2014, they still are not inexpensive relative to large cap stocks. Small cap downside risk remains relatively elevated, and as the current bull market continues to age, the focus on protecting assets during market dislocations is likely to increase.
In addition, higher-quality stocks historically outperform during the second half of the economic cycle and during slowdowns. When profits become more scarce, investors usually rotate into higher-quality companies that possess more stable, predictive earnings and durable competitive advantages that can help protect profits.
Given these two factors, investors desiring small cap value exposure may want to consider a more defensive quality-oriented manager who adopts a methodology which focuses evaluating downside exposure first and foremost, before analysing upside potential. By striving to minimize downside losses while participating in upside market gains, it may be possible to compound at a higher rate over a full market cycle. This risk-disciplined approach to small cap value investing has delivered steady long-term outperformance relative to the Russell 2000 Value Index and peers across full market cycles.
NOW MAY BE THE TIME FOR DEFENSIVE QUALITY
If, as we expect, a rotation to higher-quality securities is underway within the small cap value segment, then investors should be well served by an emphasis on defensive quality stocks. By focusing on attributes such as strong balance sheets and solid, recurring free cash flows, assets are protected in periods of greater volatility while still capturing attractive long-term outperformance over full market cycles.
Small cap value returns in 2014 were a reminder that unbridled low-quality market gains don’t last forever. History has also demonstrated that it is frequently the performance during down markets that has the greater impact on relative long-term investment results. Consequently, now may be the time to lock in small cap value gains from the past several years and apply a more risk-disciplined approach moving into the next stage of the cycle. When it comes to long-term equity investing, this type of market shift has often shown that the best offence has usually been a good defence.