In this episode of the [i3] Podcast, I’m speaking with Richard Brown, who is a Client Portfolio Manager with Janus Henderson Investors. And today we are going to talk about global small caps. We look at whether small caps are affected by the increasing concentration of the equity markets, particularly in the US, where technology stocks have dominated returns in recent years. We talk about catalysts for unlocking the current small cap discount versus large caps, including the rate environment and the current business cycle. And we take a look at a few case studies of where to invest and where not, involving fuzzy pandas, Italian industrial stocks and JB Hi-Fi. This episode was sponsored by Janus Henderson Investors, and as such, the sponsor can make suggestions for topics, but the final control remains with the Investment Innovation Institute.
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Overview of Podcast with Richard Brown, Client Portfolio Manager, Janus Henderson Investors
02:00 The appeal of small caps and the case for egg producers
08:00 Does the concentration in equity markets and the increasing value of the Magnificent Seven require you to adjust valuation models for small caps?
09:30 The small cap discount to large caps has reached quite an extreme by historical standards
11:30 More clarity on the direction of rates would help small caps
13:30 There is an opinion that if rates stay higher for longer, then that would be bad for small caps. That is something we fundamentally disagree with.
14:00 The consensus view that small caps have underperformed as rates have gone up, that just hasn’t been true versus history
18:00 About 30 per cent of small cap companies in the US has had a negative EPS over the last two calendar years
20:00 The two catalysts for small caps: clarity on rates environment and confidence in business cycle
23:00 Are the future small caps all about AI?
26:00 Examples of AI small caps; filling in doctor’s insurance papers
36:00 Healthcare, REITs and the dangers of playing the sector game
41:00 Examples of what not to invest in: the case of an Italian industrial company
43:00 Fuzzy panda, short-selling and meme stocks
45:00 Is there a small cap premium in the Australian market? Maybe, but JB Hifi has been one of our strongest performers
Full Transcription of Episode 119
Wouter Klijn 00:00
In this episode of the [i3] Podcast, I’m speaking with Richard Brown, who is a Client Portfolio Manager with Janus Henderson Investors. And today we are going to talk about global small caps. We look at whether small caps are affected by the increasing concentration of the equity markets, particularly in the US, where technology stocks have dominated returns in recent years. We talk about catalysts for unlocking the current small cap discount versus large caps, including the rate environment and the current business cycle. And we take a look at a few case studies of where to invest and where not, involving fuzzy pandas, Italian industrial stocks and JB Hi Fi. This episode was sponsored by Janus Henderson Investors, and as such, the sponsor can make suggestions for topics, but the final control remains with the Investment Innovation Institute.
Richard, welcome to the podcast.
Richard Brown 02:10
Hi Wouter. Thank you. Delighted to be here.
Wouter Klijn 02:14
So why small caps? How did you get involved in this particular area of investment?
Richard Brown 02:18
Look, I think small cap is one of the most interesting areas you can be involved in, in capital markets, in truth, huge inefficiencies available for active stock pickers. You know that can certainly peak at peak interest. But you also end up looking at some very bizarre and unusual areas of the market. You know, egg producers, other companies working in particularly niche areas of the market. And you know that that that sort of area of small cap has always sort of piqued my interest and draw me to this area within within investment. So, yeah, I’ve been working with in the equity market since 2010 and really for the vast majority of that time, it’s been with a focus on the small cap area.
Wouter Klijn 03:00
So is there a current investment egg produces?
Richard Brown 03:04
Well, actually, after a long standing investment there, we’ve actually had to just take profit after we saw some very strong returns driven by a strong pricing environment that states on the back of an outbreak of bird flu over there. But so I was quite sad to leave that investment, but it was a good one to us. So that’s a good reason to be selling a stock.
Wouter Klijn 03:24
Yeah, it would be interesting doing due diligence on a company like that, but maybe we can bring it a little bit to a higher level the current environment for small caps. I mean, I think markets are in a very interesting stage at the moment anyway, because we’ve seen a huge concentration in the US markets. We have it a little bit here in Australia, with a lot of money going into one particular bank, CBA, that seems to crowd out a lot of stocks. How do you look at the current environment for small caps in sort of in that environment where you have this domination of the Magnificent Seven. You got other stocks in, you know, Taiwan with TSMC. Do they still have a chance?
Richard Brown 04:07
Yeah, I think so. And you know, undoubtedly, this is a question that comes up time and time again recently, because the vast majority of asset allocators attention are towards the mag seven. And look, that’s hardly surprising, as it gets given this huge AI innovation wave that we’re really only just beginning to understand. But for me, what’s quite interesting is, you know, a lot of people preface that discussion by saying, well, small caps have underperformed large caps, and I think it’s quite important to pick that apart, because what we focus on is really the operational performance of small caps, and that’s what attracts us to this area, because it’s been very strong and high growth for a long period of time. And actually, if you look at this period of so called underperformance versus large caps, actually that operational performance has been fine. It’s been very solid. It’s been roughly on the same trend as what we’ve seen over the last sort of 50 or 60 years. Yes. So it’s really a case of those returns in large cap being super normal. And for me, you know that that’s certainly something that I find quite reassuring as a small cap investor, that if we just continue plotting this sort of steady course, this AI innovation wave is going to, is is going to is going to chug along there in the background. But you know, small caps can still play their part, and indeed still are for asset allocators in their portfolio. Yeah.
Wouter Klijn 05:29
So we’ve seen strong returns in equity markets in recent years, and I think it hasn’t happened too much in history that the s, p5, 100 at three consecutive years of double digit returns and four years is even rarer. But what do you think this environment does to the valuation of small caps? Does it? Did you need to adjust how you evaluate small cap models in this current climate?
Richard Brown 05:55
No, we are quite dogmatic in our approach in truth. So our valuation models are totally unchanged. And really what we do is we focus on looking for high return businesses that have positive incremental returns that are not yet reflected in their underlying valuation. And we would do that at the crop of markets, and we would do that even when markets maybe appear to be overheating. So indeed, that hasn’t really changed the way that we’re valuing stocks at this moment in time. And you know, when we take a step back and say what the valuations look like for the asset class as a whole, like you say, it’s been a it’s been a period where a number of other asset classes have been making new all time highs and potentially reaching bubble territory in certain areas of the market. So small cap, we’re on roughly our long run average, if you’re just looking at forward forward PE and that’s true of most regional markets as well as global small cap markets as a whole. So what that has ultimately meant is that the small count, small cap, sorry, discount versus the large cap area, the market has reached really quite bizarre, extreme by historical standards. And you know, the real catalyst for that came through the aggressive rate cycle that we saw through 2122 if you look back prior to that. And again, this applies to most regional small cap markets across the world. Small caps were trading on a premium versus large cap, because that strong, operational, higher level of earnings growth that small caps tend to achieve was 10 tended to be rewarded with it with a higher valuation. Yeah, as we stand here at this point in time, we’ve had that aggressive rate cycle come through now, now a massive discount applied to the small cap space. So I think is a good time to be looking at it.
Wouter Klijn 07:39
So is there any sort of market event or as a catalyst that might unlock the discount and bring it more in line with historical averages? I mean, you were talking a little bit. Maybe we’re getting to bubble territory in large gaps. Do we have to wait for sort of a correction in those stocks? Or could there be something else that would bring the discount closer to historical averages?
Richard Brown 08:03
Yeah, it’s a great question, and in truth one that we’ve sort of been scratching our heads about a little bit already over the course of the last 12 or 18 months, as we would have expected that valuation discount to already been narrowing, but we haven’t really seen that at all yet. For us, it’s really going to come down to two main catalysts, I think, to see asset allocators really move back into this space. And the first is clarity over the direction of rates. And that’s something I think is worth digging into in a little bit more detail, actually, and it’s and its impact on the small cap market. And of course, when you look at rate forecasts at the moment, I mean, they’re changing almost daily with the latest unemployment numbers or CPI pruned out of the US, or indeed, whatever next press statement we get out of the White House with regards to the lineup of the Fed, but I think more clarity on the direction of rates is one which is going to act like a trigger, as well as more confidence in the economic cycle overall. You know, small caps are more cyclical in nature versus their large cap years. So we do need to see more confidence that GDP growth is going to be be solid or strong into the future. And I think that’s going to catalyse that return to the asset class and narrowing of that valuation.
Wouter Klijn 09:12
And what is your sense about the rate environment? Because we saw here in Australia a situation where the RBA, the Reserve Bank, the central bank here has just cut rates, but the decision before that, they left it neutral, and they got a lot of commentary around not cutting in that meeting and leaving it to the latter one. But then, more recently, we’ve seen inflation figures coming out that are well surprised on the upside, and were far higher. From memory, it jumped from 1.9 to 2.8 and I think we’ve seen in the US similar sort of worries about the inflation rate there with the US tariffs. It does change this day to day, but do you have a sense of where it might go? And of course, also then the impact on. Small companies who, as you said, you know, they tend to suffer a little bit when rates go up.
Richard Brown 10:04
Yeah, yeah, absolutely. And, you know, as you’ve outlined there, I think it’s rarely been as complicated as and on a knife edge with each of these announcements, it’s actually quite nice seeing my bond colleagues actually having to do some work for once, having sort of just sat around for two decades, having a very boring period for them in their markets. Look, if you were to push me out, the view of our team is that the direction of rates is still down. We don’t think that we’re going back to zero. And a lot of people’s conclusion from that is in a higher for longer rate environment, that will not be good for small caps, and that is something that we fundamentally disagree with. And the reason for that is we think that there’s a few lessons here from history. So if you look back at the last time rates stayed at the these higher levels, well, the most recent period was back in the mid 2000s a fantastic time for small versus large. And then if you go back even further, even before I was born in the early 1970s when rates were sustainably much higher for much longer fed Fed funds rate peaking at 19% through the late 1970s and into the early 1980s again, really strong time for small versus large. So I think the sort of current consensus view is small caps have underperformed as rates have gone up. That just hasn’t been true versus history. Now, what could be the reasons for this? For us, it very much boils down to the funding on the balance sheets of these small cap stocks. A lot of them have far greater levels of floating variable rate debt rather than fixed rate debt, so and shorter duration. So what you tended to see there is the small caps were feeling this funding pinch much sooner than their large cap peers, and that’s why they’ve underperformed on the way up. It also means that actually, if we see that reversal and rates begin to come down a bit, they’ll feel that that funding benefit a lot sooner. What actually matters if rates just stay higher for longer, isn’t whether you’ve got fixed or variable, floating rate debt. It’s actually your your debt pile overall and there. And this is, I think, a common misconception, again, driven by a lot of the exaggerated statistics coming out of the Magnificent Seven market, which is a huge net cash area of the of the large cap sphere, small caps actually have less leverage than large caps overall. So in a buyer for longer rate environment, small caps actually should be in a relatively good place to be able to handle that. The one caveat, obviously, is in a higher for longer rate environment, you you need pricing power, and that’s something that we spend a lot of time trying to identify. And start by identifying those stocks with a high ROE or an improving high and an improving roe. And indeed, you’ve got to be careful in terms of the valuation you’re paying, because the cost of capital, of course, matters again. So for us, those those two things are critical when we’re selecting our stocks, but for the asset class as a whole. Think small caps are actually in a good place with regards to higher for longer.
Wouter Klijn 13:05
Yeah, that access for capital is quite important for small caps. And it made me think as well, we’ve seen sort of conversations around companies staying private for longer, taking longer to go to a list on the on the market, particularly sort of during the low interest rate environment. Has that changed the small cap universe at all? Has that had an impact at the margin?
Richard Brown 13:31
Is what I would say there. And undoubtedly, stocks are staying private for longer, VC funding in that space, particularly in the tech area of the market, that is a phenomenon that that has continued, and at the margin, that is a niggle and the frustration, because some of those stocks might present quite interesting stock opportunities for your diligent stock picker. What I would say is it, it matters even less for us, I think, and that is, a lot of those stocks are stocks. Probably we wouldn’t be particularly attracted to we’re looking for companies with a very long history of profitability, very consistent operational performance, and a lot of that funding and stocks staying private like I say, come from more the sort of unicorn type stocks that we see out of the tech area of the market, so probably stocks that would interest us a little bit less than and the other thing that I would say on the matter is, and you know, I’ve heard this narrative a few times. I’ve wondered if it’s being pushed a lot more by VC or private equity rather than your your average listed small cap manager. But look, there’s 4000 stocks in our investment universe. The fact that a few more aren’t coming to that market isn’t really meaningfully reducing the number of stocks that we can go out and find that look very interesting and priced in effectively. So no, I think you know, it’s a niggle at the margin, but not something that particularly frustrates us.
Wouter Klijn 14:58
So you mentioned the importance of profitability. Does that mean you avoid unprofitable companies? Or are there some selective opportunities? There?
Richard Brown 15:07
No, that’s right. So we do. We avoid unprofitable companies, which has become an increasing influence, especially with regards to our US allocations. Right now, at this moment in time, roughly 30% of US small cap. Yet, you heard that right? 33 0% of the US small cap market is it’s got negative, negative EPS over the course of the last two calendar years. So that’s quite concentrated in a couple of sectors, healthcare, biotech and tech. And there’s many a good manager that will go into that area and pick the winners, those ones that are going to turn from negative earnings growth up to 100 baggers because they’ve put a sensational turnaround in or found a wonderful new drug. But that’s just not something that we think our skill set is well aligned to. Is the truth. And if you look back through history, those companies with strong operating cash flows over the long term have tended to outperform the average stock with all cash generation. So for us, it’s an area that we avoided, and continue to avoid now, in truth, that does present one risk to us and one risk to our strategy, and one that we’re always keen to highlight to anyone that wants to invest with us. And that is, you know, if we do see rates going back to zero, this cohort stocks is probably one that’s going to perform quite nicely, so we’ve got to be aware of that. It’s something that we’ve got to watch in the market as it comes through. But over most market cycles, I think you’re going to be paid to avoid that area of the market in general.
Wouter Klijn 16:38
Yeah, fair enough. What about the merchant acquisition activity in the market? Obviously, that that has some potential to unlock value also takes companies out of the small cap space. What are your thoughts around that? Are we moving forward with it?
Richard Brown 16:55
Yeah, this, this has been an area that’s been, I think, relatively subdued in recent years, but there’s still been a persistent tail. Tailwind for the area. You know, just by the simple arithmetic of small caps, there’s many, many more buyers of the stocks I own versus, you know, no one’s going to be able to buy in video of this world. So by that sort of, you know, just pure maths means that the small cap area of the market is going to continue to continue to benefit from this, but it’s benefited less over the course of the last few years. You know, CEOs CFOs haven’t been, or haven’t had the confidence. You know, they’ve just seen their their funding go through the roof, so the first thing they think about isn’t going out and making a new acquisition at that point in time. So again, it’s linked to the, you know, the two catalysts I described earlier on for the small cap asset class as a whole. If, you know, we see a bit more clarity on rates, or indeed, rates coming down a little or more, you know, confidence on the cycle as a whole. I think you see that that boardroom confidence increase as well. And M A activity improved. And in truth, through, you know, we’ve been running this global small cap strategy for six years now, we’ve actually been a little bit surprised by how fewer stocks we’ve owned have been taken out. If you think about what we’re looking for, we’re looking for high return businesses trading on sensible or attractive valuations with decent balance sheets, and you think that would be a list of requirements quite high up on the agenda for private equity firms, other industrial buyers, etc. So my view there is that it’s just one of those phenomenons that you struggle to explain, and elastic band will bounce back at some point over the course of the next few years. So yeah, we think that we’re we think that that’s on its way back, and we’d certainly be benefits of that in this space?
Wouter Klijn 18:41
Yeah, yeah. Fair enough. Now, one topic that everybody seems to be talking about is artificial intelligence AI. And I was recently at an event where I was told that out of the venture capital deals today, 60% are taking place that include an element of AI, or are in the sector of AI. Is this an indication for what might happen in small cap space? Does it filter through as sort of, you know, are we going to just see this whole rest of AI companies coming through in small cap space?
Richard Brown 19:12
Yeah, well, those that don’t stay in private hands for too long for us to get our hands on them. I think that’s right. But in truth, you know, I look at that, that VC funding cycle that you see there, and I actually use that more as a gauge of excitement levels within markets, or are we indeed reaching bubble levels. It doesn’t quite feel like it yet, but you know that used to play out in terms of listed market valuations in the tech space, but now it largely plays out in terms of these funding rounds we see in Silicon Valley. For me, though, AI is more interesting for small cap, actually in a slightly different way. So first of all, there’s the AI capex splurge that we’re seeing now in data centres. And small cap are certainly participating that in that, not in the same way as a meta. Or Microsoft or or indeed, an Nvidia, but we own a number of stocks that are heating and ventilation providers, construction providers, fibre optics, all things that are going into these data centres, and they’ve seen a step change in their growth, and that looks very much set, set to continue. So that’s kind of the first wave of AI influence on small cap and on our strategy. But the second wave, I think, is actually probably a little bit more interesting, and that is the integration of AI into a lot of these business models. And their small caps are of a size that they’re able to be a little bit more nimble. They can be a little bit quicker to market in some things sometimes, and that, I think is going to drive a lot of operational efficiencies at these companies, but also revenue growth in a number of new areas. And maybe, if I were to just throw one stat around that, which I think is an interesting one, if you look at the US market today, the margins on us, small caps is around 6% if you compare that to us, large cap, it’s mid to high teens, say, around the 16% mark. Now if you apply an AI efficiency gain of, say, 200 basis points, okay, bit of labour arbitrage there. In general, you’re going to boost margins by 200 basis points. If you boost a 6% margin by 200 basis points, that equates to 33% earnings growth. If you apply the same to a 16% margin, you’re seeing a far smaller impact on on on earnings overall. So the fact that small caps are very labour intensive, they are lower margin at this point in time puts them in a good place to benefit from the AI efficiencies that should come through over the course of the next few years.
Wouter Klijn 21:45
Is there any indication of that already happening? Do you see companies where they have led to substantial productivity gains? And I’m asking that because there has been a recent MIT report where they looked into investment into AI, and it’s sort of at a high level, concluded that 95% of investments are just not adding any value. And think like, wow, that’s, that’s a lot of wasted money, but it’s, you know, what’s, what’s the picture in the small cap space? Yeah.
Richard Brown 22:15
So what I would say is we get a clearer picture from driving revenue growth of new products at this point in time, you’re asked to take a bit of a leap from the efficiency side. But looking at how I personally have started integrating copilot into my day to day, I think there are certainly, for me increasing use cases of efficiency gauge throughout my day. And you know, I think that’s going to play out in a number of different ways for almost every company within the market, but to give you a few examples, maybe, of the sort of growth side of the equation where AI has been integrated, I think these can be quite interesting and quite informative. So we own a stock over in the US called Doximity, which is effectively the LinkedIn for doctors or physicians. And quite often, when I mention this stock on LinkedIn, I get a bit of a mixed response, because I think, yeah, it’s bit like ma might either love it or hate it on LinkedIn, but it’s proven incredibly popular over in the US with with physicians over there a lot, because a lot of these doctors work across a number of different hospitals, so it’s nice to have all of their credentials just in one place, so a patient can look it up and and see what this doctor is particularly good at. And also, you know, as a doctor, you can sign up to particular news feed. So if you’re an eye doctor, for example, you can, I don’t know what an an eye doctor news feed looks like.
Wouter Klijn 23:35
I think the feed has very small lettering.
Richard Brown 23:40
Yes, but where’s where AI is really interesting for these guys is that they’ve started selling to the doctor community in the US a AI bot that can effectively help manage their time. And it’s in ways that at the moment, a lot of doctors are wasting their time with administrative duties. So the very obvious example is insurance forms in the US, if you’re a doctor and you want to treat someone that is normally accompanied with a very complicated, long insurance form that they need to fill out. And as the CEO of the company puts worse, you know, AI isn’t yet any good at writing a very interesting novel that you want to sit down and read, but it is absolutely fantastic at filling in insurance forms for for doctors. And you know, if you’re a doctor, you certainly haven’t become one to fill in forms. So they’re delighted. Also means that they’re able to see more patients each day. And you know, since they launched this product last year, you’ve actually seen a 20% jump in growth of that particular segment within their business over the course of last year. Maybe a slightly different example comes from, again, another US stock called oddity technology, and they are an online beauty company. So think of makeup and wellness products, and what they’ve done very successfully is built in a sort of person. Personalised shopper AI bot into their their offering, which, you know, we’re beginning to see more and more from a number of consumer retailers online, but they’ve done it particularly well in that, you will go on, and I’ve, I’ve tested this. I’m not normally a buyer of these products, but I’ve gone on and tested this. And, you know, they ask, you know, when does your skin when do you get skin breakouts? When are you feeling particularly tired. You know, it’s a bit of a an agony. On talking to you about all of the sort of aches and pains and woes your feeling with regards to your skincare, etc, and then they direct you to a very bespoke and specific product that is going to be going to be best suited for you. And again, the growth that you’ve seen from that company has been fantastic, even at a time where, actually, especially this year, this year, the US consumer, has been brought into question a few times and and also, you know, the broader beauty category has been been quite a tough one for a number of other operators. So it’s a really good example, I think, of AI integration, but also the ability of, you know, if you, if you get the right stock, you can, you can still earn some really attractive returns back in broader sectoral or segment trends.
Wouter Klijn 26:04
Yeah, I think the example of the shop bot, it sort of makes sense, because there’s sort of a low risk to things going wrong, right? If it recommends the wrong product, then, oh well, you just return it. But the example that you gave about the doctors and filling in of the insurance forms that seems to be a little bit more higher risk, because you can’t get that wrong. It needs to be very specific, and we all know that some of these language models hallucinate a little bit. You don’t want to have that happen on an insurance contract. How do you sort of set safeguards around it? Or how does the company do that?
Richard Brown 26:45
Yeah, and like you say, we’ve all got that funky reply out of chatgpt or copilot, or whichever one you’ve you’ve been deciding to use, and there probably will be, and undoubtedly will be, hiccups along the way on these things. It’s where you’ve got to take a view on management and the quality of their implementation. And this is where we not only lean on our vast regional network of fund managers and analysts in the US, in Europe, in Asia, in Japan, visiting the Australian market to meet CEOs and CFOs all the time, and sit down and discuss topics like that with them, understand the due diligence that’s been going on in the background, but also, you know, leaning into their track records and seeing, you know, like I say, we are not buying speculative stocks that are selling us a dream, but are sitting there, you know, Not, not making any money. We’re we’re we’re wanting to invest in those companies that have already built our trust by delivering very strong and stable return profiles over the course of many years. So it’s really a combination of all of those things, but I would say sitting across the table from a CEO or CFO is vital in getting those insights in terms of safeguards and the management of those risks, not just in AI, but across a plethora of different topics within the businesses.
Wouter Klijn 28:09
Is there also any opportunities on sort of the energy supply side, because there’s a lot of energy needed for AI, but they tend to be more larger utilities. Are there any sort of companies that maybe deliver special cables, or is there any opportunities in that space?
Richard Brown 28:26
Yeah, so we’ve got some cabling and some energy infrastructure names. We’ve particularly added one in the early part of this year. Actually, that’s more Germany facing because we’re in the process of seeing a big fiscal splurge from Germany over the course of the next few years, and a lot of that will go into energy infrastructure networks, and that company certainly seems well placed with in that regard. But we also own another stock, again, based in Europe, that does the linings of LNG vessels. So basically, if you want to fill up a ship full of natural gas, you’ve got to make sure that you don’t have any leaks, and there’s quite a lot that goes into the technology to ensure that. And this company is effectively, although they don’t admit it, got a 100% market share of that market worldwide. They say something like 90% I think just through fear of the regulator seeing that 100 number. And again, what have we seen there? We’ve seen a big boost in the LNG market on the back of Europe trying to wean itself off of Russian gas and having to source it from elsewhere. So there’s there’s elements of that within the energy market, and we’re always keen to find those sort of idiosyncratic stock stories beyond just buying a commodity price. But I’d say for the small cap market overall, it’s a relatively small portion of, small portion of our market, and a small portion of our strategy as well.
Wouter Klijn 29:47
Yeah, yeah, that’s interesting about the LNG company. I mean, maybe from a regulator point of view, that would be a problem. But what’s the point of breaking up a small cap, right? It’s already small cap.
Richard Brown 29:56
So exactly, and, and, to be honest, if you’re commissioning. A fuel commissioning a large boat for construction. Are you going to choose the lining specialist the first time they want to try this thing when it’s going to cost you hundreds of millions of pounds to build this thing? Probably not, and your insurer probably wouldn’t let you either. So no, they’re they’re in pretty good shape, those guys.
Wouter Klijn 30:18
So if we look a little bit that sort of regional divisions. It seemed that in recent Well, probably last year, European and Japanese small caps seem to have done quite well. What’s your sense of what’s going on there? Why did they outperform?
Richard Brown 30:35
Yeah, so we’ve seen, like you say, quite stark regional performance after a multi year period of US dominance. What has been the trigger for that? Well, in Europe, I mentioned earlier on the fact that Germany are turning the tax on with regards to fiscal expansion. And to be honest, when you look around at the developed world, Germany has been the dramatic outlier in terms of their their their budget over the course of the last few decades for long held cultural and cultural reasons there, but you know, under immense pressure, you’re seeing Germany and Europe push through reform fiscal in Germany, but also a large degree of deregulation across the rest of the European bloc. And Europe has always traded on quite a significant discount versus other developed markets. So as soon as you reach that point, you only need a small piece of good news to see investors come back and start saying, well, actually, it’s a very low valuation. If things do improve here, then there’s some very attractive returns on offer. So you’ve seen investors come back to that region. We’ve seen many a full storm with regards to Europe, so they’re certainly not out of the woods yet. But, you know, in terms of not letting a good crisis go to waste, we’ve heard a lot of good news out of the region in terms of, you know, trying to turn around what have been pretty anaemic growth there for many a year on the Japanese side, it’s, you know, a slightly different story, and that, you know, you’ve seen that big governance change in governance structure drive there over the course of the last few years, but the sort of more recent Catalyst has been the fact that we’re seeing wage growth come through, and that’s making everyone quite excited about domestic consumption there. And that’s normally when you see small caps perform quite nicely because of domestic their revenues are and at times, a little bit more consumer orientated than than their large cap peers. So you’ve kind of seen Japan sort of push through through the second quarter, and then actually, if we look over the last month, it’s actually been the US market that’s actually started to outperform again. Just as you know, you’ve seen slightly better economic data out of the US. You’ve seen trade negotiations largely Go, go in the right direction, and, and, and, and you see the US small cap market start to perform there. And really it’s just as you list that sort of merry go round that we’ve seen this year as a sort of service, as a good reminder for for us in terms of how to manage this risk. And what we really try and do is is ignore all of that and. And and, what do I mean by that? I mean we run a region neutral portfolio. Okay, so 60% of our indexes in the US, you’re always going to find 60% of our strategy in the US, about 17% in Europe. You’ll find 17% of our strategy in Europe. And that’s because you quite get, often get these swings in in in regional sentiment, it is not our edge to determine how sustainable they are. We think if we tried, we’d probably get it quite wrong. Actually, where we think that we’re good is identifying these interesting small caps within each region. So let’s not play that game. Let’s have a region neutral portfolio and just just try and let the stock picking do the talking rather than any sort of top down view on on regions?
Wouter Klijn 33:46
Yeah, yeah. And in terms of sectors, we talked a little bit about AI, but are there any particular sectors that look attractive at the moment, I sort of heard a lot of talk about healthcare, but at the same time, we’ve seen some large cap healthcare stocks that have done absolutely dismal. But what is sort of going on in that space?
Richard Brown 34:08
Yeah, so healthcare has kind of split into a little bit in the small cap space. In terms of, there is a large portion of sort of biotech related names, however, for us on our team specifically, you know, coming back to and I’m sounding quite boring here, but that’s probably good, because the sort of boring consistency of how we approach the market is kind of, I think, our edge actually, in our discipline there, we’re looking for those names that have performed very consistently over a long period of time that is under appreciated by the market. So you know, as soon as you’re running a sort of systematic model along those lines, large parts of the healthcare small cap space don’t really screen particularly attractively to us, where much more is about, you know, the getting the next drug right, rather than, you know, assessing its its historic return profile for us in terms of what sectors look attractive. Well, again, we’ve large run largely as. Sector neutral portfolio, because we don’t like to play this game all that much. But naturally, when you’re a bottom up stock picker, you do find an aggregation of those stocks coming in particular areas. So we’re overweight the industrials area at the moment. That includes many a sub industry, and there’s some low beta stocks alongside the sort of high beta stocks that you would think synonymous with, with the industrial sphere. And then our only meaningful underway actually comes from the real estate sector, REITs, which is probably the biggest contradiction in our positioning right now, in that, you know, you push, pushed me earlier on, on, you know, do I think rates are going up or down in the next year? And you know, the broad consensus across the team is that we’re probably more likely to see rate cuts than rate hikes. And with that in mind, you know, REITs have kind of been at the epicentre of underperforming as rates have gone up. They should benefit as rates are coming back down, but we’ve done a lot of work in that space, and very consistently when we put our most favourite stocks in that space up against the other stocks that we have in the strategy right now, they come out as a very distant second place. So for that reason, we’ve, we’ve continued to run with that underweight positioning, but they’re really the two main sectors where we’re taking a bet.
Wouter Klijn 36:14
So Is that related that on the way to reach is that related to the discussion whether REITs are actually equities or property, which, you know, I’ve heard an answer to, but I’ll let you answer it first.
Richard Brown 36:25
Yeah. I mean, it’s the classic, classic debate, isn’t it? I mean, the truth is, I don’t feel particularly strongly on in either direction. What really determines our investment universe is, is our index. We do that so that our clients have a very strong idea of the characteristics we should have dictated by the universe that is dictated to us by MSCI, and MSCI puts, puts, REITs into our listed space. So I’ll sit on that side of the fence for now. But it’s not, it’s not an area that I feel particularly emotional about I think, etc,
Wouter Klijn 37:03
Yeah, the answer I heard is that in the short term, it’s it’s equity, in a long term, it’s property. But I don’t know if that’s true. Maybe I might put you on the spot here, but if you think about the investment process, can you give an example of a company that initially looked interesting but then didn’t make it through the due diligence for for particular reasons?
Richard Brown 37:28
Yeah, sure. And maybe, maybe just for the listeners, it’s worth explaining that on on our strategy, we’ve we’ve got a proprietary screening model that is very systematic, and, you know, incorporates many of the features I’ve discussed already. Around are we paying an attractive valuation? But the second level is really these regional teams meeting CEOs and CFOs all the time. And in truth, their input is is invaluable, because there’s only so much you can learn from historic report and accounts, and it comes in many different forms. But I guess one, well, a few recent examples, maybe so. An Italian industrial company was screaming value at the top of our screen. We think this looks very interesting from its return profile. It’s trading far too cheaply. We then have our meeting with our regional team. We do the work on it. And what becomes very apparent very quickly is this, this, this company is very reliant on one very large client in the Middle East, in Saudi one, one big project that they’ve been involved with there. So the potential for re rating there, and the potential for that return profile continuing, you know, was heavily reliant on, just on huge concentration risk from a from a client point of view. So that’s one that we decided to pass on and move on with that regard. Another, I think, interesting example, which is slightly different is that one of our stocks was subject to the short sellers report by a short seller called fuzzy Panda, which really tells you everything you need to know about capital markets. Today, the company was forced to post a riposte against fuzzy panda. This was an online educational company roughly this time last year, in fact, where, you know, if we were running it purely on a screening based model, without that regional team’s input, probably would have sold it immediately, you know, given the uncertainty that that brought about. However, our team there had a long running history with the management there met with them very briefly after this short sellers report, went through every line item of the short sellers report and debunked all of the the challenges to the investment thesis they report back to to to us, and we retain the position, and it’s been one of the strongest performers for us over the course of the last 12 or 18 months. So yeah, that qualitative input, that interaction with management, especially in the small cap space, is is truly invaluable to us. And the sort of hybrid of. Approach of a systematic screen with this qualitative input, something that we think is quite compelling.
Wouter Klijn 40:07
Yeah, that name Fuzzy Panda reminded me a little bit of, like, you know, the names that you see on Reddit and platforms like that, and that made me think of meme stocks has that impacted the small cap space much? Because, I suppose with large cap, you don’t quickly turn that into a meme, but small caps maybe a little bit more.
Richard Brown 40:27
Yeah, again, I would say largely at the margin is the truth there and and again, you’re going to get a sense of how boring we are. We just kind of carry on doing what we’re doing and ignore anything that’s going on like that, because normally, once something’s remotely close to a meme stock, it’s trading on a valuation that’s probably about 50 times higher than where we would actually feel it’s all comfortable. So yeah, you know, we’ve seen that, and you’ve seen that play out in terms of the financial press, but in terms of our day to day, we just kind of plod along and ignore that and carry on with our nitty
Wouter Klijn 41:00
Fair enough, well, and as an asset owner, once told me, I want my invested managers to be very boring and that I can do the same thing over and over again and do it well. So that’s not a negative in that sense.
Richard Brown 41:11
Well, in an industry where very little is guaranteed, I can guarantee the boring, dull discipline that we will pin for the small cap market. So that interests you, please. Yeah, get in context.
Wouter Klijn 41:23
So while I if you here as a small cap specialist, I thought I asked you to finish up a couple of questions about the Australian market as well, because the small cap factor is pretty much well documented in academic literature, very many successful funds, but it seems to be absent from the Australian market. There seems to be no small cap premium here. What do you think is going on there? Yeah.
Richard Brown 41:48
Well, you know, if I, if I look at the MSCI indices, and we quite often do on on, on a regional basis, actually, I would say that the Australian market hasn’t followed all that dissimilar path to what we’ve seen elsewhere. You know, pre 2020 there was a small, small, small cap premium from a from a valuation point of view, but that’s, that’s that’s largely evaporated since 2020 and I think especially so in the Australian market. I’m not sure if I can offer too many conclusions there as to exactly what’s driving that, but all I would say to listeners, is it’s a market where we’ve quite very consistently found names that we find quite attractive. It’s not an area we’ve been overweight like I say. We tend to operate on a largely region neutral basis, but it’s one where we haven’t struggled to fill our Australian portion in a number of sort of recycling through a number of the banks that we’ve seen there, some of the metals and materials names, but a coffee manufacturer, but also, you know, the great Australian institution that is JB Hi Fi, has been one of the strongest performers for us over the course of the last few years. No, I don’t place the Aussie market in an outlier in that regard, and like I say, is one that’s that’s been quite good to us, so hopefully that continues.
Wouter Klijn 43:03
Excellent, excellent. Well, Richard, thank you very much for your time. It was great talking to you.
43:08
Thank you very much. Take care.