Selection Matters in Small-Caps

SUMMARY

• Rising rates appear to have negatively affected small-cap Financials, Healthcare, and Technology stocks.
• Conversely, reflation may benefit smaller Industrial companies.
• Looking at small-caps from the bottom up confirms our cautious top-down view.

In last week’s Strategic View we explained our preference for large-cap over small-cap equities. This week we are taking a deeper dive into small-caps, comparing four different sectors: Financials, Technology, Healthcare, and Industrials. The findings are consistent with our cautious macro view on small-caps and strengthens our conviction not to invest broadly in them currently.

Financials: Rising Rates and Negative Feedback Loops for Regional Banks

As discussed in our top-down analysis last week, rising interest rates have created a negative feedback loop for smaller financial companies. Looking at Chart 1 below, we see relative performance between small regional and large diversified banks on the left-hand axis and the inverse (lower means rising rates) of the Fed Funds Rate on the right-hand axis. While small-cap banks were able to outperform during the first couple of hikes, once the market understood that the Fed was going to continue their rate hikes, you can see the underperformance of small, regional banks to their large-cap peers begin.

Looking at the mechanics of this feedback loop more closely:

Step 1: Rising rates slows lending. Smaller banks have large Treasury and Mortgage holdings that have significant unrealized losses from the sharp increase in interest rates. Due to accounting rules, banks are able to avoid realizing those losses if they hold the bonds to maturity, which helps with solvency issues but clogs up balance sheets and restricts lending.

Step 2: Slower lending puts pressure on borrowers. Lending restrictions create a ripple effect, by which some companies that need capital cannot access it or cannot afford it. This combination of higher rates and restricted access to capital increases the risk of default on loans.

Step 3: Rising defaults slow loans further. The increased default risk forces banks to raise their loan loss provisions, which in turn creates additional stress on the small banks’ balance sheets, which then repeats the feedback loop.

While these macro factors also affect larger banks, they have a higher percentage of their revenue and profit coming from securitization of loans and other non-interest rate related activities, like trading, asset management, and investment banking. These are all activities that are less exposed to interest rates. Thus, we believe larger banks adapt to rising rates better than smaller ones.

Technology: Large Tech Companies Often Have a Moat, Smaller Ones Often Don’t

When comparing small and large technology companies, we believe that the companies with the most favorable economic profitability and widest economic ‘moats’ are much more prevalent in the large-cap space. A ‘moat’ is a sustainable competitive advantage that a company or industry has that allows it to remain profitable for an extended period. For technology, the moats that we believe make certain large-cap companies so profitable are:

• Free Cash Flow: In a higher interest rate environment, where capital is constrained, the large amounts of ‘free cash flow’ (cash left over after paying for operating expenses and capital expenditures) generated by mega-cap technology companies becomes more attractive. These cash flows allow them to return capital to shareholders, acquire emerging competitor technologies in their infancy, and continue to invest in innovation and research and development (R&D) to maintain their position over time, without having to enter capital markets.
• Staple-like Spend: Mega-cap tech companies tend to have large installed customer bases that the tech company can easily up-sell into.
• Attractive organic growth: Mega-caps also tend to have higher exposure to high growth areas such as artificial intelligence (AI) and the Public Cloud than smaller ones, in our view.

While these companies are more abundant within the large-cap technology sector, not every large-cap technology company fits the bill. Instead, we believe that this is a space where security selection is important, which we outlined in our Strategic View on 2/21/24.

Healthcare: Prefer Larger Firms with Diversified Pipelines Over Smaller, Riskier Biotechs

Like technology, larger healthcare companies have well-capitalized balance sheets that we believe are the key to their performance moving forward. Larger healthcare companies can afford to make big R&D investments to drive innovation, which in turn fuels earnings growth. As an example of why this is harder for small-cap healthcare companies than large, diversified ones, consider some of the challenges for a small biotech pharmaceutical company:

• Higher borrowing rates: As discussed above, small-cap companies face higher costs when borrowing. This is a particularly big headwind for smaller biotech companies, due to the capital-intensive nature of their business.
• High capital requirements: The cost of getting a new drug to the market can often be close to a billion dollars. Larger companies tend to have more free cash flow to cover this expense versus smaller ones.
• Clinical trial and pipeline risk: Smaller companies tend to be highly dependent on single products and their clinical trial success, while larger companies have more room for failure due to more diversified pipelines.

Just like a diversified portfolio can help an investor limit losses in any one segment, larger healthcare companies’ inherent diversification of pipeline and product allows them to better weather an adverse outcome in any one investment they make.

The Exception to the Rule: Small-Cap Industrials Are Attractive, in our View.

In our view, a macro environment of elevated but stable inflation is attractive for cyclical business models. Inflation allows industrial companies to raise prices, which drives companies’ revenues, while their cost structure is more fixed. In such environments cyclical companies are likely to experience a ramp up in their returns to shareholders as revenue accelerates against a fixed cost base – we call this operating leverage. This is the ultimate driver of value companies beating growth companies. When comparing large- and small-cap industrials, we see a few dominant themes:

• Focus: In an inflationary environment, we prefer the singular scope of smaller Industrials, relative to their large-cap peers. This is because large-cap companies tend to have more, often unrelated, business lines. This results in additional overhead, making it more difficult for them to take full advantage of operating leverage in the current environment.
• Cost Structure: Small-cap industrials tend to have a more straightforward cost structure with fewer "service" business lines, which tend to have higher variable costs. Fixed cost structures have worked against them in the low growth environment of the last decade, but we believe they will help them in our most likely economic scenario going forward.

Because of these two features, we believe that small-cap industrials can utilize inflation-driven revenues to generate profits more effectively than large-cap industrials.

Conclusion: Bottom-up View Confirms What We See From the Top-Down

At RiverFront, we often discuss how we blend top-down ‘macro’ research with bottom-up ‘micro’ research; this week’s discussion of small-cap equities is a good example of this integrated approach. Our top-down team first identified issues with the macroeconomic landscape for small-cap investing. From there, our bottom-up team began analyzing companies in this space. This company-specific research was to ensure our team had a complete picture when making investment decisions. It turned out in this case that our micro views of small-cap companies lined up with our macro views on the economy in most areas. However, we were able to identify an opportunity in small-cap industrials as an attractive investment and have positioned our longer-horizon portfolios accordingly.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Small-, mid- and micro-cap companies may be hindered as a result of limited resources or less diverse products or services and have therefore historically been more volatile than the stocks of larger, more established companies. Please see the end of this publication for more disclosures.