Conventional wisdom says that small caps are an easier investment bet than bigger companies because they have simpler business models and are less covered by analysts, Bassett told FSA on a recent trip to Hong Kong.
“Small caps are in fact more difficult, more volatile, with management teams who are less skilled or thoughtful about things and about how investors will perceive them.
“So we are constantly fighting little fires and the share prices react significantly. It’s not uncommon with an earnings report or acquisition to have the share price react 15-20% in a day or week. We don’t see that as much in large caps.”
Bassett, who also manages the firm’s North American Smaller Companies Fund, said one big risk for North American small caps is high valuations in certain segments. For example, technology and biotech small cap companies have “unsustainable valuations.
“The markets bid them up, overpricing the consistency of growth. If there are any issues around investor confidence, they would come under pressure.”
The second concern is inflation. He said in two years, the environment will be more inflationary due to trade policies and rising interest rates. Therefore, economic growth is likely to slow. “That would not be great for corporate profit margins.”
US dollar strength is also an issue, but mainly for larger companies with overseas operations and US dollar revenues, he said.
“For companies on the [Russell 2000] small cap index, only 20% of revenues on average are sourced overseas.”
However, the tariffs resulting from the US-China trade spat will have an “equal if not greater” impact on small caps than on larger companies, he said. This is due to lower Ebitda margins for North American small caps, which are on average 12% versus 20% for large companies.
“Tariffs will have an outsized impact on profitability despite small caps having lower exposure to overseas revenues.”
Energy sector exit
The fund is fairly concentrated with 51 holdings. Companies have a market cap under $5bn. The top two positions are bio-pharma company Emergent Bio Solutions (3.2%) and payroll software company Paylocity Holding (2.9%).
Recent changes to allocation include trimming down weight in industrial sector small caps.
“We think industrials are most exposed to inflationary pressures. A lot of them have also seen sizeable moves in the share price and we are concerned about sustainability of growth.”
He sold out of the energy sector a few years ago.
“Energy companies had a tough time. When Ebitda compresses by 90%, leverage becomes apparent. We learned lessons. We’re against the pairing of financial risk and operating leverage together. When the cycle turns that becomes nasty and lends higher volatility to earnings streams.”
To select investments, most of the time is spent with company management teams, understanding and analysing their business, he said. Then quantitative and qualitative analysis is applied. Overlying it all are thoughts on valuation.
ASI also has a responsible investing component to the screening process that gives a look beyond fundamentals, according to Bassett.
“They teach us how to pick up on more subtle cues – are appropriate controls in place, are small cap banks investing enough in cybersecurity, who are company vendors and how do they manage them.
“Nothing is foolproof and the companies could lie to us. But at least we are asking these questions.”
Bassett believes the fund is more concentrated than peer funds.
“Bigger peer funds manage small caps with $10bn-$15bn [in market capitalisation] with 200-300 holdings. That’s difficult to do as an active manager.”
North American Smaller Companies Fund vs the benchmark and sector
“If you’re thinking about how alpha is delivered, we have not been able to keep up with the market since starting the strategy,” Bassett admitted.
“But when there are drawdowns in the market, we preserve capital exceedingly well. We focus on better balance sheets and high quality business models. That consistency of growth over time outperforms the market.”
