Small-cap value strategies make big comeback

Tony Thomas, senior manager research analyst for equity strategies at Morningstar in Chicago, said in a phone interview that at “this point last year, it (small-cap value) was probably the ugliest segment of the market. Now, it’s the hottest sector.”

In fact, from 2017 through 2020, small-cap value “was the weakest segment,” Mr. Thomas said. “They had a long period of significant underperformance.”

For the year ended Sept. 30, the Russell 2000 index returned 47.6%, while the Russell 2000 Value index returned 63.9% during that same period.

Mr. Thomas explained that a number of these small-cap value strategies “have significant exposure to energy, and with improving oil prices and improving oil demand, that’s benefited these managers.” He added that “meme stocks” like GameStop “have (also) helped some of these strategies.”

Small-cap value stocks include a “heavily cyclical segment of the market,” with “a lot of financials and small retailers in there; areas that were badly beaten up last year,” the Morningstar analyst added.

“If there was a segment in the market that was cheaper last year, it was in small value,” Mr. Thomas said. “So, investors are seeing an opportunity.”

For the year ended Sept. 30, the median return for overall blend strategies was 48.28% in Morningstar’s universe, while value strategies returned a median 41.42%. The Russell 3000 Value index returned 36.6%. Growth strategies, as measured by Morningstar, returned a median 31.41%.

For the second consecutive quarter, DOMO Capital Management LLC topped the list of the best-performing domestic equity managers. For the year ended Sept. 30, the Germantown, Wis.-based manager’s Concentrated All Cap Value strategy returned a gross 136.24%.

David Ribbens, a partner at DOMO Capital, said that with this strategy, the firm seeks to retain a concentrated portfolio.

“We’re opportunistic buyers,” he said. “There’s been a bit of a rotation to value. We’ve seen over this past year more investor interest in beaten-up names that don’t deserve their low valuations.”

United Natural Foods Inc., a Providence, R.I.-based natural and organic food company, was a big contributor to the strategy’s performance, he said. DOMO Capital sold its position within the food supplier and redeployed the proceeds.

“COVID turned out to be a tailwind for groceries, since people stopped going to restaurants,” Mr. Ribbens said.

Old West Investment Management LLC’s Small Cap and All Cap Opportunity strategies ranked second and fourth on the list, respectively, returning a gross 115.35% and 107.7%, respectively.

Joseph Boskovich Jr., co-founder and partner of the Los Angeles-based manager, attributed the strategies’ strong performances to metals and the uranium mining space, both of which saw a huge demand “because of the clean energy revolution.”

Mr. Boskovich said: “We built a position in uranium mining three-and-a-half, four years ago, which has performed phenomenally,”

Uranium mining and nuclear fuel stocks that did particularly well in Old West’s strategies included Cameco Corp., Saskatoon, Saskatchewan; Energy Fuels Inc., Lakewood, Colo.; NexGen Energy Ltd., Vancouver; and Centrus Energy Corp., Bethesda, Md.

The firm also identified companies led by management teams “that have great records of capital allocation and buy their own stock, so the management (teams) have more to gain or lose than from compensation,” Mr. Boskovich added.

Those holdings that performed well during this period included WildBrain Ltd., a Halifax-based media, production and brand licensing company; Fulgent Genetics Inc., a Temple City, Calif.-based genetics testing firm; Zedge Inc., a New York-based content distribution firm; and St. Joe Co., a Watersound, Fla.-based land development company.

Vulcan Value Partners LLC, Birmingham, Ala., had the third-ranked strategy for the year ended Sept. 30. Its Small Cap Equity strategy had a gross return of 109.22% for the period.

C.T. Fitzpatrick, founder, CEO and chief investment officer of Vulcan Value Partners, said the firm seeks “companies that have inherently stable values over the long term, with strong balance sheets.”

“It’s all security selection,” Mr. Fitzpatrick said. “We didn’t overweight to this industry or that. We’re bottom-up people. The building blocks are the businesses themselves.”

He said the top two contributors to the strategy’s success were Upstart Holdings Inc., a San Mateo, Calif.-based consumer lending company, which was “really discounted compared to its potential”; and Park Hotels & Resorts Inc., a Tysons, Va.-based REIT, which Vulcan bought at “an enormous discount.”

And while these firms may not seem to be alike in obvious ways, the Vulcan chief executive explained that they do share some essential attributes.

“They have stable values, a lot of free cash flow, sustainable competitive advantages and are managed by really good people,” Mr. Fitzpatrick said.

The manager also owns several real estate service companies, that provide sales, leasing and advisory services and property management, that have done well, since they don’t own assets and can pivot, such as Cushman & Wakefield PLC, Jones Lang LaSalle Inc., and Colliers International Group PLC.
“They took a cyclical hit during the pandemic, but we thought people would continue to need apartments and warehouses, and that over the long term these businesses could skim the cream off the top of the real estate sector,” he said.

The firm also sold positions in the following three companies: office furniture manufacturer Noel Furniture, laser manufacturer Coherent Inc., and British aerospace company Meggitt PLC.

“We bought Noel, Coherent and Meggitt at 50 cents on the dollar or better, then sold (at) 100 cents on the dollar or better,” Mr. Fitzpatrick. Kennedy Capital Management Inc. had strategies that came in fifth and sixth on the list for the one-year period. The St. Louis-based manager’s Bank Sector strategy returned a gross 106.13% for the year ended Sept. 30, while its Micro Cap Emerging Growth strategy returned a gross 105.86%.

Although Donald Cobin, president, chairman and CEO of Kennedy Capital Management, declined to point out any specific holdings within the strategies that performed well, he explained that the firm’s bank sector strategy tends “to follow underfollowed, unknown banks that are more on the micro and small end of the spectrum.”

The strategy also looks for “banks moving into specialized services, so the payment space, credit cards and banking as a service,” Mr. Cobin said in an interview.

For the Micro Cap strategy, the sectors that outperformed during the 12-month period included health care, technology, industrials, materials, financial services and real estate, he said.

“Both of these strategies tend to follow underfollowed opportunities, so they’re not beholden to cyclicity or strategic shifts in the market,” Mr. Cobin said.

In the same interview, Anil Thomas, managing director and head of consultant relations and institutional sales at Kennedy Capital Management, added: “These are not trading-oriented products; we don’t go in and out of investments quarter to quarter. So, if there’s short-term volatility, we can maintain our conviction.”

Mr. Thomas from Kennedy Capital later said in an email that the firm was looking to change the Micro Cap Emerging Growth strategy’s name to Micro Cap Opportunities by year-end “to avoid benchmark confusion.”

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