Episode 8: Why Small Caps Now

Host: Alex Warren, CFA, CAIA

Guest: Maria Katsileros, CIMC, CSRIC

September 21, 2023

Episode Length: 13:43

In this episode, we speak with Maria Katsileros, Client Portfolio Manager at Aristotle Capital Boston. Maria shares her thoughts on the low valuations of U.S. small cap stocks relative to their own history and larger cap peers, cycles, and tailwinds for the asset class. The conversation also touches on the importance of active management in the space, opportunities in the market, and why small caps deserve a place in portfolios today.

  • Host introduction (0:00-0:19)
  • Episode introduction (0:20-0:45)
  • Introduction of the episode’s guest: Maria Katsileros (0:46-1:31)
  • How have small caps performed in macro environments like the current one? (1:32-2:55)
  • The opportunity in small caps (2:56-4:02)
  • Mean reversion and what will cause a change in fortunes for small caps(4:03-5:30)
  • Other tailwinds supporting small caps (5:31-6:47)
  • Separating the wheat from the chaff in the Russell 2000 Index (6:48-9:26)
  • Where is the investment team seeing opportunities today? (9:27-10:06)
  • Potential trade-offs of timing small cap exposure (10:07-11:27)
  • Why do small caps deserve a place in portfolios today? (11:28-12:40)
  • Conclusion (12:41-13:07)
  • Disclosure (13:10-13:43)

Alex Warren: Welcome to the Power of Patience, Aristotle’s podcast where we share our views on topics actively explored by our investment teams and across the organization. I’m Alex Warren, product specialist at Aristotle, and I’ll be your host today.

Coming up on today’s episode, we’ll be speaking with Maria Katsileros, Client Portfolio Manager at Aristotle Capital Boston. If you enjoy this podcast, please like and share it on LinkedIn to help spread the word.

Today on the show we’ll discuss the current state of US small-cap stocks, opportunities versus their larger peers, and why small-caps deserve a place in portfolios today.

Without further ado, let’s get started. Maria, thank you so much for joining us today. To lead off the discussion, can you tell me a bit about yourself and your role at Aristotle Capital Boston?

Maria Katsileros: Thank you, Alex. As Alex mentioned, my name is Maria Katsileros and I’m the Client Portfolio Manager for Aristotle Capital Boston, and I’m also a member of the investment team. I’ve been in the industry for 25 years, and prior to joining Aristotle, I was a Senior Vice President and Senior Investment Strategist at a trillion-dollar global asset management firm based out of their North American headquarters in Boston.

In my current role, I serve as the primary day-to-day contact for Aristotle Boston’s clients, providing macroeconomic and asset class-specific insights as well as assisting clients in their servicing needs.

Alex Warren: Wonderful, thank you, Maria. Now let’s dive right in.

It’s been a challenging macro environment for global investors. How have small-caps performed in times like these?

Maria Katsileros: Yes, Alex, it has been a challenging environment. A little over a year ago, we saw inflation peak at 9.1%, and since then it’s rolled over, but remains sticky, and above the Fed’s 2% target. The Fed raised rates by 5% in the past year and a half to tame inflationary pressures, and GDP growth has slowed to below 2% trend.

What’s interesting though is when you look at small-caps historically in similar periods, the asset class has performed quite well. We analyzed all time periods going back to 1950 where inflation started above 3% and was decelerating, meaning it was decreasing in its pace of change, and what we found was that the average return for small-caps during those 18 periods was a little over 20%. And when you compare that to how large-caps performed during those similar time periods, small-caps outperform large-caps by on average of 5%.

Additionally, when looking at historical environments, when inflation was high, but slowing, and economic growth was below trend, so similar to the period where we are today, small-caps were the best performing asset class, posting on average 25% return, almost twice that of the S&P and both corporate and government bonds.

Alex Warren: That makes sense. Now, why do you see an opportunity in US small-caps?

Maria Katsileros: So Alex, when you look at the long-term averages going back to 1928, small-caps have outperformed large-caps by on average by 2%. But we’ve been in a large-cap cycle for the past 14 years, basically since the Great Financial Crisis of 2008, where large-caps have outperformed small-caps by 300 basis points on an average annualized basis.

If you believe as we do that, the markets tend to be mean reverting, the likelihood that the large-cap cycle will end and a small-cap cycle will begin is more likely than not to occur to get us back to those historical norms.

This has happened in the past, so when looking at the Russell 2000 Index, going back to its inception, there have been 81 periods where the five-year trailing return is below the 10.5% average annualized return for the asset class. In all 81 periods, 100% of the time, the five-year return has been higher to get us back to the 10.5% average annualized return, essentially reverting back to the mean.

Alex Warren: Now, Maria, you mentioned mean reversion a moment ago. What do you think will cause a change in fortunes for small-caps?

Maria Katsileros: I’m sure you’ve heard the rhetoric that we’re long in the tooth on this cycle because cycles tend to last eight to 10 years and we’re kind of rubbing up against that if not over that. But the reality is that cycles don’t start and stop based on the number of years. What determines a cycle is based on historical valuations. So it’s purely valuation driven. So when you’re looking at the current valuations, small-caps are cheap not only on an absolute basis but also relative to large-caps and mid-caps. From an absolute basis standpoint, looking at the P/E, so the price to earnings ratio of the Russell 2000 Index, to get as attractively priced as we are today, you have to look back to the 2008 financial crisis.

On a P/E standpoint from a relative basis, when you’re comparing small-caps to large-caps, you have to go back a little over two decades to the 2001 recession that followed the tech bubble bursts of March of 2000 to get as attractive price as we are today. And when you’re comparing them to mid-caps, the relative PEs are the cheapest they’ve been in 25 years. It’s not just on a P/E basis. Whether you’re looking at it from a trailing P/E, forward P/E, price to book, price to sales, enterprise value to free cash flow, so a number of different metrics, small-caps are more attractively priced than large-caps and mid-caps on all of those metrics.

Alex Warren: Those are some interesting stats. Now away from valuation, where do you see other tailwinds?

Maria Katsileros: So there are two macro tailwinds, Alex, that are supporting small-caps and that’s the Russell 2000 Index’s constitution as well as reshoring. From an Index constitution standpoint, large-caps are levered more towards goods, while small-caps are levered more towards services.

As you’ve heard during the past couple of earning seasons, companies are working through an inventory glut as goods spending trailed off after COVID, and instead, customers are spending on experiences, which benefit small-caps.

From a reshoring perspective, we’ve reached a peak of globalization. You’re starting to see reshoring occur to address a lot of the supply chain disruptions many businesses dealt with during the COVID shutdowns. And that’s specifically happening in the semiconductor as well as pharmaceutical industries. So listening to earnings calls, reshoring mentions have skyrocketed and you’re seeing U.S. companies become less dependent on Chinese imports.

Additionally, when you’re looking at manufacturing jobs in the Midwest, they’re three times higher than on the East or West Coast. Reshoring typically leads to CapEx spending, and small-caps have historically had a higher correlation to CapEx spending as compared to large-caps.

Alex Warren: Three times the job openings. Man, that’s a lot of jobs to fill.

Now, let’s take a look at the index. According to Bank of America research, 34% of the Russell 2000 are non-earners. How does the investment team separate the wheat from the chaff?

Maria Katsileros: So you’re spot on, Alex. The Russell 2000 index is comprised of 34% of non-earners. But what’s even more interesting is that the number has increased substantially over the past five years where non-earners were only 20% of the index historically. And in our view, it makes it even more important to not only have a management team that has expertise in the small-cap space, but also to conduct company-specific research.

So for listeners who may not be familiar with Aristotle Capital Boston, we specialize in US small-cap and SMID-cap portfolios. The two co-portfolio managers, Dave Adams and Jack McPherson, have been managing portfolios together for over 20 years, successfully navigating through multiple market environments. And they’re supported by a four member analyst team that has over 25 years of experience.

If I had to describe what we do at the highest level, we’re a high-quality core manager with a slight value tilt, and that value tilt is due to the contrarian front end of our process.

We’re looking for high-quality companies that have sustainable free cash flows, strong balance sheets, wide moats, and by wide moats, I mean strong industry dynamics, and strong management teams that are great capital allocators. But what we don’t want to do is pay up for that future cash flow. So we’re looking to buy those stocks when they’re trading at a discount to our estimate of intrinsic value, which is why we have that slight value tilt.

So to separate the wheat from the chaff, the team starts by narrowing down the universe, blending quantitative flagging tools with qualitative analysis. Those quantitative flagging tools are meant to weed out companies that are selling at excessive valuations or have highly levered balance sheets, allowing the team to truly focus their attention on those companies that either have the characteristics that make them good long-term investments or have the potential to have those characteristics.

From there, the investment process is solely focused on a qualitative assessment of each company where the PMs and the analysts sit down with the management teams, and they truly try to get an understanding of what they see in the opportunity in front of them. They want to understand the strategy, see how they will capitalize on that opportunity, and they want to understand the sensitivities in the business model to assess what the risks are.

We then apply a valuation methodology that looks at the company’s valuation relative to its history, relative to its peer group, and relative to the market overall. When we’re looking to invest in a company, we look to have at least a three to four times upside reward to downside risk before it enters the portfolio.

Alex Warren: Gotcha. Thank you, Maria.

Now let’s dive into a question that I think folks will find very interesting. Where are you seeing opportunities today?

Maria Katsileros: As mentioned earlier, we’re fundamental bottom-up managers, so we’re not looking to make those macro calls from a sector perspective. But what I can tell you is where we’re looking and spending our research time, which tells you where there might be attractive opportunities.

So we’re finding interesting opportunities in the IT, healthcare, and consumer spaces currently. If you had to group the stocks that we currently purchased in the portfolio into a theme, we’ll call it, the two new additions can be tied to automation and the utilization of AI or artificial intelligence to gain business efficiencies.

Alex Warren: Gotcha.

Now, some folks try to tactically overweight or underweight small-cap exposure based on what’s happening in the macro environment. What potential trade-offs are they making with that approach?

Maria Katsileros: Timing the market, Alex, is very hard, and getting both sides of the trade right, meaning timing that entry point and the exit points, is even harder. We typically see investors try to time going overweight the asset class once the Index is bottomed, but trying to determine the exact entry point is difficult, and if you don’t get it right, it can actually be very costly from a return standpoint. So why do I say that?

Our research shows that going back to the inception of the Russell 2000 Index and looking at periods when the market has bottomed, the forward one-year return on average is almost 64%. But missing just the first five trading days after the market bottom, your return decreases by 12% to 52%. Missing the first 10 days shaves off 20% of your return. And if you miss the first month, your return is almost cut in half at just 37%.

So since markets are forward discounting mechanisms, that’s truly a very short window to try to tactically time when to overweight to get the benefit of that strong return that I mentioned.

Alex Warren: Absolutely. That’s a staggering drop-off and frankly, I don’t think I’m smart enough to try to time markets like that.

Now, Maria, this has been a great conversation and we have time for one final question. Looking out over the next five to 10 years, why do you think small-caps deserve a spot in investor portfolios?

Maria Katsileros: If I had to sum it up, the key things to remember are that markets tend to be mean reverting, and the fact that small-caps have underperformed large-caps for such a long time and to the magnitude that they have, based on history, we’re more likely than not to see a small-cap cycle start. But that million-dollar question is when.

Unfortunately, I don’t have a crystal ball, so I can’t tell you whether it’s three months from now, six months from now, or a year from now. But historically, the cycles have started based on valuations. As we’ve discussed, small-cap valuations look attractive on both an absolute as well as a relative basis.

Additionally, small-caps are beneficiaries of the reshoring trend and the CapEx spending that accompanies it, as well as the experiential spending of consumers.

And finally, one thing that we haven’t touched upon is that the asset class itself is the first asset class to recover going into the early part of the economic cycle. So whether the Fed can pull off a soft landing or we go into a mild recession, once we enter the early part of the economic cycle, small-caps are going to lead the way out.

Alex Warren: That makes sense. Maria, thank you so much for your time today. That brings us to the end of this episode. We hope you’ve enjoyed it and learned more about Aristotle. Thank you for listening to the Power of Patience.

To learn more about Aristotle, please visit www.aristotlecap.com or follow the link in the show notes. If you enjoyed the show, please rate and review us on Spotify and Apple Podcast. On behalf of Aristotle, this is Alex Warren, and thank you for listening.

The opinions expressed herein are those of Aristotle Capital Boston and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Aristotle Boston reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Aristotle Capital Boston, LLC, is an independent investment advisor, registered under the Investment Advisors Act of 1940 as amended. Please see additional disclosures within the show notes.


For additional disclosures please refer to www.aristotlecap.com