"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity…" So begins Charles Dickens's A Tale of Two Cities, a monumental historical fiction centered on two unlikely protagonists whose lives become intertwined by a combination of fate and circumstance during the French Revolution. Without giving too much away to those with a mind to revisit this classic, let me only say that it is both tragic and redemptive, a story of two men on very different paths that lead to starkly different, yet strangely satisfying, outcomes.
This opening passage is often cited for its timeless relevance and, while lacking some of the human drama of that era, the economic and political environment we find ourselves in today has many parallels.
One of the most interesting conflicts playing out of late in the equity market, particularly in the small-cap space, has been the persistent disparity in performance between high- and low-quality companies. Over longer periods of time, higher quality companies have generally noticeably differentiated themselves from a performance standpoint, especially compared to the lower quality segments of the market.
More recently, however, lower-quality companies have held a distinct advantage, much to the consternation of active managers such as ourselves. Several factors have been at play, with the most significant being the distortive effect on asset prices caused by the Fed's zero interest rate policy and multiple quantitative easing (QE) initiatives.
Experience shows that lower-quality companies tend to demonstrate their most robust outperformance when markets are in the initial recovery phase following a recession or bear market low. Two elements usually galvanize this dynamic—stimulative Federal Reserve policies that lead to a drop in interest rates and a resulting acceleration in economic activity. However, once economies and markets move from recovery to expansion, the rate of change in these inputs begins to slow while leadership tends to rotate back to higher- quality companies whose business fundamentals are more compelling.
The recovery from the recent financial crisis has altered this script. The four rounds of QE have created an extended tailwind for low-quality companies. Highly levered businesses—a low quality attribute from our standpoint—have benefited from the sharp drop in the cost of capital that has accompanied the Fed's bond buying programs. Access to capital has simultaneously improved allowing weaker companies to stave off potential financing challenges. This is particularly relevant in the smaller company space where financing is often tenuous. Interestingly, companies with large net cash positions have also lagged as that cash has been viewed as an increasingly unproductive asset that generates little or no return, even though it provides a healthy margin of safety and results most often from business profitability.
The drop in market volatility back to pre-crisis levels, as measured by the VIX, has also contributed to the relative strength of low-quality companies. Investors' appetite for riskier assets tends to correlate with sharp moves—both up and down—in volatility. As the more violent swings in the market have largely dissipated, investors have been increasingly willing to embrace the added risk associated with lower quality enterprises.
The current preference for passive strategies and ETFs at the expense of active management has also played a role. In the small-cap space, active managers, especially those with a long-term orientation, tend to have a quality bias in their portfolios while the passive index vehicles, especially those meant to replicate the Russell 2000, have no bias other than market cap and therefore have a much higher weighting in lower-quality companies. Persistent redemptions of actively managed funds combined with modest inflows to ETFs have further distorted the low quality/high quality performance differential.
According to excellent work by Furey Research Partners, since the third quarter of 2011 the bottom quintile of the Russell 2000 ranked by return on invested capital (ROIC)—one of our core measures of business quality—has outperformed the top quintile by more than 10% through September 2012. This has obviously presented challenges for active mangers such as ourselves who consistently focus on higher-quality companies that are also trading at attractive valuations.
Of paramount importance then, is when will this relationship change? It is our view that it may already have begun. Interest rates, while at historic lows, cannot fall much lower. In fact, each successive round of quantitative easing is exerting less and less pressure on rates while at the same time raising the specter of increased inflation down the road. While liquidity should remain abundant, the rate of change in the cost of capital has clearly peaked. By the same token, the rate of decline in market volatility has significantly slowed with the VIX now back to its long-run averages. And while the global economy continues to grow, GDP statistics are anything but robust.
In sum, high-quality companies in the small-cap space look to us to be highly attractive relative to both their lower-quality counterparts as well as their high-quality peers in the large-cap space, setting the stage for what could be a lengthy period of outperformance. Low-quality companies have had an extended moment in the sun, but it is our strong belief that we are entering a new era for quality.
Important Disclosure Information
Chris Clark is a Portfolio Manager and Principal of Royce & Associates LLC. Mr. Clark's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity and industry grouping, among other factors. The Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index.