Co-CIO Francis Gannon talks about how abnormally high returns are unsustainable, why the fundamental laws of capitalism will once again reward profitable companies, and how investor preferences for lower quality and more speculative growth over the past several years have given the kinds of companies we want to own for the long term favorable valuations.
“Every cycle is different, and this particular cycle has been marked by really three distinct things. First, you’ve seen very high returns over the past five years—in fact historically high returns over the past five years. The second would be the fact that negative EBIT companies, non-earners if you will, have outperformed for an extended period of time, something we hadn’t seen in a very long period. Finally, low-quality companies have also helped generate a lot of the returns you have seen in the market and, therefore, high-quality small-cap companies are quite cheap. In fact, you could argue they’re as cheap as they have ever been.
“One of the things we have known over the past several years is that you have seen very high returns—in fact historically high returns over the past five years, and we think that is going to change going forward. As we go back to what we perceive to be a much more normal environment, we think returns are going to normalize going forward and we think that is good for the active investor.
“The second unique thing about this particular market cycle is negative EBIT companies—companies that actually have and make no money—have actually outperformed over the past three years. It doesn’t make sense when you think about it, especially from an active management standpoint. We think that is already beginning to change in the overall market, specifically in the biotechnology sector, which you saw get hit in the latter part of the third quarter of this year.
“Finally, the odd aspect in this particular cycle has been that low-quality companies have outperformed. People talk about the market being expensive in general. We would tell you that within the small-cap space, it is those low-quality companies that are driving the valuation in the market today and that high-quality companies represent the largest opportunity for investors within the small-cap space. So as investors continue to forget about risk and risk management, in general, particularly in the small-cap space, that is where your opportunity is today. High-quality companies in the small-cap space are as cheap as they have ever been.”
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