In April 2021, First Eagle Investment (Trades, Portfolio) Management established a new Small Cap team consisting of Portfolio Manager BILL HENCH, Associate Portfolio Managers SUZANNE FRANKS and ROB KOSOWSKY, and Senior Research Analyst ADAM MIELNIK. Though new to First Eagle, the teamis well established within the industry, having previously worked together on a small cap equity strategy at another firm. Below, our new Small Cap team discusses their time-tested approach to leveraging opportunities in the small cap market and how they are approaching today’s uncertain environment.
Q: Why small cap stocks?
Bill: Small cap stocks represent a particularly volatile and inefficiently priced segment of the US equity market. It is our belief that these dynamics can create opportunities for disciplined active investment managers to identify undervalued small cap names in an effort to generate attractive returns for investors over the long term through diversified portfolios.
There are thousands of publicly traded small cap and microcap companies across the US participating in a wide range of industries, but they do have a number of common features that distinguish them from larger businesses and that promote greater price volatility. Smaller companies tend to offer a relatively narrow line of products or services, with most (but not all) focused on the US market, resulting in a concen-trated source of revenue and earnings. While many small companies have high-quality management teams, organizational depth tends to be lacking, making key-person risk a greater concern. They typically have more limited access to the capital markets than larger companies, which can result in vulnerable balance sheets. And their stocks often are thinly traded and have limited coverage by Wall Street analysts. These risks are even more pronounced further out on the small cap spectrum and into the microcap space—areas where we, as true small cap specialists, feel quite at home.
Small cap stocks, due to their higher risk, historically have outperformed large cap names. Our team’s strategy is built on the premise that we can further widen this performance gap by building diversified portfolios of stocks that not only are trading at what we believe to be a discount to their normalized valuation but also have a visible and fundamentally sound catalyst for price improvement.
Q: How does finding opportunities in the small cap universe differ from the market for large cap stocks?
Suzanne: As Bill mentioned, small cap stocks tend to have limited coverage from Wall Street analysts, which we believe is a big reason why the market price of individual companies can at times become widely disconnected from their normalized values. We find there are a number of common reasons for this. The first is a company that is simply being inefficiently valued by the market, typically due to an underestimation of its sum-of-the-parts value. Other companies represent classic turnaround scenarios in which some adverse event like a demand disruption or management failure depresses a stock’s price until a solution can be implemented and the improvements are recognized by the market. Finally, we have companies whose qualities—be it accelerating growth potential, the efficiency of their operations or an advantaged industry position—appear to be underappreciated by the market.
Despite their many differences, one commonality between large and small cap companies is that businesses with competitive advantages, regardless of size, tend to trade at a premium to their lower-quality competitors. Understanding this, we look for companies priced at a discount to either their history or to their industry and then seek to understand why this discount exists and, importantly, if it is fixable. If we believe the current discount is due to some transitory issue, we look for a specific catalyst on the horizon that may serve to normalize the stock’s market valuation. Catalysts can include new management, a more favorable business cycle, product innovation and margin improvement, and they are key to avoiding “value traps” in which low-priced stocks are cheap for a reason.
Rob: We have a saying on the team that “no price is too low;” in the small cap market particularly, prices can plummet independent of fundamentals simply because there is no buyer on the other side of the trade. We have a very disciplined approach to taking advantage of these opportunities. Instead of trying to identify a stock’s bottom, which tends to be a fool’s errand, we establish a position at a level we find attractive and slowly add to it in order to get the best average price we can. This patience has tended to pay off when markets turn and prices normalize. Our sell discipline is the same, but in reverse. We’ll slowly exit our positions at a price we find sufficiently rewarding and at a pace that can be absorbed by the market without unduly impacting the price.
Investing in the small cap space is a continual cycle of selling stocks and redeploying the proceeds into new positions. We don’t want to hold a basket of value stocks indefi-nitely. We want the stocks we buy to overcome their issues and become attractive to small cap core or growth investors. Upon driving these better fundamentals, the valu-ation discount potentially narrows or even closes. Once our investment case on a stock is realized, we move onto the next opportunity.
Q: How does your team stay on top of all the companies in the vast and undercovered small cap universe?
Suzanne: Honestly, it’s a lot of work. But the beauty of it is that with each stock we own we’re focused on a defined problem and what the company is doing to solve it. We’re listen-ing to 1,000-plus earnings calls a year, but we don’t need to process every single detail about a company’s performance; we’re interested primarily in the progress they are making toward overcoming the identified impediment to price appreciation.
Adam: All four members of the US Small Cap team are analysts, and we’re all generalists. We all pitch potential investments from a range of sectors and industries, and when a company enters the portfolio we’ll rotate primary coverage of that name over time. We meet every morning to go through the portfolio from top to bottom, from larg-est position to smallest, giving us a forum to discuss news on any of the names in the portfolio. The news could be an announcement about a stock offering, an acquisition, earnings, price volatility—anything really.
In our view, this approach enables each of us to stay current with all the names in the portfolio while creating a broader pool of opinions and less personal attachment to individual stocks.
Suzanne: In terms of generating new investment ideas, we run very few screens, which comes as a surprise to some people. Instead, we’re always reading—not just general market or macro content but also industry-specific publications like Women’s Wear Daily or Automotive News or Semiconductor Review—in hopes of sourcing an idea for furtherresearch. We’re also listening a lot; we probably have 1,400 engagements with company managements a year, through conferences, one-on-one meetings, earnings calls, etc.
Bill: Pre-Covid, we would regularly attend industry conferences where we’d see presen-tations from 10 or 12 small cap companies over the course of a day; most of these businesses were not necessarily in our wheelhouse from a pricing perspective, but we took note of them all the same. For years, I went to an annual consumer conference in Florida and would hear from all these great small cap restaurant companies that didn’t meet our investment criteria. With the onset of Covid-19 and its disruptions to markets and the economy, particularly in the restaurant space, these names suddenly became viable options for our strategy.
Rob: We’ve all been working in the small cap space for a while in various capacities, and we all have a lot of history with these companies. A fair number of our investment ideas involve companies we had invested in or researched previously. Again, these are small companies with limited resources relative to larger cap names. Sometimes a problem gets fixed and then reemerges in the future or a different problem crops up to impair market valuation. Or it could be a cyclical business whose price ebbs and flows with conditions in their industry. We believe ourselves to be long-term shareholders, and in practice many of our portfolio companies past and present tend to stop by to see us once a year to bring us up to speed on their operations.
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