Lead-Lag Live
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Lead-Lag Live
Brian Drubetsky: Unlocking Small Cap Potential
Dive into the intricacies of small-cap investing as Michael Gayed and Brian Drubetsky explore the current economic landscape and its implications for market opportunities. With interest rates being a pivotal factor for many small-cap firms, our discussion unpacks the latest trends in earnings growth and the potential for favorable shifts in monetary policy.
From analyzing the essential characteristics that can help small-cap stocks thrive, to recognizing the undervalued opportunities in sectors like consumer discretionary and real estate, this episode aims to equip you with the knowledge to recognize and seize upcoming market trends. As we uncover the transformative influence of technology and automation on small caps, listeners will gain a better understanding of how to navigate this often-overlooked segment of the market effectively.
Join us as we dissect key questions surrounding the future of small caps, from their historical performance to robust strategies for capitalizing on growth. Don't miss this insightful episode—subscribe, leave a review, and share your thoughts! Your engagement is invaluable as we continue to explore the evolving world of finance together.
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Right now the market's pricing in two and a half cuts. I think even if you get one cut, small caps could do well. And even if we don't get any cuts, I think rates could eventually come down if there starts to be labor weakness. So, importantly, the mortgage rate is usually about 150 basis points ahead of the 10-year and right now mortgage rates are close to 6, 7, the 10 years around 4, 2. Mortgage rates are close to 6, 7, the 10 years around 4, 2. So that's almost a 250 basis point spread where it's usually 150 basis points, and I think there's a lot of uncertainty of Fed policy and whether it's in the tariffs or how they're going to respond to inflation. But that spread should narrow and it doesn't really take rate cuts to happen. It just needs more policy certainty what's going to happen with tax cuts? And I think, importantly, for the small cap stocks to work and we haven't really talked about this much yet but you need earnings growth and acceleration to come and in the fourth quarter of last year we finally had positive earnings growth.
Speaker 2:This is a very timely topic. If you've been following me for a while, you know that I, in a very annoying way, continuously say small caps, hold the key. I think it's a very important part of the marketplace and one that potentially has a lot of opportunities. With all that said, my name is Michael Guyatt, publisher of the Lead Lag Report. Joining me here is Brian Jaresti Schaefer Cullen. Brian, a lot of people who are tuning in may not be familiar with who you are, so introduce yourself what's your background?
Speaker 1:what have you done throughout your career? What are you doing currently at Schaefer Collin? Yeah, sure Thanks for having me, michael, and yeah, so I started my career at KPMG and I hold an MBA from Columbia. I've been with Schaefer Collin, my current firm, for 12 years and prior to this role, I was at a long short equity hedge fund. So here at Schaefer Cullen, I manage our small cap value strategy, as well as our small and mid dividend focused strategy. The small cap value strategy is available as an SMA as well as a mutual fund, and this mid dividend right now is available as a separate managed account.
Speaker 2:Since you mentioned the experience with the long short equity hedge fund, I am curious because if you're going to be doing long-short portfolio positioning, you really have to kind of know your stuff on what it is that you're trying to short right and be very careful, obviously, on fundamental analysis as well. Talk to me about how the experience at the long-short equity hedge fund maybe shapes your way of how you think about individual companies.
Speaker 1:Yeah, sure.
Speaker 1:So we spent about most of the time investing on the long and short side on small and medium-sized companies.
Speaker 1:So I think there's an edge there on really doing the fundamental analysis.
Speaker 1:So most of our strategies here at Schaefer Cullen are long only but we're fairly concentrated, so our portfolios have between 30 and 40 names typically in the portfolio and that allows us to do deep research and that's really required both on the long side and on the short side. And a lot of the work that we do here is really figuring out what the key investment factors are for the stock to work, but understanding what the risks are, because as value investors there's certainly a lot of value tracks and I think, having had experience on looking at the company from a lens of which ones could be short, whether they're accounting issues or whether the company or the sector is in structural decline and a lot of what we do at Schaefer Cullinan we're looking at a stock is figuring out is this something that is cyclically challenged and this is going through a cycle, or is there something structurally wrong where you could get conviction in staying away for that reason? So I think on the short side it helped me in just looking out for value traps.
Speaker 2:I want to focus on that point about deep research, because I think you and I both know that most people's impression of deep research is here's a chart and it's going up and to the right. That's deep research for most people. What goes into the kind of research process that you follow, Meaning? What kind of things are you looking at when we say the word deep? How deep is deep there?
Speaker 1:Yeah, sure. So looking at companies and following companies, there's the maintenance work, but also doing the pre-work and a lot of the initial research is really deciding again what are the key investment factors and what is our variant perception. And if you think back to the high school days of science, you have a hypothesis. You want to test that hypothesis and, if possible, try to refute it, going beyond of just reading the sell side reports and meeting with managements, reading the transcripts, but also speaking to industry experts that either worked at the company prior or worked at competitors and really getting an edge. And in small caps there really aren't as many analysts on the sell side covering the names, whereas if you have an analyst covering community, covering Apple or Meta or NVIDIA, there might be 50 analysts. In small cap the average is about five analysts and in many of the companies there are no analysts covering the stock, so they're really left for dead, which creates an opportunity for us.
Speaker 2:Which gets into the most important question from my standpoint, which is this point about small cap volatility. Why is it that small caps have just struggled, really since the 2021 peak, at least in the Russell 2000? I mean, you look at the market. Most people obviously define the market as the S&P 500, but I think the market is much bigger than that. It's just from the standpoint of the number of companies, many more small cap names than large cap names, and a lot of small cap names are still way below their after inflation adjusted peaks from 2021. So what's going on in that part of the world?
Speaker 1:Yeah, small caps have certainly struggled and it's gone beyond 2021. It's really seven consecutive years that they have lagged large caps and I think there are a multitude of factors. One, it's the industry or the sector index. Construction Technology has been a big driver of returns for large cap indices and small cap just doesn't have as many technology companies in the index. So if you take the S&P 500, technology is about 30% and the Russell 2000 is 12. And then if you add on communication services, that's another 12% for the S&P and it's something like 4% or 5% for the Russell 2000. So that's one reason. On top of that, you've had high interest rates and a lot of the small cap companies rely on debt financing and variable debt is approximately 65% of their debt structure, where that's only about 30 for large cap companies. So the cost of debt has been kind of an issue for small cap companies that need to finance themselves. Now, how we invest is much different than the small cap index, the Russell 2000. And we focus on companies that have really strong balance sheets. So financing is not so much of an issue, but on index level it has been.
Speaker 1:And while we're talking about indices, I think the whole passive movement has also contributed to the lag of small cap versus large cap. I mean, it's been self fulfilling a lot of the fund flows come in and allocations get set and builds on itself and a lot of times small cap is not getting those flows. I think small caps have seen outflows when you combine mutual funds and ETFs for something like the last 15 years and that's finally, I think, starting to abate. Where people are looking to get out of maybe some areas that they're concentrated in whether that's large caps or technologies and looking elsewhere whether that's small caps value international. But I think we're starting to see that rotation occur and it has had full starts Number of factors that I think have kept small caps underperforming. And then there's labor costs, inflation but those are starting to abate and higher interest rates have certainly hurt them for the last couple of years.
Speaker 2:I think also you can argue that, at least when you look at indices like the Russell 2000,. What's helped a lot of that back have been in the biotech space and in the regional bank financials space. In the biotech space and in the regional bank financial space obviously post what happened in March of last year or the year before that, my memory's getting fuzzy right on the regional bank crisis. How much co-movement is there within the small cap space Meaning? Is it that investors broadly allocate into small caps or is there a more sector specific type of best that typically occur in small cap?
Speaker 1:Yeah. So financials are a big industry as well as industrials. So it's financials, industrials in small cap value. There's even a larger proportion of stocks that fall into the financials category. Biotech is more on the Russell 2000. It does play a role in the Russell 2000 value. But I'll have to say that if you look at the constituents of both, a lot of the companies don't earn any money, so earnings are negative. But if you dig down further you'll see about 40% of those companies that don't make any money. They're coming from these biotech companies and we don't invest in biotech. It's not our knitting. But if you invest in the index you're investing in about 40% of the companies that don't make any money and a lot of that is coming from biotech.
Speaker 2:Yeah, and that's always a hard place to position. I think a lot of the biotech weakness you can argue was just because everyone got so distracted by the GLP-1 craze and just forgot about all these other biotech companies. Okay, so let's talk about some of the work that you do at Schieffer Cullen as far as the composites and the fund in general. First of all, deep dive research. You mentioned a small number of stocks. Is there any particular specific overweight in any particular sectors in the SMA composite?
Speaker 1:Yeah. So right now we're overweight consumer discretionary in real estate. We think those are two areas that have lagged recently and we see a lot of opportunities for growth there. So if you look at why we think small caps are set up to do well now, I did mention their higher interest rates, but we also have our higher interest rate margins from the banks because of the yield curve has been steepening, so the 10-year now is at under 4.3. I mean, most recently it was at under five, but we are starting to see a steepening of the yield curve. So we are overweight regional banks. We're overweight consumer discretionary. There are names there in the restaurant industry.
Speaker 1:But one of the themes that we're playing and are excited about over the next 12 to 18 months is this normalization of interest rates, and I think a lot of the beneficiaries there are going to be housing related. So housing has been decimated. The cost of a mortgage to move has been prohibitive. So we're invested in brokerages like Douglas Elliman, lead generators like LendingTree, which helps with mortgage origination as well as refinancing, loan Depot, which does the originations, and then in our other portfolios we also have plays like Whirlpool, which is a maintenance as well as a housing movement story where there's a lot of opportunity as rates come down.
Speaker 1:Now I think the whole discussion of rates moving down, it's been pretty controversial. Some think that the 10-year is going to go back up and others think that we're going to get back under four. But I think eventually we'll get back to this normalized level and we hold stocks typically for three to five years. So we're trying to be patient and willing to wait. But if you look at our composition, we have a lot of interest rate beneficiaries as rates come down, so I'll pause there.
Speaker 2:Yeah, and that's going to be the interesting dynamic. Now I guess the pushback that I've heard on that is why would rates come down when inflation still looks like it's fairly sticky? Sure, the Fed wants to cut rates, but the futures market seems to not be betting, at least right now, that there's going to be some aggressive cutting cycle. So If the thesis is that you need to have rates going down for small caps to our reform, how much lower do rates have to go? Can it just be incrementally enough that you don't need to go and cut rates by a significant amount?
Speaker 1:Yeah. So right now the market's pricing in two and a half cuts. I think even if you get one cut, small caps could do well and even if we don't get any cuts, I think rates could eventually come down if there starts to be labor weakness. So, importantly, the mortgage rate is usually about 150 basis points ahead of the 10-year and right now mortgage rates are close to 6, 7, the 10-years around 4, 2. So that's almost a 250 basis point spread where it's usually 150 basis points. And I think there's a lot of uncertainty of Fed policy and whether it's in the tariffs or how they're going to respond to inflation. But that spread should narrow and it doesn't really take rate cuts to happen. It just needs more policy certainty what's going to happen with tax cuts?
Speaker 1:And I think, importantly, for the small cap stocks to work and we haven't really talked about this much yet but you need earnings growth and acceleration to come and in the fourth quarter of last year we finally had positive earnings growth. It actually beat expectations. It came in at mid-single digits. The consensus was at 2%. We need earnings growth to come in stronger than large cap EPS growth for 2025. So analyst estimates for the S&P for 2025 are around 13%. But if you look at the S&P 600, which is the higher quality small cap index where you have to be a positive earning company to be included, analysts expecting 21%. I don't think we need to get to 21% earnings growth this year for small caps to work.
Speaker 1:But if we get double digit earnings growth, the valuations are way too cheap and right now our portfolios are trading about 12 times. Small caps are closer to 18 times. So there's about six turns of PE of opportunity to narrow that spread. If you look at where small caps trade versus large cap historically, you have to go back to the tech bubble in the late 1990s, early 2000s, and small caps as a universe are only 4% of the entire stock market. The last time it was such a small percentage like that goes back to the 1930s. So I think earnings growth is going to be important and the earnings estimates tend to come down from the beginning of the year and then analysts start to cut them. But I think right now earnings for small caps look good and if we do get interest rate cuts, that's only going to further the case for small caps.
Speaker 2:On the earnings growth and the acceleration side. I think one thing that maybe you've already been missing is all the supposed benefits that AI should be giving to its users. I've made that argument before. It's like well, if AI is real, then you would think small caps should be the next big winner because you should have some margin improvement then as AI is integrated. Am I off on that idea that AI should really be wildly bullish for small caps?
Speaker 1:Yeah.
Speaker 1:So I think small caps are definitely well positioned to benefit from AI.
Speaker 1:We haven't seen it to great extents yet and we've been tracking this and B of A did a recent analysis of earnings calls and what they found was that about 50% of companies in the large cap universe have mentioned AI on their calls, where less than 25% did if they were a small cap company.
Speaker 1:I think that number for small caps is going to go up and I think there's more opportunity to take out labor costs and really benefit from productivity. So if you look at kind of what drives GDP growth and it's supposed to be out two and a half percent, something that could come down and decline less than two. But productivity will be key for small caps and I think we're starting to see, even from places that we go out to lunch, solid places have automated machines. Now that's not so much AI but the automation and AI combined, I think could be revolutionary. And small caps are just way too cheap and in terms of their margins, if they do see incremental margins from this and they have a lot of operating leverage, boy these small cap stocks could do well.
Speaker 2:So you'd mentioned banks. That was the value side. I think we should talk about growth versus value when it comes to small caps versus growth versus value when it comes to large caps. How do they differ when it comes to the small cap space in terms of sector allocations, and why small value versus small growth?
Speaker 1:I think it comes down to cyclicality and I consider cyclical sectors. You have to immediately think of industrials, financials, materials. Some think technology is cyclical, some don't bucket it that way, but the growth indices are so concentrated in technology and healthcare and a lot of these stocks have done really well. I think they're just priced too expensive versus the opportunity set that we see Now. It comes down to a stock by stock basis for us and I think if you look at the regional banks and the ability for them to grow loans, increase their net interest margins because of the steepening yield curve and get costs out and consolidate, I think that's a big opportunity and a lot of times you have growth companies making acquisitions of other, maybe value, companies for the stability of free cash flow. So that's another way that we invest.
Speaker 1:I haven't talked about this much yet, but for those who know our investment style, we're very much focused on PE and value. So what does that mean? We're typically running screens on companies that have about PEs that are 20 to 30% on the bottom. So the ninth and 10th decile, if you will, on cheapness, whether it's PE price to book, if we're looking at financials with strong balance sheets that generate a lot of free cash flow and I think a lot of times people overpay for growth and growth stocks could do really well and they have their runs.
Speaker 1:But I think what people forget is that, whether it's small cap or large cap, things move in cycles and growth can outperform for a decade and then value can outperform for a while, and I think we're just in one of those periods, for the reasons that you and I were talking about earlier in this webcast, that small caps, just for structural reasons, for macroeconomic reasons, fiscal policy reasons, have just underperformed.
Speaker 1:But everything has a price and I think value is just set up to do really well. And lastly, I think M&A and this corresponds to this administration, where we are in the interest rate cycle I think we'll see more in M&A and our portfolios have benefited a lot from takeouts. Since 2020, our small cap value strategy have had 12 names taken out and this is a portfolio where we hold typically 35 names. So it's not something we look at saying we're only going to look out for companies that are going to be taken over, but it does come into our process thinking like what's the asymmetric reward and what's the downside and could this company be bought out? Because a lot of times they have strong balance sheets, they're generating cashflow and they're synergistic to a larger company, whether it's another value company or a growth company.
Speaker 2:Let's talk about the actual portfolio itself and pause it. I'm going to share my screen here to show it. But you've had some pretty good results under your stewardship using the process that you've built out. Schaefer-cullen, Give me just a second, Let me pull that up here. So if we look at the small cap value equity fact sheet here, if those are curious, you can go to Schaefer-Cullen's website to get access to this as well. Firm of dollars have been around for a while and that's A3, story history 23 billion AUM. I want you to talk a little bit about the portfolio characteristics here. You mentioned the PE ratio a little bit earlier, but let's go through some of the points about valuation in general here.
Speaker 1:Yeah, sure, so our portfolio typically is under the market benchmark. For the last several years we've been somewhere about that six turns cheaper than the benchmark. But this is not to say that we're just buying deep value stocks. We're looking for stocks with catalysts that have good earnings, growth potential and, just going back in terms of our philosophy and kind of how we invest, we're looking for stocks that are misunderstood, that are maybe going through a cyclical downturn, but there's nothing structurally wrong with them. They're not going out of business and sometimes they have zero analysts covering them and it'll just take eventually maybe six months, it could be longer where eventually people run screens and say, hey, this company is just too cheap or another company in the same industry might acquire them, and they're the only ones that are really doing the homework, and that's fine too.
Speaker 1:It's nice to get that 20% pop, but typically we're looking for a larger return than that and we've had strong returns focusing on this discipline, and that's what Schaefer Cullen does. We are tried and true investors that stick to our value discipline and free cash flow. Yield, you could see, is higher than the index here and, like I said, we're not investing in overly levered companies that are needing you know the banks and to be able to finance themselves. So net debt to EBITDA about half of what the benchmark is, and so, yeah, we think we're well positioned based on these characteristics.
Speaker 2:Yeah, and the free cash flow yield obviously a big deal. Again, going back to that, you're automatically screening out zombie companies. Obviously when you're focusing on the cash flow side of things. Let's talk about the sector breakdown on the composite, financials obviously being the big overweight alongside discretionary. I'm curious do you think that under the Trump administration, if he's serious about deregulation, that the market is really underappreciating how much room financials have to run, because it seems like that's important? You need to have some greater degrees of freedom, especially for the regional banks, to really get some increased margin.
Speaker 1:Yeah, so there's been a consolidation story for the banks going for the last 20 years. It's slowed down. With the Biden administration I think we'll see a pickup. It just makes logical sense. I still think we have too many banks in this country. 20 years ago we may have had 6,000. Now there's 3,000. And that's just too many. And I mentioned in this strategy we've had 12 companies acquired. I think three or four of them have been banks and there's a lot of opportunity to take costs out. I don't have to tell you there's probably, you know every corner. There's so many banks and now even with tellers you know being you know probably half the amount of tellers there were before. People are using the internet and banks really have been overburdened with regulation and the larger banks haven't been able to be as acquisitive. But I think with the Trump administration that's so much not longer in play and I think we'll see opportunities on the banking side.
Speaker 2:Yeah, I mean, I agree 100%, and you could argue it's also related to discretionary, because to the extent that there's more lending activity, then consumers will have more ability to lever up, even though you can argue they're already pretty lever, at least on the credit card side. So I think that's an interesting dynamic. And then, of course, the biggest underweight there is healthcare, which I think goes back to the earlier conversation around biotech.
Speaker 1:Yeah, no, exactly. So there's just not many opportunities that we find attractive that are disciplined in healthcare.
Speaker 2:We've been larger in healthcare when there are opportunities and we've had success in takeouts in healthcare as well composite against the Russell 2000 value and you know to get 140 basis points annualized of extra performances pretty remarkable, especially over that full 15 year type of track record. Do you think that there are more opportunities to generate alpha now than before? Because, to your point, there's just not that many active managers that are allocating there, because all the flows have been passive towards large cap, market cap waiting.
Speaker 1:Yeah, I do so just for reference and transparency. I've been co-managing the portfolio for about eight years, so I think like that seven year track record is kind of a good way to look at it and since inception we've kept the same strategy and discipline throughout and really we stuck to our knitting. We're not overpaying for stocks, we're benefiting from takeouts and also investing with a theme focus. So I think, looking at the opportunities today, we're excited about this housing theme and the recovery in nearshoring and reshoring, as well as electric infrastructure plays. We've invested in companies like Quanta Services, which has graduated to the mid-cap, and I'd like to talk a little bit about the other strategy, eventually the SMIT and mid-cap strategy, where some of those companies that graduate can be bought in those other ones.
Speaker 1:Vistra, we've owned for five years and that company has done really well. It's in the news a lot. It's definitely benefiting from the AI demand story for energy, but the energy infrastructure in this country is really poor and we have plays on that. So combining the discipline with theme thematic approach has really, I think, helped our opportunity set and it just it continues to be underfollowed, neglected, misunderstood, and therein lies the opportunity, in our opinion.
Speaker 2:Let's talk about SPID. I've heard more and more argue that in general, mid-caps are kind of the, you know, even more of a sweet spot than small caps, for a lot of different reasons valuations, less risk of bankruptcy, dynamic zombie companies. Let's make the case for mid-caps over large caps and then, if there is a case of mid-caps maybe on par or maybe even slightly ahead of small caps, yeah.
Speaker 1:So look, mid-caps are kind of this neglected child, right, the middle child. People are looking at large, people looking at small and sometimes they just are not focused on mid caps. But there are a lot of quality companies and by quality again I mean companies that are generating double digit free cash flow yields, that don't have really over bloated balance sheets, that are trading attractive valuations, that have graduated from the small cap. So if a small cap has been in the index for 30 years and hasn't graduated to the mid-cap index, sometimes those are just not good companies. They didn't get taken out, they didn't graduate to the mid-cap sector, so sometimes those opportunities can be found in mid-cap.
Speaker 1:So that's where we started the small mid-cap focused fund. It's run very much like the small cap strategy. It has a dividend component, so the yield is close to 4%, with strong double-digit dividend growth but attractive free cash yield over 6% and we've had takeouts there. So we started the strategy in 2020. If you want, you could pull up the fact sheet from our website, cullenfundscom, and we've been able to find names that either graduated from the small cap, that became mid caps, but really also play into these themes of interest rates, normalizing, reshoring, infrastructure plays and, looking at the opportunity set, it's really quite attractive.
Speaker 1:Where all the focus has been on large caps and when you can combine the opportunities of the really small cap companies that are not followed by analysts with mid cap companies that just fall between the cracks of large and small, I have to tell you it's an exciting opportunity set. So we build this portfolio between 30 and 40 companies and I think what's misunderstood is how many companies in the small and mid-cap space pay a dividend. So about 45% of the companies in the Russell 2500 value pay a dividend and 40% of those 45% have a dividend yield that's over 4%. So, as rates come down and people are looking for income, that's just another way to be defensive and provide an income source in markets that are volatile. So it's defensive, but also really an opportunity to participate on the upside, and a lot of times these large cap companies buy these mid cap and small cap companies, as we've talked about.
Speaker 2:So for those reasons, we think it's a good opportunity that really gets you that breadth and valuation and it also looks pretty, uh, you know, on par to a relative inexpensive risk with the small cap uh composite.
Speaker 1:Yeah, correct, um, so it's.
Speaker 1:It's also trading at a meaningful discount. The index for the Russell 2400 value is at 20 times, we're at 12. Our free cash flow yield is double than what the index is and again, we're below on net debt to EBITDA. And we invest typically in companies that are up to 15 billion in market cap, as low as 100 million, as long as the liquidity is there. And I think it's also misunderstood how many sectors actually have attractively paying dividend companies. So, whether it's real estate, financials, utilities, consumer discretionary and we can look at the breakout there you can see we're overweight.
Speaker 1:Consumer discretionary. There's just been so many nays have been pummeled over concerns that the consumer is slowing down, but I think the consumer just needs to take a breath. I mean, there's been a lot of stimulus that's run through, but wages are still strong, people have jobs and there's some noise on the Fed side and a lot of Fed workers potentially could lose their jobs, which perversely, I think could lead the Fed to lower interest rates. I mean, treasury Secretary Besant is really focused on the 10-year now. Well, how are they going to get the 10-year lower If they cut enough jobs from the federal government which they can control much more than the private sector. That might get the Fed to cut rates and it might bring interest rates low and that helps homebuyers and companies in our portfolio to finance themselves.
Speaker 2:I had mentioned that on a post on X that went a little bit viral, something along the lines of you know, trump is laying off all these federal workers to get the Fed to cut rates. So I think Possible. You know 4D chess or not, but you know, it seems like it's a possible direction.
Speaker 1:When the deficit's so large and your interest expense is greater now than your defense budget, it plays a role.
Speaker 2:And the performance. Same story has been meaningfully outperforming since inception against the Russell 2500 value.
Speaker 1:Yeah, yeah. So we've had strong performance about 25% versus 19% for the benchmark. Our upside capture is over 100% it's about 104% and our downside capture is 86%, so providing good downside protection in periods of market volatility. Because they have the free cash flow yield, they have stable businesses. We've owned companies that are in the banking that have been rumored to be taken out, like First Horizon. Elizabeth Warren didn't want that deal to go through by TD. They're located in a really attractive area in the Southeast, where they're based in Tennessee and they have branches in Florida, so a lot of opportunities for growth.
Speaker 2:I know you're doing deep dive research, obviously, but let's say that there's concerns around an economic slowdown, right, and it's time to play somewhat defensive in the small cap and smith space. I'd argue it's a lot easier to play defense with large caps because you can just go into utilities and you know lower beta, consumer staples, names. But if you're going to try to play defense, if you have a macro view that you want to integrate into the portfolio, what's the best way to do that with small and mid-cap names?
Speaker 1:yeah, I think, just on a portfolio construction basis. It has to start there. Then you can do sector based on the portfolio construction basis. It has to start there, then you can do sector-based On the portfolio construction. You want companies that are ready trading at cheap valuations Not to say that they can't get cheaper, but the high flyers, I think, are just going to get put it this way hurt more than companies that are trading close to trough valuations.
Speaker 1:So a lot of times we're looking at how the companies are trading versus their own tenure history as well as to their peer group. And then companies that can return high free cash flows as well as high returns on equity. So with good balance sheets, leverage cuts both ways. So companies that are over levered are going to get crushed in a macroeconomic downturn and we haven't seen credit spreads blow out. But credit spreads totally typically blow out when the crisis is starting already. It's not really a good predictor. So you can look at credit spreads and see what the CDS rates are, but at the end of the day you want to own quality companies. And then on a sector basis, consumer staples, utilities, telecom these are all areas that are pretty defensive and you could find companies also that have a yield and people want that income in periods of market volatility. So I would say those are the three sectors that we gravitate towards when we think that there's potential risk on the macro side. But we're fundamentals, bottom-up investors, but we do take macro into consideration.
Speaker 2:Yeah, I think I was like how can you not take macro to some extent into consideration, just given how much flows have driven the economy and asset allocation in general? Do you look at the? I'm just curious do you look at the bond market side when you're doing analysis on the small cap stock? End of things?
Speaker 1:Yeah, we do, but we're not. Yeah, you're doing analysis on the small cap stock end of things. Yeah, we do, but we're not credit experts. So we do look at where things are trading.
Speaker 2:Just to get a sense of some strain or disconnect right From a default risk potential.
Speaker 1:Yeah, same way as we look at the short interest like what are we missing? What's the bear case? And a lot of times we use credit research to see also on an aim. It's always interesting to see what, like, a sell side credit analyst thinks of a name, if they do follow it.
Speaker 2:How do you? What's the? What is the sell discipline? What causes a company to totally just bomb out of the portfolio?
Speaker 1:Yeah, good question. So typically three things. One is that we got the thesis wrong, right. So I mentioned you kind of put the hypothesis there. You test the hypothesis and then we try to do the pre-work and really just what the pre-mortem is. But if something's going wrong and the thesis has changed, we'll sell it. Our turnover typically is 30% on a name basis. It's lower, but we sold names earlier than our typical holding period of three to five years where we're just flat out wrong and it's a humbling business. You're going to be wrong. Other times just the risk-reward isn't so attractive. Typically we like this three-to-one risk-reward ratio. Let's say stock could be up 60 but down 20. And we like the probabilistic weight kind of outcomes. If that has really compressed and we see other opportunities elsewhere, whether it's in that sector or not, we'll swap that out. And other times we just think it's dead money. There's no catalyst anymore. The catalyst has played out and we're not going to wait around for like a 10% upside in the stock if we see other opportunities.
Speaker 2:So you've got the SMAs Talk to me a little bit about the fund itself. Any kind of key differences? Typically, do you find that investors prefer, when dealing with small caps, that's simply a managed account of vehicle versus a mutual fund dealing with small?
Speaker 1:caps. That's simply a managed account vehicle versus a mutual fund. It really depends on the holder and the investor and how they want you to manage their holdings and their strategy. So one thing I would say is we want to stick to our discipline and we want our financial advisors and institutions to be able to plug us into whatever model they're running and just rely on us to be the small cap value manager or the SMID manager in their books. So that's one thing. Whether they choose SMA or mutual fund, it's really up to them. We have both vehicles available for small cap value. The SMID right now is in the separate managed account form and whether it's if people want to manage taxes differently or have some exclusions that they don't want allocations to like tobacco or other things, they may use a separate managed account. But the minimums have come down so much for separate managed accounts compared to what they were 20 years ago where oftentimes you could have an account holder that is larger in the mutual fund than it is in a separate managed account vehicle.
Speaker 2:You talked to a lot of advisors individuals, I'm sure as well just about markets and small caps in general, and I'm sure you get a lot of things that people say to you which are outright wrong, that make you want to totally counter those arguments, outright wrongs, that make you want to totally counter those arguments. What are some of the the more popular myths out there about investing in small cap?
Speaker 1:Yeah, one that comes to my mind is you really need a recession and a total market blowout to make small caps attractive, where you're going to get paid for the risk, and I just don't think that's true. There's been a lot of periods and it goes back to cycles right when small caps can outperform for seven to 10 years and it didn't require a recession, a bust, to get that attractive entry point. I think there's always uncertainty of when is the right time to pivot and get out of something that's worked, because momentum is strong, but I think we're starting to see some breaks there. So I think that's probably one of the misnomers. And two is like small caps they don't make any money. They're terrible companies, and I think that's partially true, depending on which index you invest in. If you're investing in an active manager that invests in fewer than 50 stocks, let's say, that has a discipline that can follow the companies, know where the bodies are buried and knows the space well and is willing to do the work, I think you could find out performance there.
Speaker 2:Brian, for those who want to learn more about Schaefer Cullen and who might be interested in either the SMAs or the mutual fund, where would you point them to? Cullenfundscom. And that's also for the SMA series. So same center.
Speaker 1:Correct. You can find all our strategies listed there. Both are at CullenFundscom. You just select whether you're a financial advisor or a private investor and it'll lead you to the right path. You could also find us on LinkedIn, where we post some of our research and findings and we're happy to start a conversation. But reach out to your advisor that you could find and it automates who that is based on your region.
Speaker 2:Hopefully everybody enjoyed the conversation. I personally think it was very interesting. I still maintain small caps hold the key, myself quite optimistic on small caps, certainly on a relative basis. I think we are way overdue for some broader leadership and I do believe, like you do, brian, that there's a lot of alpha potential there. And congrats on all the performance. Again, folks, it was a sponsored conversation by Schaefer Cullen. This is LeadLag Live. Learn more about Schaefer Cullen at cullenfundscom and I'll see you all on the next episode. Thank you, brian, appreciate it. Thank you, michael. Cheers everybody.
