Aidan Farrell
While volatility recorded in the first quarter of 2020 has been unprecedented and challenges remain, global investment manager, Eaton Vance, continues to see opportunities for investors with a long- term mindset in small-cap equities.
In a recent research paper, Aidan Farrell, Director of Global Small Cap Equity at Eaton Vance, presents his analysis of factor returns for the global small-cap equity universe and explains why long-term investment opportunities remain for the asset class.
“Our findings show that high-quality companies reaped attractive excess returns during the heightened volatility of Q1 2020. Strong balance sheets also proved critical in protecting capital during the heightened market turbulence in the first quarter.
“Given that targeting financially strong, high-quality companies at attractive valuations is core to our investment philosophy, these findings are particularly relevant at this crucial time for small-cap investing.”
The truth is that nobody knows what the future holds, says Mr Aidan.
He notes: “As of early May 2020, equity markets have moved significantly from the lows seen just two months earlier in March. Investors are taking hope from the enormous monetary and fiscal policy responses across the world, and the first tentative steps by some countries to reignite their economies by easing stringent lockdown measures.
“In the short term, until a vaccine or effective treatment for COVID-19 is developed, equity market sentiment will be shaped by the path the virus takes and any additional policy measures applied. As to possible longer-term implications, there is no shortage of commentary in the financial (and other) press as to likely structural and behavioural changes in a post pandemic world.
“Irrespective of the duration and shape of recovery, we firmly believe that we will look back at factor returns in 20 years’ time and once again see that higher-quality companies with healthy balance sheets purchased at attractive free cash flow yields will be a winning strategy for investors.
“Our faith in this investment style is the “compass” that helps us navigate even the most challenging of market environments. Key to our ‘Quality, Valuation and Time investment’ philosophy is a preference for targeting financially strong, high-quality, small-cap companies at attractive valuations. Our investment style, which we maintain regardless of changes in the economic cycle, has served us well historically and, we believe, will continue to do so going forward.
“In the Eaton Vance small-cap equity team, our QVT investment philosophy is biased toward higher-quality companies with healthy balance sheets, irrespective of the economic cycle. The aim being not only to ensure healthy capital appreciation when markets rise, but also to exhibit a degree of capital preservation in times of challenge.
“Notwithstanding the analysis suggesting that companies with stronger-than-average balance sheets have not been as alpha-generating over time (Exhibit A), the fact remains that the world economy can and does hit periods of significant stress.
“ In our view, these periods of pronounced stress are reason enough to invest in companies with strong balance sheets.
“We believe that trends observed in Q1 2020 validate such an approach. Simply put, financial strength allows a company to better withstand periods of economic uncertainty, while at the same time amassing capital that can be deployed to strengthen its strategic position, often during periods of uncertainty. To be able to “withstand” and “deploy” in this manner goes to the heart of how and why capital preservation and capital appreciation form a central role in our Quality, Valuation and Time investment philosophy.”