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.”

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Aidan Farrell

Investors searching for broader sources of return and diversification have been revisiting global small-cap stocks notes Eaton Vance, a global investment manager.

Aidan Farrell, Director of Global Small Cap Equity, Eaton Vance Advisers International Ltd. says: “In our view, this is one of the largest, most diverse and least researched segments of the equity market, offering fertile territory for alpha generation.

“We believe that a focus on companies with high or improving quality attributes can make a meaningful difference when investing in the global small-cap equity sector.”

Here are some thoughts on what matters to this sector.

Why focus on quality?

Our aim is to manage small-cap portfolios that are well-positioned for both capital preservation and capital appreciation. That’s why we’re committed to investing in companies we deem to be of high or improving quality, based on our proprietary research process. In fact, quality is the cornerstone of our investment philosophy.

What is quality?

The quality characteristics we seek when evaluating companies for investment include:

• Well-entrenched franchises
• Durable and scalable business models
• Beneficiaries of structural growth and change
• Strong management teams
• Healthy balance sheets

In our experience, companies with these attributes tend to have the ability to maintain or grow market share during economic expansions and contractions, while also exhibiting better downside protection – a combination that we believe is critical for achieving better risk-adjusted returns throughout the business cycle.

Considering valuation and time

Once we identify a quality small company, the next step in our decision-making process considers current valuation and time. Are the company’s prospects already priced in? Would any other factors keep us from adding that position to the portfolio now? As we see it, time is essentially the discipline of exercising patience on entry points and holding periods, which relates to the long-term nature of our investing mindset.

Quality, valuation and time are vital to our investment approach. If we’re satisfied that all three inputs are aligned, then we would add the stock to the portfolio at an appropriate risk position size. However, any company of sufficient quality without the necessary valuation and time conditions would continue to be monitored closely for a more suitable entry point.

Evidence that quality and valuation outperform

We have evidence to support our focus on quality and valuation. Over the 19-year historical period from 1999 to 2018, we divided the MSCI World Small Cap Index constituents into quintiles based on fundamental factors – with stocks sorted high to low using return on invested capital (ROIC) and return on equity (ROE) as the quality indicators, and free cash flow yield (FCFY) as the valuation indicator.

Please see disclosures*

Stocks scoring in the first and second quintiles for quality and valuation – in this case, less expensive stocks – outperform the index, while the lowest quality and most expensive stocks in the fifth quintile significantly underperform. The annualized active returns demonstrate the magnitude of outperformance or underperformance that the ROIC, ROE and FCFY factors contribute across each performance quintile.

From our perspective, these results provide compelling evidence that stocks with more attractive quality and valuation metrics have delivered superior performance throughout the cycle and over the longer term.

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* Alpha measures risk-adjusted performance, showing excess – or active – return delivered at the same risk level as the benchmark. It is not possible to directly invest in an index. Index returns do not reflect the effect of any management fees, transaction costs, or expenses. It is not possible to invest directly in an index. Past performance is no guarantee of future results. Investing involves risk including the risk of loss. The value of equity securities may increase or decrease in response to economic and financial events (whether real, expected or perceived) in the U.S. and global markets. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, more established companies.

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It has made sense to stick with small caps around recessions.

Eaton Vance, a leading global investment manager, notes global small-cap stocks investors have been worried lately about volatility, rising geopolitical risks, a potential recession and the sheer length of the current rally.

Aidan Farrell, Director of Global Small Cap Equity, Eaton Vance says “It makes sense intuitively why investors are more nervous about small caps because they tend to have higher volatility than their large-cap peers.

“While we could debate the prospects for equity markets at length, let’s assume the glass is half empty, and that global stock markets face imminent challenges ahead. In that case, many investors would have the knee-jerk reaction that small-cap equities are the last place they want to be, especially in the later stages of the economic cycle.

“However, it’s not that simple, and investors dismissing the idea of investing in small caps may be making a big mistake.

“Instead, we think global small-cap stocks deserve a place in many long-term equity portfolios. They may offer strong risk-adjusted performance versus large caps, diversification and opportunities for active managers.

“Now, we can still make a solid case for global small caps even if investors are worried about the economic cycle for any reason, including trade wars or other political risks. Trying to time exposure to small-cap stocks to avoid recessions is a loser’s game, as we’ll discuss.”

Eduardo Lecubarri and his team at J.P. Morgan produce regular in-depth research on the small- and mid-cap (“SMid”) universe. A recent piece from them studied the historical performance of SMid stocks before, during and after recession-linked market downturns.

Lecubarri looked at the last three U.S. recessions and found that SMid outperformed large-caps more often than not in some regions, including Europe and Japan.

Looking at the U.S. market, as noted in the charts below, small caps as measured by the Russell 2000 Index underperformed large caps as measured by the S&P 500 Index by an average return of -5.2% during recessions (peak-to-trough). That data alone is not totally reassuring as far as timing an investment in small-caps.

However, when combined with additional analysis around the late and early stages of a bull market, the picture becomes clearer. There have been five recessions since 1980. During the 12 months prior to the peak, the Russell 2000 Index averaged returns of 37.9%, compared with 19.8% for the S&P 500 Index. During the 12 months after a trough, the Russell 2000 averaged a return of 75.8%, versus 45.4% for the S&P 500. The takeaway is that it has made sense to stick with small caps around recessions, despite the historical moderate underperformance during a downturn.

Mr Farrell adds “So there are numerous reasons to consider an appropriate allocation to the small cap universe — diversification benefits, inefficient markets and the sheer breadth of investment opportunities when compared to the large cap universe. History suggests investors should think twice about trying to time an investment in small-caps due to concerns about the economic cycle and the near-term outlook.”

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