We Like Small Caps Too

We enjoyed reading Jim Paulsen’s recent piece in Barron’s, explaining why it may be a good time for small cap stocks (which we’d encourage you to read as well). We were tempted to simply post it as validation for what we’ve been telling clients, but upon further reflection, figured it would be better to articulate why we at 361 Capital like the asset class generally, and what we believe to be the compelling merits of our approach more specifically.

I like Paulsen’s analysis because it is well thought out, data-driven, and not based on speculative projections. He lays out the current environment and explains how it could prove conducive to small cap equities based on historical performance. He argues that smaller stocks can outperform larger ones based on six economic factors playing out. That said, it is not how we devise investment strategies.i Furthermore, he is taking the top-down approach as to the relative attractiveness of smaller equities. That covers the allocation decision. Then there is the implementation.

As an asset manager with a small cap strategy, we already believe small caps are an attractive asset class. Not because of the timing of things we cannot predict, but because of simple, yet proven research. At 361 Capital, we have long since made the argument that analyst earnings revisions for a company are what investors would want to know mostwhat we call perfect foresight. Over time, there is a significantly positive return to knowing which companies would receive the most future net positive earnings estimate changes. This response transcends market and economic cycles since it is based on human behavior, which has proven to be predictably consistent. Ranking the Russell 2000 Index constituents back to 1996 on a monthly basis and taking the forward month return would yield a Decile 1 (most net positive) return of over 98% annualized. This is a pretty telling metric to us, which is why we think small caps provide fertile ground for our approach.

Looking at this graphically, there has been an inflection in the return spread between the top decile returns and the decile containing the least favorable revisions.

Source: 361 Capital. Universe includes stocks from the Russell 2000 and S&P Small Cap indices.

You can see the most recent quarter’s end saw a sharp increase from its low reached in the second quarter of this year. The spread was the highest seen since the fourth quarter of 2013. What this says is that investors rewarded the stocks with the most net positive estimate revisions at an increased rate compared to those with the least positive revisions.

The 20+ year average spread is 33%. It is slightly higher (38%) from 1996 through 2009 and then falls to 25% from 2010 to the end of September. More research is required to make an informed assessment as to why, but it appears something changed after The Global Financial Crisis. Quantitative easing? Massive net flows to passive investments? Large cap dominance? Either way, the value of perfect foresight remained healthy. Obviously, one quarter does not make a trend, but if this reverts back to its longer-term mean, it would add to the current excitement for our small cap strategy.

We already like small caps and think we have a differentiated approach. But don’t just take our word (or Jim’s), do your own work and form your own beliefs.

Read more on Small Caps with Three Reasons Small Caps Should be Part of Your Equity Allocation