Smaller companies in cyclical sectors that do business abroad -- or with other U.S. firms that have global exposure -- could be well positioned to benefit from improving global growth.
Why do certain small-cap cyclicals with more global exposure look attractive to you?
FG I think it's the fact that small-cap cyclicals with global end markets are very well-positioned to benefit from improving economic growth. In contrast to the conventional notion that all small-caps derive the bulk of their revenue from domestic sources, many small-cap companies have a healthy percentage that comes from outside the U.S. More than 400 companies in the Russell 2000 currently derive a third or more of their revenue from foreign sources. And that total doesn't capture those small- and micro-cap companies that deal mostly or exclusively with U.S. firms which have global exposure.
Factor in the weaker dollar, and we see solid-to-strong economic prospects, combined with relatively more attractive valuations, potentially adding up to positive outcomes for a certain kind of small-cap company. From our perspective, small-caps in cyclical industries with modest valuations and global exposure look poised to lead—and we are happy to be holding many.
With the global economy growing, why do you think cyclical stocks have underperformed so far in 2017?
FG To be sure, we see a lot of U.S. stock performance as disconnected from what's happening in the economy. For example, stock and bond investors alike appear to be pessimistic. The yield on the 10-year Treasury was tumbling into early September, which typically (though not always) is a sign of concern about economic growth, just as equity investors' preferences for higher yield and other non-cyclical investments is evidence of caution.
We're more optimistic. So while we recognize the uncertainty, we also see more than enough reasons to be cheerful about economic prospects—especially on the global level. Historically, economic accelerations have been good relative periods for value, and, not surprisingly, cyclical stocks.
Why do you think the markets have seen such low levels of volatility over the last 12-18 months and do you anticipate that changing?
FG Sooner or later it will, of course. It always does. But it's important to remember that volatility doesn't revert to the mean, with the exception being periods of high volatility, in which it dwindles back to lower levels. The misperception that volatility is cyclical may be rooted in the mistake of equating it with down markets. In any case, the current period of very low volatility doesn't mean that we're "due" for higher levels, and we don't see the market's placidity as an ominous sign.
Are you still finding interesting opportunities in healthcare outside the biopharma complex?
CR When it comes to healthcare and tech, I usually invest with the same approach—I look for suppliers and service businesses that provide 'picks and shovels' for more speculative, higher-growth players. In those areas I'm much more likely to find that sweet spot of quality and value, those more conservatively capitalized businesses with strong records of earnings and a history of free cash flow generation. That way, I can potentially avoid some of the higher risk while receiving what I think is a good return.
What are your thoughts on the performance of financial stocks so far in 2017?
CR There've been some disappointments in banks, so we've added names or built existing ones in a couple of portfolios. The state of rates is obviously a key factor in the industry. Since I'm confident that rates will rise, I like the long-term prospects for a number of smaller banks, particularly those with strong loan growth.
I also still like a select group of alternative asset managers and am pleased that some of them have been attracting other investors, who seem to recognize the attributes that drew us to these companies in the first place. In general, asset management remains an important area of focus for my portfolios.
What other areas look attractive to you?
CR We've seen some interesting opportunities in food- and agriculture-related stocks as well as in shipping companies so far this year. In each case, industry slowdowns have hit stock prices hard, which is giving us a chance to buy leading businesses with strong fundamentals—balance sheets, returns on capital, free cash flow—at prices that look attractive to us. Even in up markets, there are almost always pockets of opportunity.
What is your take on the fact that growth stocks continued to lead the U.S. market in 3Q17?
CR It initially looked surprising to us, especially in light of how powerfully value stocks rebounded in 2016, but I think it begins to make sense when we look further. The markets and economy are still winding their way back to normal after the seismic events of the Financial Crisis, which were almost a decade ago.
Over this period, the economic recovery has been long and very slow, some would say painfully slow, with growth in the U.S. still not proceeding at a fast enough pace to reassure most investors. During six of the eight calendar years following the Financial Crisis, small-cap growth beat small-cap value. Investors tend to stay loyal to what's worked for them and are slow to change. That's understandable, but we think small-cap investors' confidence in growth stocks is misplaced, particularly from a valuation standpoint.
Given investors' current preferences, what do you think needs to happen for small-cap value to regain leadership?
CR I think the style leadership in the market is driven by interest rates as much as anything else. And when we talk about the road back to normalization, a large part of what we mean is the normalization of interest rates. Ultimately, small-cap value will need to outperform for several years to win investors back, but we think that style leadership may have turned a corner in early September.
We began to see reversals at the level of small-cap style and sector that lasted through the end of the month. Small-cap value decisively beat small-cap growth, and cyclicals outpaced defensive sectors while small-caps also outperformed large-caps in September. Lending support to the idea that style leadership is influenced by interest rates, the 10-year Treasury reached its YTD low around this same time, hitting 2.05% on 9/7/17 and rising through the end of the month.