Investing in an informed and intelligent manner

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Small cap stocks have a reputation for being volatile, but AXA Investment Managers Rosenberg Equities has shown with the right investment approach they can produce strong returns.

The group has considerable expertise in the small cap arena, having started investing in US small cap stocks in 1987 and global small cap stocks in 1999. The firm launched a global emerging small cap strategy earlier this year.

Its small cap investment strategy is unashamedly bottom up, consisting of detailed quantitative analysis of company fundamentals, with a strong focus on understanding company valuations and earnings.

Patrick Kuhner, client portfolio manager at AXA IM Rosenberg Equities, explains: “We look at very detailed characteristics of a company’s balance sheet, its income statement, its cash-flow statement, and pull out from those companies a line item for as many of those individual characteristics as we can find.”

He says: “We consider ourselves traditional managers in that we are trying to uncover similar mispricing insights that a traditional fundamental manager would look for.”

The group takes the view that while markets are largely efficient, they are not perfectly efficient, and it is this difference that it seeks to exploit.

“We find investors can do a poor job of valuing those individual pieces of companies in the marketplace. By breaking up the pieces of a company, looking to the marketplace to price those pieces, and then reassembling the company, we have a very good idea of what that stock should be worth in the marketplace if investors were, on average, valuing these companies along these pieces,” Mr. Kuhner says.

He adds: “It is a very detailed, fundamental, analysis. We harness market insights and market information in a quantitative systematic process to come up with what we would say the fair value of a company should be. The process can look across many companies providing uniform and comparable insights into the details of each of the companies we value.”

The group believes it is unique in the broad selection of stocks it looks at, covering around 12,000 small cap companies globally, and carrying out this fundamental bottom up analysis for every stock in its universe.

Mr. Kuhner says: “At any given day, we can tell you for all these stocks whether or not, in our view, the stock is attractive from a valuation standpoint and the evolution of company fundamentals and earnings over the next 12 months.

“That is a very powerful insight that we can use in order to develop and exploit mispricing that we see across the globe. It is a distinctive, systematic and repeatable investment process.”

He goes on to say: “We are going to employ those insights across a broad number of names. This is part of the process of diversifying some of the risk that we find in this space, but it allows us to exploit the alpha opportunities that we see in the marketplace in a risk aware manner.”

Factoring in risk

Mr. Kuhner points out that in equities generally, and in global small cap stocks particularly, it is easy to take risk, but it is much harder to be rewarded for that risk.

“Our investment process focuses on maximising our investment opportunities where we find them and minimising the risk we take in areas where we don’t necessarily have skill,” he says.

Unsurprisingly, risk management plays a key role in portfolio construction, with the group considering both the financial characteristics of the stocks in its universe, and historical information on their risk. The firm strives to build highly-diversified, risk-controlled portfolios with superior fundamentals relative to the benchmark. “As active managers we are not interested in neutralising all risks, but rather trading off alpha insights versus the risks those opportunities bring to the portfolio,” states Mr. Kuhner.

“We recognise that the broader macroeconomic economy will impact our portfolios, but we are not a top-down manager. We would much rather take our bets along the 12,000 names that we can identify recurring mispricing opportunities, and diversify our bets across that global small cap range, as opposed to taking bets on macroeconomic themes such as whether the dollar is going to go up or if China will slow, etc.,” he adds.

“Our success will lie in a more dependable, disciplined, and consistent investment process which looks across the entirety of the global small cap equity market rather than a few concentrated bets on a limited number of companies,” he says. “Top down or bottom up, the challenge remains the same – identify stocks that are attractive along valuation and earnings dimensions and understand the risk of those stocks.”

Mr. Kuhner notes that investors often overlook small cap stocks and concedes the sector does have a “bit of an image problem”. “To many investors, small caps are very closely aligned to this idea of higher risk,” he says, adding that AXA IM Rosenberg Equities aims to ensure investors are amply compensated for these risks by investing in an informed and intelligent way.

“Many investors are too pessimistic about the risk associated with global small cap stocks. Although smaller cap companies are more volatile, superior earnings growth has historically driven small cap outperformance and supports small cap valuations,” he notes. “Additionally, investors can be excessively over optimistic for company growth expectations, especially the highest growth companies, and overly pessimistic around smaller cap companies facing earnings challenges – this creates an ideal environment for a profitable value-orientated stock selection strategy.”

Mr. Kuhner proceeds to say: “If you can access global small cap stock in a true fundamental valuation manner, you can minimise many of the risks that investors take as a given when you are in this space, particularly if you are an asset manager like us, which takes a very diversified and fundamentally-focused approach.”

He goes on to point out that global small cap accounts for around 15% of global broad market coverage and over time have outperformed large cap stocks.

“I think that there is a growing realisation that global small cap stocks as a dedicated asset class can provide a lot of opportunities for stock investors,” he says. “Investors need to be aware that you are going to experience more volatility with small cap than with large cap stock investing. But for those investors who take a diversified and valuation-focused investment approach, and for those who are already committed equity investors, the additional volatility can add improved returns and significant additional downside risk to the overall investment profile.”

Benefits of the sector

The investment community is waking up to the benefits for the sector, particularly emerging small cap stocks. Mr. Kuhner says: “In the institutional space in the US, we have seen an increase in the interest in emerging small caps as a dedicated asset class,” adding that AXA IM Rosenberg Equities launched a product earlier this year in this area at the request of two large institutional clients.

“There are a lot of mispricing opportunities in global small caps. For emerging small caps we also have identified similar mispricing opportunities,” he points out.

One factor that may have an impact on the performance of small cap stocks in the near term is the interest rate environment. Mr. Kuhner says: “Our research shows that when interest rates are going up, small cap stocks on average outperform large cap ones, as it tends to be a better economic and earnings environment. It is also an environment where investors are more attracted to what are perceived to be risker stocks.”

He continues: “If the Fed moves on rates this year or next year, the research we have looked at suggests that it should be a good environment for small cap stocks from a macro economic standpoint and from an earnings stand point.”

But he adds that small cap stocks tend to be a lot more prone to the cyclicality of the earnings cycle than their large cap counterparts. “As we transition from one economic theme to another, we tend to see small caps move around quite a bit.”

He adds: “In the end it all comes down to valuation and earnings, and what we are focused on as a firm is trying to understand company valuation and earnings opportunities, the source for those earnings, the quality of those earnings, predicting those earnings, and not paying up for those earnings streams.”

Mr. Kuhner concedes that the firm’s valuation and earnings insight can be challenged if there are dramatic changes in the earnings environment driven by macro themes, or if investors become focused on a theme that is disconnected to company fundamentals, such as the tech bubble back in 1999 or the global financial crisis in 2008/09. But he says these periods where earnings and prices diverge historically have been short lived, and they often present alpha opportunities the investment process is able to exploit.

He is confident that AXA IM Rosenberg Equities brings a diversified, thoughtful way in which to invest. “Ultimately, we believe that the challenge in equity markets is not the lack of information but, rather, how to effectively use the vast amounts of information that is available to market participants.”

Mr. Kuhner concludes: “We are very excited about the opportunities in the global small cap space, we see a lot of opportunity to do well for our investors. Our investment process that focuses on valuation and earnings has generated very solid investment returns and we expect going forward to be able to do the same.”