Exploiting The Inefficiencies In Small-Cap Stocks – ValueWalk Premium
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Exploiting The Inefficiencies In Small-Cap Stocks

Judd Peters, CFA, is a portfolio manager of the Hotchkis & Wiley Small Cap Diversified Value Fund (HWVIX). Along with co-manager Ryan Thomes, he coordinates the day-to-day management of the fund, as well as represents the strategy to current and prospective clients.

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Small-Cap Stocks

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He has been with Hotchkis & Wiley for 18 years. Prior to joining the firm, he was an analyst was an analyst in the investment banking division of Wedbush Morgan Securities. He received his BA in mathematics and a BS in biochemistry from University of California, San Diego.

As of April 30, since its inception (6/30/2014), the fund’s annualized return has been 9.45%, resulting in a 232 basis point outperformance versus Russell 2000 Value Index, which returned 7.13%. The fund is rated five stars by Morningstar and is in the top 7th percentile of its Morningstar peer group over the three years ending March 31, 2018.

I interviewed Judd last week.

Tell us about your investment process. Specifically, how do you find value in the small-cap space?

We use a two-step process to construct the portfolio. In the first step, we use proprietary valuation models to narrow down a universe of around 3,000 small-cap stocks to a group of 500-600 stocks that our models indicate are attractive investments. In the second step, we distribute these 500-600 stocks to our team of 22 investment analysts based on their industry coverage. These analysts perform a fundamental review of each stock and based on their recommendations, we build a portfolio of 350-400 undervalued stocks. We typically find opportunities in companies that are temporarily under-earning relative to their long-term potential, either due to industry cyclicality or company-specific situations.

How do you seek to capitalize on overreactions by investors in small caps?

Investors often overreact both positively and negatively to short-term financial results. The market has a tendency to extrapolate short-term performance into the future. For example, we might find a company that has a 2% operating income margin this year, but earned an average margin of 10% over the last decade. Because the market tends to project the current low margin into the future, this valuation is likely to be a reasonable or even low multiple of this year’s depressed earnings. If our research indicates that the company can improve its margins toward to the historical average, then we are investing at a very attractive valuation relative to the long-term potential earnings.

What is your view on valuations today in small cap and more generally? How do you compare the current era of outperformance of growth stocks to the dot-com era?

There are certainly lofty valuations in parts of the U.S. equity market today, particularly in large-cap technology stocks. We’ve also seen valuations in small-cap growth run far ahead of small-cap value. Based on 10-year rolling returns, the Russell 2000 growth index has outperformed the Russell 2000 value index by more than 2 percentage points annualized. The last time the Russell 2000 growth got this far ahead of the Russell 2000 value was early 2000, after which value outperformed growth by a large margin.

How do the valuations in your fund compare to that of the Russell 2000 value index, in terms of P/E and P/B ratios?

The P/B of the portfolio is 1.3, compared to the Russell 2000 value index at 1.5. The 2018 P/E of the portfolio is 13.3 compared to the Russell 2000 value index at 15.0. We are more focused on normalized earnings, and on that metric our normalized P/E is 10.1 compared to the Russell 2000 value index at 14.9.

As of March 31, the strategy had $412 million in assets (of which $27 million was in the mutual fund). How big can it be before you consider closing it?

We estimate that we can manage $4 billion in total-strategy assets without compromising the integrity of the portfolio. However, we will close the fund if trading becomes a challenge. Hotchkis and Wiley has a track record of closing funds at conservative levels to preserve trading liquidity and protect existing shareholders.

Read the full article here by Robert Huebscher, Advisor Perspectives

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