Knowledge. Shared Blog

July 2020

Awaiting a Return to Rationality in SMID-Cap Growth

Portfolio Managers Jonathan Coleman and Scott Stutzman discuss the unusual trends they have observed in the small- and mid-cap growth space, where money-losing companies have outperformed profitable businesses through the distinct market cycles that have occurred since late 2019.

Key Takeaways

  • Since late 2019, three distinct cycles have occurred in U.S. equity markets: The peak in late 2019, the panic selloff in February driven by the expansion of COVID-19 and the rebound that started on March 23 and continued through the end of the second quarter.
  • Throughout these cycles, we have seen money-losing companies consistently outperform moneymaking companies – a rare situation that we think is bound to eventually reverse.
  • We believe companies with durable, self-sustaining business models and reasonable valuations have the best potential to generate positive returns in the long-term, despite the irrational environment we are currently experiencing.
View Transcript

Jonathan Coleman: The last six or seven months we have seen really dramatic times in the small- and mid-cap growth space in the indexes – times that are virtually unprecedented in stock market history. I think of three distinct regimes that we have seen, that we have lived through in the last seven or eight months, in the stock market. The first being late 2019 through February 19, which was the peak of the market. I really think of this as the late stage of a bull market in which you might expect the most speculative companies to perform very well, kind of in a late-cycle blow-off phase. And one of the things we saw during that phase was that money-losing companies outperformed the moneymaking companies by a significant margin during that period of the market, from late 2019 to February 19 of 2020. We are defining this by saying that companies that lost money over the previous 12 months and comparing those to companies that actually made money in the prior 12 months, and we saw again the money losers meaningfully outperformed the moneymaking companies.

The second phase of the market was the panic selloff related to the dramatic expansion of COVID-19 cases and deaths from February 19, the market peak, to March 23, which was the bottom of the U.S. equity markets. And in that phase of the market, we also saw that the money-losing companies outperformed the moneymaking companies.

The third phase that I would describe would be the rebound from the panic selloff that started on March 23 and proceeded through the end of the second quarter, June 30. Interestingly, in that phase, we also again saw money-losing companies outperform moneymaking companies this time by the widest magnitude of either of the previous two phases that I talked about. This is exceptionally rare in stock market history. It is not often that you see three very distinct types of markets and yet you see the same leadership in each of those markets. And it’s setting up a situation that we think is bound to reverse, even though it is difficult to predict the timing of when that will occur.

Scott Stutzman: We believe that it is a more prudent approach to invest in companies that have self-sustaining business models, that have proven over a period of time their competitive advantages, the durability of the businesses and have good returns on invested capital in virtually any environment. Many of the companies that are doing well or the stocks that are doing well in the market today actually have no profit, negative returns on capital, and have been unproven. It remains to be seen how they will do over the course of time and what the competitive dynamics may be as their industries evolve, because many of them are in nascent stages in highly competitive markets.

Coleman: Well, it’s impossible to predict the future, but we know a couple of things from the current environment that make sense to us having observed the small and the smid-cap space over a long period of time, both individually and as a team. One is that we know, as Ben Graham famously said, in the short term, the market is a voting mechanism, but in the long term, it is a weighing mechanism. And so a certain group of investors is certainly voting on their favorite stocks – in our opinion here, these money-losing companies – and giving them lots of votes. But we know over the long term, the time-tested approach to outperforming is buying high-quality companies at a reasonable valuation.

The second observation I would just make is that there is fundamentally a difference between what is a good company and a good stock. And you can have many good companies that go to excessive valuations and unfortunately, ultimately that results in the stock not being a good investment prospectively. And when we look at many of these money-losing companies and the excessive valuations that are being afforded to them in the market today, our humble view is that while many of these companies may be well-positioned in their marketplaces, the valuation accorded to this stock today does not make them an attractive risk-reward investment looking prospectively.

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