The extraordinary opportunity in unloved US small-cap value
By Andrew Beck, president and CEO of River Road Asset Management, portfolio manager of Nordea’s North American Value Strategy and North American Small Cap Strategy
The continued plight of the ‘value’ style of investing relative to ‘growth’ has been well documented, but what many market participants may be underappreciating is the sheer length of this era of underperformance.
In the US, value has lagged relative to growth since 2006, which is by far the longest period on record. In comparison, the second lengthiest phase of underperformance for value was almost half this duration – between 1993 and 2000. The key driver of growth stock outperformance has been the weak economic growth witnessed during the current expansion – which is also at record length.
As long as growth remains scarce, it is unlikely the value style can regain the ascendency. However, there is only so long investors can continue to ignore today’s valuation gap – with growth stocks trading at multiples significantly wider than value counterparts. This is true across the entire market capitalisation spectrum.
While valuations are still below historical extremes, such as during the TMT bubble, we are highly unlikely to be still talking about a growth dominance in the coming years.
Speaking of the internet boom and bust at the turn of the millennium, I was a portfolio manager during this period, and it helped form my philosophy on investing. I fundamentally believe the price you pay for any investment is crucial – as critical as any other metric. Therefore, the margin of safety associated with value investing gives me the peace of mind required to invest the hard-earned savings of our clients.
However, as is the case with all value investors, it is important to have a rigorous process in order to avoid being lured by value traps. Our proprietary ‘Absolute Value®’ approach is explicitly designed to avoid value traps, by focusing on high-quality companies trading at attractive discounts to intrinsic value – rather than low-quality companies trading at deep discounts.
It is also imperative to have a structured sell discipline that avoids averaging down on losing positions – which is a critical flaw in the approach of many value investors. As a result, our style yields an attractive combination of value, quality – as well as growth – characteristics.
The small-cap sweet spot
While value stocks have been unloved for some time, we see numerous compelling opportunities – particularly within the industrials, communication services and technology sectors. An overweight position in technology may be surprising for a value-biased investor, but not all tech stocks are priced at extreme multiples like the FAANGs – with many mature, high-quality companies in the sector trading at reasonable discounts.
Within the industrials space, our investments largely include business service providers and distributors – rather than the more cyclical manufacturing companies. On the flipside, we are negative on the small-cap US bank space, which faces enormous secular headwinds.
At market cap level, we believe the current sweet spot for value investing is in stocks with a market cap of $10bn or less. We are consistently unearthing undiscovered value opportunities in this segment of the market. In addition, the valuation of small caps relative to large caps is at the most attractive level in many years.
A good example of an attractive overlooked small-cap value opportunity is Cannae Holdings – a holding company led by Bill Foley, one the most successful investors we have ever encountered. Foley – who has been successfully buying, building and monetising companies for more than three decades – spun Cannae out of his mortgage insurance company, Fidelity National Financial, in 2014. We established our initial position shortly after.
Cannae has significant equity stakes in a diverse group of companies – such as human resources services provider Ceridian HCM, data services provider Dun & Bradstreet, urgent care documentation services provider T-System Holdings and restaurant operator American Blue Ribbon. Cannae has reduced its share count by approximately 22% since 2014, buying at an average price less than half where the shares are trading today. Additionally, it has maintained a strong balance sheet, with most debt carried at the subsidiary level. Using a sum-of-the-parts valuation, Cannae continues to trade at a meaningful discount to our assessment of its intrinsic value.
Another ‘off the beaten path’ opportunity is Hostess Brands, the iconic century-old American snack cake brand. In 2013, Hostess was purchased out of bankruptcy by private equity firm Apollo Global and successful billionaire private equity investor Dean Metropoulos – before eventually going public in 2016.
Today, Hostess is the number-two brand in US sweet baked goods, with over 18% market share. Additionally, its products sell at a significant premium to the industry leader. Management has significantly improved operating efficiency and profitability, while expanding its brands and capabilities through the acquisition of Chicago’s Cloverhill Bakery, which it acquired at a remarkably low price. Similar to Cannae, the stock trades at a meaningful discount to our assessed intrinsic value, enhancing its attractiveness to a potential acquirer.