- Smaller companies popped in October, and investors are growing more optimistic about the stocks.
- Jeremy Grantham’s firm GMO just launched a fund targeting “quality” small-cap stocks.
- Its managers explain how they’re finding companies that are positioned to be long term winners.
Growing fears about a recession weren’t enough to stop small cap stocks from having a great month in October.
Markets bounced back in a big way last month, with smaller companies leading the way. The small-cap S&P 600 rallied 9% in October, while the S&P 500 benchmark rose a respectable 5%.
Conventional investing wisdom holds that smaller companies are more vulnerable to an economic downturn, and that their balance sheets and business track records aren’t as strong as those of their larger peers. But small caps seem to have some momentum behind them despite rising interest rates and signs of a slowing economy.
Count Jeremy Grantham’s firm as part of that bandwagon. Grantham, Mayo, and van Otterloo, which managed $59 billion as of mid-year, launched a new small-cap strategy focused on quality stocks in late September to reflect its bullishness on the group.
“We believe a moment has arrived when long-term and short-term opportunities in quality small cap equity are finally aligned, when one can invest in high-quality small cap names at attractive valuations,” wrote Hassan Chowdhry and James Mendelson, who manage the fund along with Thomas Hancock.
In a recent report, Chowdry and Mendelson said that quality stocks — a broad term that generally means companies with a history of consistent results, high profitability as measured by criteria like returns on equity, and a healthy balance sheet — have a long history of beating the market with less volatile returns.
They say that quality small caps have outperformed small caps in general by 1.8% a year since 1976, and they’ve beaten a mix of small-, medium-, and large-caps by 2.8% a year in that time. The trick, in essence, is to filter out the unprofitable companies and flashes in the pan that often seem to clutter the space.
“More predictable, long-term winners are very often undervalued by the market, buried under the buzz of stocks long on narrative but short on fundamental stability,” they wrote. “Investors tend to overpay for shares of weaker and more volatile businesses, perhaps lured by overly optimistic projections or lottery-ticket-like chances for sizeable payoffs should these companies succeed.”
The duo argue that quality stocks will do fine in a downturn because historically, quality small caps actually perform as well as large caps do when the economy is slowing, but they outperform in recoveries.
Getting the right mix
In their fund, Chowdry and Mendelson want to find companies that can deliver exciting results for the long term. That’s a challenge for any investor, but they say it’s harder with smaller companies because their competitive edges fade faster.
“The key focus of our small cap research is distinguishing which companies have truly sustainable competitive advantages that can support long-term outperformance,” they wrote.
In their small-cap fund, they own about 40 names that are attractively valued and have outstanding business models. They also try to steer clear of relying too much on any specific sector or trend to avoid overexposure. They say many of their holdings fit one of the following descriptions:
- Niche leaders like Acushnet, which they describe as a leading company in the golfing equipment industry.
- Innovators like medical device maker Globus Medical and chipmaker Power Integrations.
- Key parts of supply chains like aerospace and industrial company Woodward.
- Companies with a razor and blades business model like packaging maker Kadant.