In this episode of Markets in Focus

After small-cap stocks notched record-breaking performance in 2020, how will they deal with inflation fears? Eric Mintz, CFA, Portfolio Co-Manager at Eagle Asset Management, and Tim Miller, CFA, Portfolio Co-Manager for Scout Investments, join Matt Orton, CFA, Director and Portfolio Specialist at Carillon Tower Advisers to examine sectors of opportunity.

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Transcript

Matt Orton:
Small cap stocks had quite a roller coaster ride in 2020. The first quarter of the year was the worst for the space, while the fourth quarter marked the strongest small cap performance in history and the upward trajectory has continued into 2021. Now the questions become, how long will condition stay favorable for small caps? What role does cyclicality play and which sectors are poised to benefit?

Matt Orton:
This is Markets in Focus from Carillon Tower Advisers, I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights.

Matt Orton:
Eric Mintz, Portfolio Manager on the Eagle Asset Management, small and mid cap growth team and Tim Miller, Portfolio Co-Manager for Scout Investment, small cap products, join me now to chart the potential path of small caps. Thank you both for being here today. So Eric, I'm going to start with you. How much longer do you think the outperformance of small caps can continue? And what do you think are the biggest risks for small caps right now?

Eric Mintz:
Thanks Matt, I certainly think that the small cap rally that we've seen as you've pointed out, that began in the second quarter of 2020 can continue. I mean, I think we're actually right in the sweet spot of when small caps perform exceptionally well, which is coming out of a recession and clearly we had a very severe and sharp recession, albeit short-lived in duration. I think that we certainly have another six to nine months of pretty strong performance for small caps. And certainly when you think about the macro backdrop, it's exceptionally positive. I mean, you've got $1.9 trillion of fiscal stimulus about to come into the system. I think of the fiscal stimulus that was passed in 2020, there's still 2 trillion of that, that hasn't even been funded yet. And then at the same time, you've got exceptionally loose monetary policy, not only here but globally.

Eric Mintz:
And that's an important consideration to take into account, is that this really is happening on a synchronized global level. Everyone coming out of this pandemic induced sharp downturn and that's just fodder for this economic expansion, that's already really begun in the second half of 2020 and continues to accelerate. And as you think about that economic recovery, I think there's two big drivers going in here in 2021 beyond just the stimulus. And one is, as the vaccines are rolled out and clearly we're seeing acceleration in that. I mean, I think we're running two and a half million vaccines a day now in the U.S. It's just unleashing tremendous pent up demand for the services side of the economy and it's no secret that the leisure travel, hospitality sectors of the economy have absolutely been pummeled during this recession.

Eric Mintz:
There's clear demand, people want to get back out, they want to see friends and family they haven't seen in months if not over a year, so we're going to unlock that demand. And then on the manufacturing side of the economy, there's also pretty good stimulus here in that, there's a clear need to restock inventories. Channels are incredibly lean, there's been all kinds of shipping, logistics issues and we're probably going to see a pretty good amount of investment as companies look to reassure their supply chains. So I think those two components on top of the monetary and fiscal stimulus are going to be pretty strong growth drivers for the economy. And typically when we do get these expansions, small caps really performed quite well. In terms of the risks, it's no secret that there's clear pockets of froth in this marketplace, in the stock market.

Eric Mintz:
These meme stocks, the short squeeze and the Reddit favorite names and obviously there's a lot of activity on these celebrity SPACs (special purpose acquisition companies) to have raised a tremendous amount of capital. Obviously, there's heightened interest in cryptocurrencies. And even this new asset class of non fungible assets has really captured people's imaginations. And I'm not, I'm not entirely certain what it takes to unwind some of that, but there's definitely animal spirits on the retail side of the ledger in the stock market that are cause for concern. We've already seen a back-up in interest rates, pressure overall valuations and there certainly are areas of the market that are expensive, but I think overall that's pretty healthy. And I think two other risks for small caps that are really worth monitoring, that might not be top of mind right now but could certainly come into the fold.

Eric Mintz:
One, would be any potential increase in the corporate tax rate. Rollback of former president Trump's signature legislation, was obviously lowering corporate tax rates and that it's no secret that President Biden has that on his top of the to-do list, to raise corporate tax rates back up. So clearly that would pressure corporate profits and probably lead to perhaps even reduced multiples on earnings and small caps and then finally, profit margins. This is something that... Yeah, I'm probably going to refer back to this several times but it's really an area, I think it's almost the inverse of what we had last year. Where expectations got absolutely pummeled as the pandemic took hold and people were expecting corporate profits to completely collapse. And to some extent they did but there were certain areas of the market where companies took drastic action, albeit one-time measures to really control the cost side of the equation.

Eric Mintz:
We saw both the second quarter, the third quarter, the fourth quarter of 2020 big upside surprises on the corporate profit side, especially outside of those hard hit industries that I referred to earlier. So I think profit margins, especially as we start to see the tightness in the supply chain, tightness in the labor market, that's going to be the key. And we're really not going to get our arms around that until we work our way through this first quarter earnings season and get updated outlooks on earnings expectations. But I think that's going to be an area you really want to drill down onto on the risk side of the equation.

Matt Orton:
Those are all really good points and I want to drill just a little bit deeper into something that you mentioned, which is about the potential rise in interest rates, the amount of really unprecedented fiscal stimulus. Loose monetary policy and what that could do to rates going forward. And Tim, given this backdrop with an improving economy, interest rates moving higher, pretty sharply over the past few months. How is that impacting and how could it impact small cap equities going forward?

Tim Miller:
Well, conventional wisdom says that rising interest rates means rising discount rates, which should be bad for stock valuations. But if we look at historical performance, small caps have tended to be one of the best performing asset classes in these rising rate regimes. And they've generally exhibited significant positive returns over the last 40 years. The Russell 2000 has actually performed better in rising rate environments than in falling rate environments, which is the exact opposite of how the S&P 500 has performed over those time periods. So that means that small caps tend to outperform large caps in these situations.

Tim Miller:
Small cap PE multiples have tended to expand with rising rates regardless of the magnitude of the rate increase, but that probably has as much to do with strong economic activity and other macro factors as anything else. Another interesting phenomenon of these rising rate environments, is that active managers tend to outperform their benchmarks during these time periods. And the bigger the rate rise, the more meaningful their performance. So I think to summarize, we expect a rising rate environment should be good for active small cap managers like us, but it certainly doesn't happen every single time.

Matt Orton:
And so drilling a little bit deeper in the rising rate environment, what happens if inflation starts to increase? The 10 year inflation breakevens are now the highest they've been since the taper tantrum in 2013. And it seems the consensus is that we're going to see a significant pickup in inflation going forward. We can certainly debate that, I think I'm more in the camp with the Fed that it might be transitory but Eric, I want to throw this to you to, to get your thoughts on whether you think inflation could meaningfully pick up over the long-term. And what do you think the impact of this could be, do you think it's really just going to be base effects or temporary dislocations or do you think it'll be a longer term?

Eric Mintz:
That's interesting that you mentioned you shared the Fed's viewpoint because certainly Chairman, Powell did everything he could possibly do to emphasize the key point that the Fed believes that the inflationary data that's going to show up in the coming months and clearly be biased higher, will be temporary in nature. And I think when you consider the component shortages that we're seeing, whether it's semiconductors that are in scarce supply that have actually halted auto production lines or some of these shipping and logistical bottlenecks, we're seeing backup in the Port of Long Beach, that's continued to hamper production. And then most recently on the weather side, obviously we've had some... February was really marred by some pretty severe winter weather. And most notably what we saw in Texas, obviously there was a shutdown of power lines for an extended period.

Eric Mintz:
So certainly all three of those factors without a doubt, fall into that temporary side of the equation. But you just don't, you just don't know once those pressures start rising, what the ability is for people to push through higher prices. And as always in my mind, wages are really going to be the key and it's really going to be the overall labor market's ability to attract talent. And I just I don't think we're going to get a great answer on this question and it is a very important question, but I just don't think we're going to get an answer on the question, honestly, until after the summer. As I referenced earlier we definitely believe people are going to go out and travel certainly over the summer. They're going to have their so-called "vacci-cations" as they're vaccinated and get out and about.

Eric Mintz:
And I think when they come back after those and kids can return to school finally, in a lot of areas where they haven't been back in school. That's going to free up labor availability of parents that were forced to stay home and stay with their children. And I guess we'll just have to see what the wage rates are going to need to be, to pull those people that are on the sidelines, back into the labor force. And it might not be significant and it might in fact play out that the fed is 100% correct on that, that these inflationary forces are temporary. And certainly that'll be the tell in our mind. We're just not going to have a great answer on this question and I don't think until you get into the fall.

Eric Mintz:
But certainly as much as the Fed and we can say that we don't believe these things to be long lasting. The key that you also referenced obviously, and their question was monitoring long-term inflationary expectations. Because once that gets out of the bag, then I think that could force the Fed's hand to take more disciplined action, if you will, with regard to monetary policy, in terms of taking away some of the, I guess so-called punchbowl.

Matt Orton:
Right. And I guess, the uncertainty is perhaps what's causing some of the jitters that we're experiencing in the market right now. And Tim, let's say that we do see an inflationary uptick that could be longer lasting, how does that impact the equation for small cap equities going forward? And are there any sectors that might be better positioned than others, should we see higher inflation?

Tim Miller:
Well, Matt, as Eric noted, the Fed is telling us that lasting inflation is unlikely but the bond market certainly tells a different story and it's suggesting that there's an increased likelihood of inflation. But like a rising rate environment, periods of low and rising inflation tend to be very good for small caps on an absolute basis and also relative to large caps. Higher inflation also tends to favor small cap value over small cap growth. So even growth managers like us, who have evaluation tilt to their discipline, can tend to get better relative performance in these periods. You asked about sectors that are best positioned for an inflationary environment. Historically that's tended toward the more cyclical industries like, energy or industrials and materials that might benefit from better pricing power and increasing margins. But we believe there are still opportunities and less expensive companies within technology, consumer and even healthcare. Let me just caveat that at some level rising rates and inflation can be a negative for stocks, including small caps. But we think we have a long ways to go before that happens.

Matt Orton:
Right and so if we do have a good runway, I guess then the question is maybe thinking on a more tactical basis, we've seen a pretty rapid increase in a lot of these more cyclical companies like you'd mentioned, Tim. So if we dive a little bit deeper into some of these industries that are up significantly, Eric, we we've seen a big run in different pockets in the industrial, some of the EV (electric vehicles) related names, alternative energy. Do you think this run is sustainable? And how do you manage risks around that, when you can see names move so significantly in such a short period of time?

Eric Mintz:
Yeah. I think post the election, we certainly saw a understandable surge in investor appetite for clean energy, sustainable, ESG type thematic names. Recognizing that you would have obviously a democratic controlled House and Senate to really help President Biden push through some green initiatives. And that's fully understandable but I think one of the issues that that came about was the use of ETFs, these thematic ETFs. As vehicles to express a bullish opinion led to really an upward surge in valuations across those names that really went well beyond what you could probably expect those companies to deliver at least in 2021, on the earnings front. And I think we've already seen, courtesy of the back-up and interest rates an unwind of some of those valuation excesses in those alt energy names.

Eric Mintz:
So I think that's really creating an opportunity for us to really dig further into those names and find the right opportunities. And then I would just point out the other dynamic to this, is that there certainly was a handful of very successful SPAC vehicles that moved into this EV space, this, Alt-energy space that captured tremendous attention from investors did exceptionally well. And I think the one rule of thumb that we've already seen is that, if something works and Wall Street can make money off of it, you're going to see that repeated. There's a new one of those that pop up every day, courtesy of investment bankers, who are obviously interested in capturing fees on those transactions. So I think we've seen a supply of EV stocks really overwhelm the demand.

Eric Mintz:
And I think there's certainly been already a period of unsettling in the market, where you really had to go back and dig through what is actually worth something and what isn't, that's already been brought to market. So there's already a shakeout obviously and that's underway and that's entirely healthy against the backdrop of that surge and euphoria that we saw earlier on. And I think that that extends, anytime you get one of these thematic rushes, whether it's electric vehicles, or even obviously legalization of marijuana, attracted a lot of attention. There will be a surge of supply of investment opportunities for people to play it. So you don't necessarily have to pay nosebleed valuations, because if you are, you can be well assured that in the future, your local investment banker will bring you several more of those just like it.

Eric Mintz:
So there were clear excesses in valuation and speculation in this area of the market, that are being wrung out again, the catalyst was the back-up in interest rates and the increased supply brought to market through these SPACs. So I think we're returning to a more normal and healthy environment and it's one where you can really dig in and try to find the best names to play. Because without a doubt, it is an endurable theme that should be a good source of growth for the market overall in the coming years.

Matt Orton:
And now I just want to dig just a little bit deeper into SPACs, because they've taken a lot of flack recently as being pockets of excess, like you had mentioned. But on the flip side, SPACs have also provided some, I'd say, long overdue new lifeblood into the small cap space, where we haven't really seen that much new issue and set side of say, biotechnology. How do you look at SPACs and perhaps the viability of investments. And do you think overall the growth in SPACs is a good for the markets or do you think it's one of the situations where you really have to be very careful?

Eric Mintz:
We don't actually invest in SPACs that are brought to market purely as blank checked companies. And I've referenced earlier celebrity SPACs, where you're seeing high profile athletes with their names on the door, come to market. And if the deals are priced at 10, I think that we were an environment there for a bit where they would immediately trade to $12 and obviously, you know, $11.50 you're making some good money on the SPAC deal itself. But more recently, I think the deals are trading flat so it's not as compelling to get in on the SPAC. We certainly will look at the de-SPAC transaction, which also by the way is accompanied by typically an equity raise.

Eric Mintz:
So you don't necessarily have to be in on the initial SPAC offering and I think what will be interesting as this plays out. Because there's only so many targets out there and certainly there's a lot of SPAC money already in the market, but they're going to need it when they identify their targets and the businesses that they want to invest in or own, they're going to have to come back and raise more capital. So it'll be interesting to see how it plays out, because you could get into an environment where people want their money back, if these deals don't come to fruition. Where definitely as interest rates move up, which I don't think there's any doubt that there's going to be upward pressure on interest rates that there's going to be more scrutiny on these transactions.

Eric Mintz:
And that's all very healthy, very healthy for the market. But you're right in the sense that it does create opportunities for small cap investors. And I think you could also see a trend coming out where SPACs will acquire a business line of a larger conglomerate to bring it public via that transaction. And that could certainly be an interesting trend going forward and as you mentioned, have very positive implications for the overall small cap investment universe. So you're absolutely 100% right in that regard and I think that any type of more rational behavior should be very well received by the market. Because it is a risk that they're going to chase deals and the economics of the future transactions will be compromised and that public shareholders would be the ones that lose out.

Matt Orton:
I'm going to transition a little bit now, since I think we've set the stage pretty well and just tie some of these themes together that we've discussed. We we've seen a large run, like we talked about in alternative energy names. We've also seen a big run in biotechnology, pharmaceuticals, life sciences, over the past year. And I think that points to another big trend that has dominated the small cap space lately, which is the run in the smallest of the small companies and also lower quality companies. And Tim, had mentioned this potentially being a good environment for active managers. So I'll start with, Tim, maybe you can help our listeners contextualize how this environment went with some of these trends going on has impacted active manager performance in small caps and what headwinds that's presented but then looking forward to some of the more opportunities or reasons why active management can outperform.

Tim Miller:
Sure, Matt, some of these have presented a massive headwind in recent years. Biotech, for example, has significantly outperformed the Russell 2000 growth for the last five years. And it's currently around 20% of that index, given that the significant majority of these businesses don't make money like 90% of biotechs in the benchmark don't make money, it can be tough to keep up. We see a similar phenomenon in areas like, alternative energy, software as a service and cloud computing. To frame the conversation a little bit, over the past five years, companies with zero earnings have outperformed earners by over 14% annually. And in 2020, those non earners, that non-earner cohort outperformed earners by over 50 percentage points. They were up almost 70% versus profitable businesses that just shy of 18%. And with this massive run that these lower quality socks have been on, non earners now make up nearly half of the companies in the Russell 2000 growth index.

Tim Miller:
We saw similar percentages back during the tech bubble and I think we all know how that ended. We're certainly not making macro calls but if the market action over the last few weeks and months continues, then you could see the higher quality names that our philosophy favors continue to outperform. And we certainly believe that higher quality outperforms, lower quality over time. Fortunately, we found ways to keep up within non earners when those are working well. And while we may not prefer the so-called public science experiment biotech stocks that are relying on a binary outcome from a drug approval to succeed, there are other ways to participate in the broader growth of biotech. That may be through companies, providing tools and services to the industry or companies that already have an approved and profitable drug, but they're driving further growth by broadening markets for their drug or developing other drugs in their pipeline.

Tim Miller:
For example, we've done research on a company that had a failed drug candidate but now licenses an outstanding drug delivery technology they created, to a number of other biotech and pharma companies. And the case of all the energy, as I mentioned, there are opportunities to invest in companies that provide enabling technologies and infrastructure to the industry and they don't have to suffer the losses that some of the emerging technologies are amassing.

Matt Orton:
And Eric, building on this, if you look at this performance of smaller and smaller companies and what we've seen lately, how do you think that impacts some of the areas that you cover and do you think it could be sustainable going forward? And what might cause this recent change to continue?

Eric Mintz:
To the extent that the quintile, the smallest market cap stocks in the benchmark being exceptionally strong performers, I think is a clear headwind to all active managers that manage a substantial asset level. I mean, you simply are not going to get that much exposure to that micro-cap sleeve of the overall market. And certainly those are going to be the stocks that typically recover most sharply during a post recession, boom that we're in. So, that really is to be expected but I think as we move into a more normalized phase of economic growth in the back half of 2021, 2022, I think those headwinds subside. So there's really nothing abnormal that's going on, it's just clearly names that were beaten down the hardest during the pandemic are the ones that are recovering. And it's an area that you can benefit not owning and then you have to just grin and bear it when they recover.

Eric Mintz:
And I think that the caveat to the discussion would have to circle back to my comments about profit margins. And for sure some of those companies that are more cyclically, deeply cyclically exposed that are more in the commodity side of the equation, that don't necessarily have great pricing power are going to be the ones that are really challenged to control and improve those profit margins. And that dynamic is going to be the key for them to continue to outperform in 2021 and into 2022.

Matt Orton:
Great, I think all of this provides some great context where I think what the million dollar question really is, which is going forward, what do you think are some of the most interesting opportunities as we head into the rest of 2021? We've established that small caps can perform well and the type of environment we're in, Eric has established some of the risks that we have to look at going forward. So maybe, Tim, why don't we start with you to discuss what you think are some of the best opportunities and then we'll let, Eric finish things off.

Tim Miller:
We expect the next several months should be a fun and interesting time in the market, the market trades on expectations. So like I said earlier, rising rate environment, and even the anticipation of inflation should bode well for small caps. The set up seems to favor value over growth, but we believe a philosophy with a strong valuation discipline and an eye for higher quality profitable businesses like we implement should still be able to perform well on both an absolute and relative basis. We're optimistic that the world should return to some semblance of normalcy in the back half of the year. We should drive a lot of activity by consumers and travelers, those stocks already reflect a fair amount of optimism. But trends like, cloud computing and software as a service that were bolstered by the work from home world that we've been in, they may slow a little bit but they're likely to continue growing longer term. A lot of these stocks have gotten expensive but there's a great value to be found and we're going to work hard to continue to uncover those.

Eric Mintz:
Yeah. I would just emphasize something in terms of, on a sector level basis, that the groups that we're seeing acting quite well right now, which is really consumer discretionary. The transports, the home builders, those are really mid cycle type of performers. And I think that's especially encouraging in light of the fact that we have had this backup in rates that we're continuing to see the mid cycle names do well. And again thinking about the summer and thinking about everyone going on their vaccication. Obviously leisure and travel should be exceptional performers. At some point the market is probably going to transition into the late stage names, the late cycle names and really at the top of the list is going to be energy. And energy is obviously an area that people have been absolutely obliterated by, over the last, I don't know, 10 years.

Eric Mintz:
And it's one where you've got really a new regime on the management side because people have really been forced to succumb to... I'll call it equity vigilantism. Their share price has been depressed for so long that their forced equity investors will no longer tolerate energy companies that are going to grow their oil and gas production just for the sake of production growth. They want to see real returns of capital, they want to see returns on investments that exceed the weighted cost of capital. And at the same time you're getting some pretty good support here from OPEC (Organization of the Petroleum Exporting Countries) showing discipline, now that they've got their market share back. As long as North America keeps in line with a more disciplined production recovery, which I think the equity markets will demand. That certainly is an area where you could see real outperformance, which would be somewhat interesting in the fact that it was basically the only sector that did not work in 2020.

Eric Mintz:
So this could really be the year of recovery for energy, which overall's a very small percent of the Russell, growth benchmark, I think it's less than a percent. Which in and itself is actually a pretty good tell, that things are pretty washed out in that sector. I mean, that's down from at least six or 7%, several years ago. So obviously not a top of mind for people but certainly an area where you could see upside surprise, especially if these companies can actually show an ability to return cash to investors and put up returns on their projects that exceed the cost of capital. And I think they can also get bonus points if they can come up with a strategy that can help them pivot into cleaner fuels, cleaner energy sources over the intermediate to longer term. Which could be a tall order, but it's nonetheless a source of upside surprise that investors should probably be considering as we work our way through 2021.

Matt Orton:
Well, excellent. I think that's a lot of really good ideas for our listeners and Eric and Tim, I certainly appreciate your time today. To our listeners, thanks very much and until next time, take care.

Matt Orton:
Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsainfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify or your favorite podcast app. Until next time, I'm, Matt Orton.