Small caps: Looking past the short-term noise

Host Paul Blane discusses abrdn’s philosophy of identifying high quality, mispriced stocks that offer sustainable business models with portfolio manager Chris Colarik on the latest podcast episode. 

Transcript

Paul Blane: Hello everyone and welcome to the abrdn Open-end Fund podcast series, where we catch up with our portfolio managers from around the globe to gain some perspective on the state of the markets and the abrdn open-end funds.  I'm your host, Paul Blane,  Senior Director with the National Accounts Team and today we're focusing on the abrdn U.S. Small Cap Equity Fund (ticker -  GSCIX). It's my pleasure to welcome Chris Colarik, Head of U.S. Smaller Companies and Lead Portfolio Manager on the abrdn U.S. Small Cap Equity Fund. Hi, Chris. It's great to see you. 

Chris Colarik: Hi, Paul. Happy to be here. 

Paul: So, Chris, maybe if we could, let's sort of start at the beginning. Would you mind giving a brief overview of the abrdn small cap strategy?

Chris: Sure. So, the strategy is guided by our philosophy of identifying high quality, mispriced stocks that offer sustainable business models. Specifically, we take a team approach to construct a high conviction portfolio of 40 to 60 stocks based on deep fundamental analysis with a long term view in mind. Now, this long term view allows us to look past short term noise that often occurs in the market. We’re a core strategy, we’re benchmarked against the Russell 2000 and, although we're benchmark aware, our active share usually is somewhere in the mid nineties. We overlay some risk controls. We limit position sizes to 5%, including cash and have bands around our sector exposure. The end result is a portfolio of high quality stocks that participates in up markets while providing downside protection over a market cycle. 

Paul: Great. Chris, thank you for that. So, can we shift gears to maybe talk about the markets from a broader perspective? Would you mind letting us know what's been happening in the  small cap markets this year? 

Chris: Well, it's been a whirlwind of a year. The Russell 2000 started out very strong with a double digit gain within the first few weeks. However, the uncertainty around inflation, the Fed's rate hike path and fears of a recession drove investors out of the market. But then over the summer, the Russell 2000 rallied and retested its highs, but failed to break out. Continued strong economic data then forced the Fed to message higher rates for longer and that has been the center of debate ever since. In fact, during the Fed's last meeting, they lowered the number of rate cuts expected for next year. So, that sent panic waves through the market and so the third quarter was fairly bleak with the Russell 2000 selling off about 5%. Unfortunately, we underperformed for the quarter as our economically sensitive stocks came under pressure. But with that said, for the year, we've more or less matched the index. And so as we sit here today, the Russell 2000 is essentially flat for the year. However, we're entering what has been historically the strongest months in the market and, although uncertainty remains elevated for sure, we believe that historical seasonality trends still have a good chance of playing out. 

Paul: So, if we could drill down, can you get specific on the sectors that you are investing in and what you're avoiding? 

Chris: Yeah, for sure. So entering the year, we were underweight energy, what was certainly the right call as energy stocks underperformed for the first half of the year as the price of oil declined. However, during the third quarter, we began to neutralize the sector as we believe crude oil may be set up for an extended period of supply demand imbalance. So, our outlook is supported by low inventories in the U.S., which are largely driven by the SPR, which was tapped to help lower gasoline prices during the pandemic. But really what's important is that the Department of Energy has committed to refilling the SPR and would be a buyer around $70, which ultimately puts a floor on the price. Saudi Arabia has also committed to cut production by a million barrels per day through at least year end, and then finally, the recent conflict in Israel may create further disruptions. So given all that, we spent a lot of time identifying companies in the ENP space to neutralize the sector. We focused on companies with under levered balance sheets, strong free cash flow and those that offer a dividend or have a share buyback program in place. 

Conversely, areas we have been underweight have been those that are considered to be interest rate proxies such as rates and utilities. Until there is some clarity on peak rates, these sectors are likely to lag. 

Industrials and technology are areas we continue to like. Within industrials, we remain overweight. We are finding value in a number of companies, some of which are participating in onshoring and others that are benefiting from the Inflation Reduction Act. Finally, technology is another area we are overweight. Areas of interest include companies providing cybersecurity services and semiconductor related companies that are benefiting from the AI movement. 

Paul: So, Chris, final question for you in a few parts, if I could. So, for investors listening today, one, why do you think they should invest in small cap stocks? And two, why abrdn? 

Chris: Well, first of all, small companies are under-covered by the street compared to large caps, providing active management a great opportunity to add alpha. So, having small cap exposure is always recommended for a diversified portfolio. That being said, there are several reasons why I believe the backdrop is set up for small caps to outperform large caps. First, valuation for smaller companies continue to look very compelling. In fact, on a price to earnings basis, the discount for small relative to large cap is at generational lows.

Second, small caps have historically performed well during periods of high but declining inflation, which is exactly what we're seeing now. 

Third, corporate balance sheets are flush with cash. This has led to an uptick in M&A activity as companies look to acquire growth, and that environment tends to be good for small cap returns. 

And fourth, small caps have historically recovered strongly after significant market drawdowns, including outperforming larger companies during the rebound phase. Currently, small cap stocks are under owned due to concerns around the economic outlook. And once there's more clarity on interest rates, cash will move off the sidelines and small cap stocks will likely move higher rapidly. But trying to time that move is difficult and missing the first days of that move can cost an investor significant potential gains. And finally, looking out to 2024, earnings expectations are higher for smaller companies, which could be another catalyst for investors.

Chris: So, why abrdn? Let me start by saying that I believe our U.S. small cap strategy is a hidden gem. We have a strong global franchise and investing in smaller companies with over 10 billion in assets under management. We believe that global footprint provides us an edge over our competitors, both from a depth and breadth perspective. Also, higher quality companies look cheap relative to lower quality companies, which is a core investment tenet of the strategy. And then finally, unlike many who just began talking about ESG, it has been a core pillar at Aberdeen since the 1990s. We believe understanding a company's ESG profile can provide insight into potential financial risks, helping provide better outcomes. All of these factors have led to an impressive long term track record, and we have been able to accomplish this while taking on less risk.

Paul: Chris, it's been great speaking with you today. Thanks very much for your time and your insights. 

Paul, thanks for having me on. 

Paul: So, for anyone interested in learning more about the abrdn U.S. Small Cap Equity Fund (ticker  - GSCIX), please email us at adviserservices-us@abrdn.com,  and abrdn is a b r d n,  or feel free to call us at 800 485 2294.

Chris thanks again.

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