Transcript: Conditions look good for this forgotten asset class

Finding opportunities

FG: I always think of declines in the market as buying future performance. When you’re in a bear market — which is never fun — you just nibble a little bit every day. Hopefully you’ll have a great average price around your position. Most of our focus is on domestic U.S. small caps, but you’re seeing kind of a change in mindset around international equities this year. You are seeing things change and percolate outside of the United States in a way that we haven’t seen in a long period of time. So, I’m excited about the opportunity set outside of the United States that I think will be very beneficial to small caps.

Tailwinds for small-cap stocks

FG: You’re seeing valuations in the small-cap market on a relative basis. You’d have to go back 20, 25 years to see the same relative-type valuation opportunity that we’re seeing today. Small caps are working their way out of an earnings recession that we think you will actually see some significant growth in the small-cap space over the next, really, two years, driven by AI as well as reshoring and re-industrialization here in the United States. Small-cap companies will benefit from the efficiencies of AI, and they are also part of the AI machine, if you will. So I think that’s part of the tailwind story. The other one that I really like: in a world where everybody’s focused on the large-cap space, I believe one of the greatest tailwinds that small caps have is that they’re under-owned. As people think about diversifying away from that concentration of the large-cap space, I think small caps are a wonderful alternative asset class for them to be looking at.

Prevailing headwinds

FG: We know that 40% of the Russell 2000’s debt is variable rate, so anything around rates could really affect lower-quality businesses. I would also say that over 44% of the Russell 2000 is comprised of non-earning companies. So, it actually just argues for active management within the small-cap space, right? You want an active manager. You want them to be able to find these durable businesses that aren’t relying on the bond market or banks to grow their business. They’re actually generating free cash flow and investing that free cash flow. They have earnings, they can grow their business in a lot of different ways.

Names he likes

FG: Yeah. So, two names for you. One is AAON, which is benefiting, increasingly, from the growing need for cooling on these AI-heavy data centers. It’s a leader in this large and growing area around AI. So I think that’s one worth focusing on. The other one is a multi-family mortgage bank with fee annuity servicing and growing advisory asset management arms called Walker & Dunlop. It’s a capital-light business, and we’re big, always big fans of asset-light businesses. And we believe this is a company that is really being able to grow, and grow pretty effectively.

And finally, what’s the bottom line on investing in small caps in the current moment?

FG: People should think about adding small caps to their portfolio because they’re under-owned, because they are diversifying away from the large-cap space. And to be quite honest with you, they’re not taking on the concentration risk that you’re finding in the large-cap indices today. Here you have an asset class that has a valuation advantage over large. We know they’re kind of under-owned at the moment. And so I think any diversification away from the large-cap space and broadening of the overall market will really benefit small caps and in a way we haven’t seen in a long period of time.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Francis Gannon of Royce Investment Partners. Visit us at investmentexecutive.com where you can sign up for our a.m. newsletter and never miss another sound bite. Thanks for listening.

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