Small-Cap Investing: More of an Art than a Science

The CFA Institute Equity Research and Valuation Conference is an annual event covering global investing strategies and valuation approaches and analysis. The Equity Research and Valuation 2019 Conference, hosted by CFA Institute and CFA Society New York, will be held 14–15 November in New York City.

“Successful investing requires both art and science,” said Preston Athey, CFA, a 34-year veteran of T. Rowe Price. “When T. Rowe Price was founded back in 1937, Mr. Price always considered investing an art, and in fact, he often considered it a black art.”

Athey has seen all sides of the growth/value investing spectrum as analyst and portfolio manager, and has managed T. Rowe Price Small-Cap Value Fund (PRSVX) since 1991. He imparted pearls of wisdom, timeless investment principles and keys for investment success from his years of experience to the audience at the 15th Annual Equity Research and Valuation Conference in Philadelphia.

The Science of Risk and Return

Athey is highly skeptical about some of the theories and formulas developed by the scientists and academics in the field of investment management over the last 50 years. “Granted, the scientists have had some successes. For example, the Black-Scholes model and certain fixed income models are fairly well accepted,” said Athey. “But in the small-cap equity world where I invests, the science is less proven and in some cases just plain silly.”

To help demonstrate his point, Athey plotted the 20-year return and risk of the Russell 2000 Value Index (RUJ), the Russell 2000 Index (RTY), and the Russell 2000 Growth Index (RUO) against the S&P 500 (SPX). Over the last 20 years, small-cap value stocks performed much better than small-cap growth stocks with significantly less volatility (as measured by the standard deviation of returns).

Athey asked the audience why this occurred given that small-cap growth stocks have higher earnings growth and perhaps higher predictability? Was it because investors tend to overpay for growth and are ultimately disappointed? Athey said no — over time that should be reflected in the prices of growth stocks. Was it because of the time period chosen? Again, Athey said no, and presented the rolling 10-year performance of the Russell 2000 Growth Index vs. the Russell 2000 Value Index. He found that the value index beat the growth index 96% of the time with a smaller standard deviation 100% of the time. (He added that if a rolling 20-year average was used, value beats growth 100% of the time).

Athey believes that the way risk is measured distorts the picture for value stocks; risk is not just volatility of returns. “Look at the typical stock in the Russell 2000 Value Index. They’re not good companies. They have below average ROEs, poor profitability, don’t grow, often have bad corporate governance, poor balance sheet quality, and high leverage.” These risks cannot be measured by stand deviation alone. Factors like the degree of leverage can make a huge difference in the level of risk for some companies (semiconductors), but not for others (utilities). “If we could graph ‘total risk’ that included business risk, financial risk, management quality, macro risks, and so on, the Russell 2000 Value Index would certainly be further out on the risk/reward spectrum than the growth stock index,” Athey noted.

The Dark Side of Style Investing in Small Caps

Another area that bothers Athey is a purely systematic or model-approach to investing in small caps. He named eight familiar equity styles, providing examples of successful managers who typified some of them: deep value (Tweedy Browne), out-of-favor value (Southeastern Asset Management), relative value, GARP (The Royce Funds), P/E to growth (growth stock management at Capital Research), fundamental growth (T. Rowe Price New Horizons Fund), earnings momentum (Friess Associates), and price momentum. Each style could easily be modeled based on the characteristics of the style, but Athey cautioned every style eventually goes out of favor, and the model will fail when that happens.

The “artful” investor, according to Athey, can recognize the shifting tides and modify his portfolio accordingly. “Let’s say you’ve ridden the tech boom in 2000. Then you should ask yourself if you are a tech manager or a growth manager, and is the risk too high? Another example was in 2008, when many value managers piled into financials like Fannie, Freddie, and Bear Stearns, and road them all the way down as they got cheaper and cheaper without stopping to think. If a stock is down 50% and the short sellers are all over the stock, then I would definitely take a second or third look because they could be right.”

Athey believes flexibility is a key. “You need to be flexible enough to move assets at the margin when the risk/reward equation is out of balance.” For example, if markets are favoring growth stocks, a manager who focuses on a P/E-to-growth style also needs to know what the implications are for earnings and price-momentum strategies. If the market is conservative, perhaps a growth manager should fall back to more of a GARP style that is value oriented. If one style is really out of favor, then lean away. If one style has been a real winner but now seems to be going too far, pull back. For Athey, flexibility is an art and over time, he has developed his own personal style that blends several related styles. “I’m rarely in deep value, but I will move into the out of favor value and relative value styles and even up the spectrum as far as PE/Growth.

Athey emphasizes the importance of studying market history — especially when certain equity styles worked and when they failed. He also recommends identifying the top managers who have been most successful in a given style and voraciously reading whatever they have written.

The Power of Patience

Athey concluded by emphasizing the power of patience in investing. “I believe patience is underappreciated and underfollowed,” a line often said about stocks in the small-cap universe that Athey invests. Athey believes you should be patient on the front and back end of an investment.

1. Be patient entering an investment. “A sage old value investor once told me that like real estate — where the mantra is location, location, location — in value investing it is price, price, price.” If you work hard to get the lowest possible price, it could cover up a world of sins (inadequate analysis, being too early, thesis not working, etc.).
2. Let your thesis play out. Companies and their managements do change. Markets are often slow to react even when the change does occur. Think 3M when Jim McNerney took over as CEO; the stock rose 4% on the first day, but then it took three years to prove to the markets that 3M was on the right path.
3. Ride your winners. This works for value and growth investors. Nevertheless, you do not want to put too much of your portfolio in an investment — even a winning one. Sell along the way up to control risk.

Many of Athey’s universal and timeless investment principles transcend the small-cap world and have broad implication for equity investors across the style spectrum: (1) Be wary of science and understand where the theories of risk and return fall short; (2) Watch market and sector trends and play against the extremes; and (3) Be flexible and patient with each investment. It is clear that Athey practices the “art of investing” in his portfolios. Mr. Price would be smiling.

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