Talk Your Book: Finding Small Cap Diamonds in the Rough

0:00Today's Animal Spirits Talk Your Book is brought to you by Calamos. Go to calmos.com to learn more about the Calmos Timpani small cap growth fund which we're talking about today. Also check out the new structured products that Calmos is releasing. They have a new S &P 500 structured protection ETF, CPST. 100 % downside, same thing for the NASDAQ, that's CPNS. 100 % downside, they also give the ranges for the potential upside on there. We'll have links to that in the show notes. Calmos.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching.

0:41All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

1:02Welcome to Animal Spirits with Michael and Ben. Michael, I'm a big cycles guy. I think Howard Marks said something along the lines of, the only thing you can count on in the financial markets is cycles. And I believe this to be true. But I think it's harder for a lot of people to believe it because the S &P 500 and U.S. stocks have done so much better than everything else for the past 15 years. When are you going to throw in the towel? It would have to be a lot longer, I think. It's 2046, Ben says, all right, I don't believe in cycles anymore. It's only US large cap growth. I guess the magnitude of this outperformance is not like the biggest outperformance by amount.

1:43It's just the timeframe. I think that's what has gotten so many people to... And if you've been investing in the markets for one to two decades, you look back on it and you say, yeah, why would I ever invest in anything else? And I understand why people think that. But I choose to believe that diversification is still a thing. That's what I'll go to my grave with. on my headstone, it'll say like diversification never dies. That's, that's kind of my feeling on these things. Yeah. It's a, it's a, it's a good place to be. I was looking at it on the show. We said that like, or you said that small cups have underperformed for the last seven years.

2:15So I was looking while you said that and they have underperformed for a long time. However, from 2013 through the end-ish of 2018. So almost a six-year period, the S &P and the Russell 2000 were neck and neck. And then during the sell-off of 2018, a gap opened up and it's just beginning wider and wider and wider. So really for the past five years, it's been pretty painful for small cap investors relative to large caps. The thing is, it's not like small caps have done horrid. They just have a hundred. So if you look at the last 10 and 15 years, so this is over the last 15 years. So I'm using a little longer experience.

2:56Like I said, 15 years is about it. The Russell 2000 is up more than 11 % per year. It's just not up to 14 % per year that the S &P is. So it's not like small cap stocks have just been like languishing and doing nothing. No, no, right. They've given pretty solid returns, just not as good as the S &P 500. So that's something to also remember. And for the first, it's the funny thing is, as cyclical as these things are, the narratives are cyclical too, because in the early 2000s, it was small caps did so much better than large caps coming out of the dot-com crisis that the small caps were the battle of the ball.

3:30And everyone was wanting to allocate more to that asset class. So it's cyclical. I can't predict the timing on these things, but I'm still sticking with that theory. So on today's show, we talked to Brandon Nelson. Brandon is a senior portfolio manager, CalMOS Investments. formerly of Tempani Investment Research, I guess Calmos bought them and their small cap team, brought them in. Fellow Midwesterner, based in Milwaukee. Calmos is based in the outskirts of Chicago. Sorry, Michael. These are flyover state people. But we had a great talk with Brandon today about the small cap universe, how they pick small cap stocks.

4:03So here's our talk with Brandon Nelson from Calmos Investments.

4:10All right. We are joined today by Brandon Nelson from Calmos Investments. Brandon, welcome to the show. Thank you. Thanks for having me. So you're in the small cap space. We've seen a lot of movement there. It feels like the last, I don't know how to define some of these cycles between asset classes. Let's call it the last, I don't know, seven years or so, large cap stocks and especially large cap growth has kind of dominated everything. And people have been waiting for the small cap arena to take its place because these things are cyclical. And in the past couple of months, looks like the Fed's going to cut rates and small caps had this huge bounce.

4:44And everyone's like, all right, here we go. This is it. So I'm just curious, just your thoughts on where we are in this cycle. And if, if the small cap opportunity really is as big as everyone says it is in terms of the valuation differences between large and small caps. Yeah, I think it is a great opportunity. And there have been head fakes before. So I think it's reasonable to be, you know, a little guarded, but, and I think it's even been longer than seven years where large caps have been winning. And if you look at multiple decades, you do tend to see the small caps will lead for a decade, give or take, and then the large caps will lead for a decade, give or take.

5:27But looking long term, the last 100 years or so, small caps do have the upper hand if you've got sort of extremely long timeline and sort of perspective on things. So I think that's point number one, I guess I would keep in mind is they do tend to win, even though they haven't won in recent years. It's been easy, I think, to forget that very long term small caps are great asset class and tend to perform extremely well. But I think, you know, zooming in more recently, I think the valuations are very extreme. As you pointed out, large has been winning for a long time. That's caused valuations to become very stretched for small caps, you know, being there around the 15th percentile, give or take of where they typically are relative to large.

6:18But that in and of itself isn't a catalyst. You know, you need some reason other than valuation to get people to actually move money, I think. And I think that brings us to the where we stand in the Fed tightening cycle, soon to be loosening cycle. And that could be the catalyst that actually causes people to do something about it and start that mean reversion to small cap valuations, getting back to maybe where they normally are or even at a premium to large caps. We have a lot of advisors listening to this podcast. We were taught in the advisor community from the academics, the gene farmers of the world that small cap value is the area to allocate money to.

7:03And actually, small cap growth has had the best individual performances have come out of the small cap arena. But if you were to just index the small cap growth area, probably or perhaps not the best place to index. Would you agree with that and then say, well, yeah, that's why you need to be stock pickers and not index investors in the small cap growth area? Or would you go further and just reject the whole premise out of hand? You know, just like with small versus large, you see small value and small growth kind of change which ones have a leadership role. I think, yeah, long, you know, starting since like the late 70s when the Russell indexes were created, I think small value is outperformed modestly over small growth.

7:49But small growth has had, you know, huge surges. And I think it would be foolish to just dismiss small growth as an asset class. Both have their day in the sun. And I think it's appropriate to keep an eye on both. But I think to your second point, stock picking is extremely important in small cap. It's probably more important than in large cap. The smaller you go in terms of the stocks you're trafficking in, they tend to exaggerate your decision-making. The good decisions get rewarded disproportionately. The bad decisions get punished disproportionately. And I think that applies to small growth and small value.

8:32So stock picking is huge in the small-cap world. There's a data point showing that the percentage of non-profitable companies with the Russell 2000 has grown over time. It was 20 % a decade or two ago, whatever it was, and now it's closer to 40%. And I would imagine that within your universe, the small growth universe, it's even more. There's even more more higher percentage of companies that are losing money on the bottom line. Can you talk about that dynamic? Yeah, that's that's probably true. I haven't seen small growth versus small value broken out. it. Us being active managers and not hugging any particular index, the stocks we choose are substantially more profitable than the index components overall.

9:18I just looked just this morning, actually, just in anticipation of your question, I wanted to get current data. And for our portfolios, looking out to 2025 profitability, less than 10 % of our stocks are unprofitable or scheduled to be unprofitable. So, you know, we're stock picking. We're not beholden just to whatever's in an index. I think there's some truth to what you're saying. Just the components tend to be less profitable. A lot of that's biotech. And in and of itself, biotech, you know, isn't inherently bad. It's just, it sort of goes with the territory that they tend to be less profitable.

10:01There's more binary event risk. And there just so happens to be heavier exposure to that industry in the small growth index. So is it just a pretty simple, some sort of qualities career, and however you define that, to get rid of those bad companies in the Russell 2000? Because people talk about that a lot saying, geez, I'm not going to touch small caps because of this component. But isn't it fairly simple to weed out those really bad companies that probably aren't going to do much? Yeah, absolutely. You could run screens to isolate just the profitable companies. But even there, what's profitable isn't necessarily a great investment.

10:41They could be barely profitable, not have any sort of growth prospects. I think there's this, again, as I pointed out, we're biased toward profitability, but But not being profitable is not an automatic stock is horrible. You know, like if there is an exciting situation, you know, they've got some, you know, amazing medical cure or some some other sort of, you know, exciting opportunity. A GLP one drug, for instance, that's not yet profitable, but has the makings of being a huge company. You still want to pay attention to those. And so, you know, we do our best to navigate through the profitable and unprofitable and look for companies that and stocks that have, you know, home run potential.

11:32Michael was shorting Amazon in 2014 because they weren't profitable. Yeah. 2011, 2011. I'm sorry. You're ahead of the game. And you got to remember, some of these unprofitable ones can turn profitable very quickly, too. So I'm saying this, and our portfolios are, again, very much more profitably tilted than that. Brandon, we're going to get into your portfolio. But before we do that, I think it was David Einhorn who was talking about that it's hard picking stocks that people don't care about that are undercover by analysts. Because if there is value, but there's nobody there to ultimately realize the value, if there's no shareholders that catch on to the story because everybody's focused on mega cap growth, then these companies can remain disconnected from intrinsic value for an uncomfortably long period of time.

12:22Curious to hear your thoughts on that dynamic, where if these businesses, because these are businesses, they're not just stocks. If these businesses are so undercover that nobody really pays attention, can the disconnect remain indefinitely? It definitely could. The stocks we traffic in are very exciting and are linked to companies that are growing very fast. And with that tends to come increased awareness and this tendency for liquidity to get better as they hit milestones. that attracts more investor attention, more sell-side analyst attention. We're looking for companies that have the potential to get re-rated higher, to get discovered.

13:09We want to go along for that ride where they're going to get re-rated. Maybe they started at a 12 PE ratio, and through the course of time in discovery and well execution by management, they go, they become a 25, 35 times PE multiple. That's the way we're looking for and looking for stocks that have the potential to get re-rated. So yeah, you know what? That makes a lot of sense. I think Einhorn's lens is more through the value. So these companies that are trading at four times earnings, yeah, they might be undervalued, but if nobody's going to re-rate them higher because they're not growing, they're not a story, then they could just languish forever.

13:45Yeah, I think you're right. I think he's got more of a value tilt and that's probably a greater risk. Yeah. I'm curious about like that. You mentioned the headwind of higher rates hurt smaller companies, which makes sense. The larger companies were able to borrow more and the smaller companies are maybe rolling over their debt at higher rates. So it makes sense that they've had this this headwind in a higher rate, higher inflationary environment. So that's a catalyst. One of the other things people have been mentioning in recent years, I've heard people there was a research report. Someone sent me a couple weeks ago saying one of the reasons that that small cap investing is so much harder these days is because these companies are staying private longer and they're not becoming small caps.

14:21They're jumping the boat and going straight to mid or large cap when they go public. Do you find any truth to that in terms of your opportunity set? How are you thinking about how that has evolved? Has it impacted the stocks that you pick in any way, or do you think there's still plenty of opportunity there? We see tons of opportunity. I've heard that argument many times, and I just don't see it moving the needle for us. We've got more buy ideas than sell ideas. And there's just, there's so many opportunities and it's a dynamic world. And just, it hasn't been a constraint in us finding opportunities and finding stocks that chuck our boxes.

15:02Do you think, so people casually say this, it sounds smart. It sounds right to me anyway, that small cap stocks are more levered to the economy. They are more sensitive. Well, I guess being sensitive to interest rates and more leverage to the economy are two different things. But how do you think about it? I know you're more of a bottom-off stock picker, but how do you think about the macro impact in these companies? Yeah, I think for the average small-cap stock, they are more sensitive to cost of capital, just to cyclicality overall. I think it's just, I think, factual. You've just got the Russell 2000 is going to have more of a cyclical tilt than the Russell 1000 large cap index.

15:47And so, again, that's at the index level. And, Michael, like you pointed out, we're stock pickers. And we try to find secular growth where the stocks we're choosing aren't dependent on the overall economy. Or that's more of a rounding error on how fast they're going to grow and what they're going to see. they've got some unique service or good that they're selling where they're insulated to a great degree by what the overall economy is doing, what the cost of capital trends are looking like, and a whole bunch of other macro factors. We try to find stocks that, you know, maybe in a recession, they're going to grow 22%, but in a GDP plus 2%, they're going to grow 25%.

16:31You know, like it's just, it's around the edges. It's going to matter, but it's, it's still going to be a great growth profile, even if they don't have macro tailwinds. So I'm curious about your process. We talked about the small cap universe overall. Do you have a universe that you start with? Do you start with a Russell 2000 and then window it down? Or how do you, or do you have a group of small cap growth companies that you're following? How do you, how do you window down that universe? Because there are so many more small cap companies to choose from. Yeah, we've, we've been doing this, you over 28 years and have fine-tuned the processes, you're right.

17:04There's a lot of stocks to choose from. We have certain criteria we're looking for. And when you kind of narrow it down to a sort of smaller list to work from, you start with 2 ,000 plus stocks, you narrow it down to call it 150 to 200, kind of layering on our initial criteria. And then you roll up your sleeves and dig into each of those and come up with a portfolio that's 80 to 120 stocks. And I'm making it sound so easy and you just kind of do this so quickly, but it's a long process. We take our time and really try to be thorough with the analysis. Are there any sectors within small cap that you're particularly excited about or is it really on a company by company basis?

17:55There are certain sectors that do have more of that secular tailwind that I was describing before, where you've got less sensitivity to the economy, consumer discretionary, trying to find one-offs within that sector. At the company-specific level, there's something unique going on. Healthcare, there's a lot of secular growth. And then technology is another sector of a lot of secular growth. So those are the big three. We've been finding other opportunities around the edges in some other areas too, industrials. There have been a few names there that have benefited from a lot of this AI spend that we've seen really ramp in the last year.

18:38So we're open-minded. We'll go anywhere. But the big three are consumer healthcare and technology and have other exposures. But that's where we probably spend the most amount of time. So I'm curious. So you screen out stocks. you screen into stocks, whatever. And then you've got a list of 200. How do you go about learning these companies? Are you looking at, do you start with financials? Do you start reading some of the SEC filings? Do you read, like Buffett does a lot of industry publications? How do you learn about these companies? And then what does the process look like to evaluate whether or not these are attractive opportunities?

19:15Yeah, we look at everything. And I feel like day to day, my team and I, we're drinking out of a fire hose, right? It's just a lot of information from a lot of different directions. But, you know, big picture, we've got database screens that we run to try to, you know, use technology to help us look in the right direction for stocks that have criteria that we're seeking. We're interacting with management teams all the time. So we go to conferences, we have a lot of traffic come through our office, management teams, and then we're interacting with the sell side community regularly. You know, we have relationships with all the brokerage firms that you're familiar with and then some.

19:52And so that's sort of our new idea generation pipeline. It comes from one of those three areas, as well as just the maintenance that goes on once the name is in the portfolio. We're listening to the conference calls, having follow up meetings with management teams and just in the trenches, just constantly doing research and balancing our time, finding new ideas for the portfolios, as well as just conducting the maintenance research necessary to gauge conviction. But the common denominator of what we're looking for, we call it fundamental momentum. And that's companies that have a sustained growth profile where they have an open-ended growth situation.

20:33They're going to be able to grow for the next several quarters and hopefully years. And then second, have an underestimated growth profile. So we like to find companies that have a knack for beating expectations. Management teams that not only know how to run their businesses efficiently, but know how to manage expectations. And so really, it's those two things we look for. Again, fast growth and underestimated growth that we think is key to finding big winners for the portfolios. That firehose of information you're talking about. if you were doing this, I don't know, 20 or 30 years ago when you first started, there probably wasn't as much information available.

21:14So is it still true that small caps are so under the radar because there's not a lot of analyst coverage? I guess I'm guessing, is there more attention paid to these companies now, even though they're not household names? Looking at your top 25 list of holdings as of June 30th, there's not many companies here that I know on a name brand basis because they're still small caps. So that makes sense. But is there more attention being paid to these stocks now because of the free flow of information? Are these still kind of diamonds in the rough in a lot of ways? I think it's the latter. I think there's still diamonds in the rough.

21:43And, you know, we're speaking generically, but I just, you know, especially in the last five, 10 years, I just feel like this asset class has been very neglected. And there's been such a love affair with the mega caps that I feel like a lot of these have just gone by the wayside. And that's where I think there's opportunity. And I think there's always been opportunity. And it just seems like the stars are aligning for the asset class overall. There's always opportunity at the individual company level and finding these diamonds in the rough, whether the asset class is performing or not, you've always kind of got that constant.

22:23But what's interesting now and what I think incrementally is exciting is just this asset class really is teed up, I think. And it's been beaten up. The valuations are stretched to the downside. And you're entering a time period where you could get a re-rating higher just for the asset class. Just getting it back to sort of equilibrium where it sort of normally is that 50th percentile. If that ends up happening, it's got huge implications at the index level. And that's just assuming you're an average stock picker. And I like to think we're above average. So we could even do better than however the index has performed.

23:07So it's a really interesting time, I think. If I was to look at your buy decisions over time, I'm curious, how do you think about price when you're buying? Or how do you think about supply and demand? I guess what I'm getting at is technical analysis. Are you more likely to buy a stock on the way down or on the way up? And I guess given that you're buying fundamental momentum companies as opposed to like companies that you think can have a turnaround, you're probably more likely to be buying a stock that's going up than down. But I'd like to hear from you. Yeah, that's a good guess. Price momentum does tend to be highly correlated with companies that have fundamental momentum, right?

23:47It's really the market confirming that fundamental momentum. It's the market is telling you, yeah, we see it too. And we acknowledge the stock deserves to be rising. So I'm curious, like as a follow up, has it ever happened where you're looking at a company, you're doing the work and you see all of this fundamental momentum, you see it in the data, you see it and you hear it from the customers, from the suppliers, from management. And then you look at the chart and it's going down and to the right. How unusual, have you ever even seen something like that? or is that pretty? Yeah. So, okay. So in that example, would you say, okay, the market's missing something or are you more likely to say the market knows something that we don't, and therefore we're going to maybe take a break and watch and see if it stops going down?

24:37We don't like to catch falling knives. So for whatever reason it is, we don't need to be a hero and try to step in and we're going to let the market tell us when it's ready to embrace those fundamentals. And if it's not, for whatever reason, we'll just wait until things settle down a little bit. We want to see it just neutral at a minimum in terms of that sort of price momentum element of things. I love that answer because oftentimes fundamental investors will say like, no, no, no, there's value here and the market is getting it wrong. But ultimately, the market is the ultimate arbiter of what something is worth.

25:19And it doesn't mean that The market's always right. But I love your answer of respecting price and respecting other investors. We like the stock, but we'd rather it stop crashing and maybe at least stabilize before you try and buy. Yeah. And I think the biggest mistakes people make is they sell their winners too soon and they hold their losers too long. And I think the latter part of that statement ties in with what you're talking about. But people just, yeah, they just, I think when they sell a losing situation, they feel like, you know, they're locking in a loss forever. And it's, you know, humbling.

26:03And, yeah, I think there's a lot of hubris in this industry. And people say, you know, if I liked it at 20, I love it at 12. And I'm going to triple down. And someday I'm going to get rewarded for this. You only try that so many times before you realize, all right, that maybe is probably not the best way to invest. So I actually am not to brag. I'm pretty good at taking losses. I don't take big losses. I take losses pretty quickly. Unfortunately, the selling too soon part of it is something that I just can't shake. So riding a winner to – forget about the completion. Nobody's going to sell at the top.