Why Small-Cap Value Stocks Have Lagged the Market So Badly

On this episode of The Long View, Charlie Dreifus, the portfolio manager of the Royce Special Equity Funds, talks about market efficiency, small-cap investing, value traps, and more.

Here are a few highlights from Dreifus’ conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

Dan Lefkovitz: I wanted to get your perspective on small-cap value. If you look at the Morningstar Style Box, it has been the worst-performing corner of the market for the past 10-plus years now. Ironically, there’s academic research that says that it should outperform over the long term because there’s compensation for risk. Why do you think small-cap value has lagged so badly?

Charlie Dreifus: I think the time frame you suggest is correct, perhaps increase it to 13 years or something like that. It has to do with the great financial crisis and then the pandemic, quantitative easing. The low interest rates, the deficits, and obviously in the extreme case when the pandemic hit, we had aggressive monetary easing as well as fiscal stimulus. And in a period of time when interest rates are low, everything looks cheap. And until the stimulus came about during the covid pandemic, there was low growth. So, people drifted toward areas that were growing—the growth stocks generally, whether it was tech. And if you remember circa 2015-16, we had a biotech bubble. People gravitated toward that and ignored small-cap value. Also, in zero interest rates, even the worst small-cap companies—and you have to understand the small-cap indexes have a large proportion of nonearners with atrocious balance sheets. But in that environment where there’s zero cost of capital or near-zero cost of capital, they’re all survivors.

Not only was the asset class itself shunned in favor of large-cap growth, but those areas within small-cap that did better, not exclusively, but tended to be not the pristine, high-quality, low-debt, high-free-cash-flow companies that are embedded in Special Equity. So, we had some good years in there where we defended well when the market actually did go down, and where we met the market when the market went up. But generally, it was a very tough environment.

The methodology that I explained before, the cap rate and using it both in terms of self-governing, getting us out of stocks. Back in late 2019, the market looked expensive. We couldn’t find new names to buy, and the things we owned had low to disappearing cap rates. So, we sold them, and we ended up with a lot of cash. People say, “Aha, the cash is where you earn your outperformance.” No.

First of all, we’re holding cash too long, we’re underperforming with cash for quite a period of time. We do benefit when the market initially goes down, but the real alpha comes about by deploying the cash when our screens tell us we’re a kid in the candy store, where it’s raining our kinds of names on us. And as an example, in March/April of 2020, when the pandemic hit and the market bottomed, we added between 10 and 12 names in a four- to six-week window—more names than we added the previous year entirely. And that’s where the cash-hoarding or cash-build benefits the investor.

Encore Wire was an 8% position. We also had another company, US Silica, that was taken out a little later in July. Those two combined were over 8.5% of the portfolio. So, all of a sudden, we had 8.5% in cash on top of a previously midteens kind of cash position, and we can’t find new names. Some of our names are still attractive to buy. Some of the names have risen to the point where we’re turning them. So, we have not yet found ourselves as the kids in the candy store, but it comes. Again, having done this for 44 years with the same methodology and same product, there’s a huge advantage in doing that. And I know it will arrive. What I can’t tell you is that a month from now, six months from now, or two years from now. And in the meantime, we’re going to underperform, most likely.

The Current Small-Cap Valuation Gulf and How to Build a Special Equity Portfolio

Christine Benz: I wanted to ask about valuations. There has been a gulf in valuations between small caps and the rest of the market for some time now. First, I’d like you to talk about whether you think there is a huge gulf in valuations, and also can you address how that compares with the late-’90s period when, by a lot of measures, small caps and especially small value got very, very cheap relative to some of those big-cap tech stocks?

Dreifus: Great question, Christine. Statistically, with the easing of interest-rate mentality and the fact that they’re sensitive to economic growth and that they are US-centric, small caps generally, and small-cap value, have done somewhat better. So, the valuation isn’t as extreme as it was a couple of months ago, but it still is relatively extreme.

In terms of the comparison, it does remind me a lot of ‘99, 2000, the dot-com, and I performed miserably then. Because again, the names in my portfolio didn’t have growth. They weren’t tech, and they weren’t growth. So, they languished. But the market, as we know, corrected in March 2000. The market reached a low. And there were some stocks of the big tech companies that haven’t even reached the values—forget about the ones that went bankrupt, but there are some that still haven’t reached the levels they sold in those days. But interestingly enough, and this is a point—it’s a single number and one shouldn’t take this as representative of our performance. But it shows how the markets’ mentality can swing. And the importance of the deep dive into the accounting that we do. Fast-forward from 2000 to 2002—the year of Enron, WorldCom, and all of the accounting implosions. For that year, the Russell 2000 Value was down 11.4%. Royce Special Equity was up 15.3%—a 26-, 27-point differential. How is that possible? There were no tricks, there were no new issues, there was nothing done that would have influenced that other than the inherent strength of the portfolio. What happened is everyone got religion in 2002 after Enron.

And they went for companies that had the kind of financial footings that we insist upon. Again, I stress that it’s a one-off, it’s one year. But we’re facing something—it’s not as bad as what was going on in 2002 in terms of the accounting in those days. But I have taken Abe Briloff’s mantle, and I’ve given lectures—this is largely prepandemic—across the country at CFA societies on the evils of non-GAAP accounting to the point actually where the PCAOB, the Public Company Accounting Oversight Board, caught wind of it and actually interviewed me on the subject. There are all kinds of shenanigans played with non-GAAP earnings. And it can seep its way in very unfortunate ways and consequences to the proxy statement because a lot of the incentive compensation these days is based on non-GAAP measures. And if you define what you’re going to be measured against rather than generally accepted accounting principles, you can obviously game it so that you win more often than perhaps you should.

Lefkovitz: That’s interesting. What are some common practices that you see as red flags?

Dreifus: So, my two colleagues are both CPAs. I never did that because I never joined an accounting firm. But we are accounting nerds, so to speak. And we read the documents, and we find every little detail. We then contact the company we’re looking at. We look at these incidentally separately and then we come into a room and that’s where the devil’s advocacy comes in, and we just go over page by page what we found. And then on the important points, we get back to companies, and this is the most fascinating thing. We get back to companies we say, “Well, footnote 12 in 2022’s 10-K said this. We had difficulty understanding it, could you elaborate.” And the response we get: “Thank you for asking, no one has ever asked us.” And this is a document that could have been out now for two years. And they say, “We were wondering why people didn’t ask us. We understand that it’s confusing, and we’re willing to help you better understand it.” And that goes to the root of again—to use a Benjamin Graham margin of safety. Our investing is margin of safety.

It’s interesting, Christine. In reading, a review of your new book, entitled How to Retire, you touch upon something that is critical in retiring, which I would think Special Equity addresses: People have to withdraw from their retirement funds. And unfortunately, they may have to withdraw when the market is at a low point.

So, by having very good downside-capture ratios, meaning we decline less of the market, We did studies—it’s hypothetical and therefore the SEC won’t allow us to publish it—but anyone can do this. Start with a million dollars in Special Equity, any day you want. We did it from the inception of the fund. We put a million dollars into the Russell 2000 Value, which is the best benchmark but not ideal because we don’t own a lot of the Russell 2000 Value sector weights. On the same day each year—you pick the date—take 5% out from Special Equity and 5% out from the Russell 2000 Value. You will find that you will have taken out much more annually over that time period from the Special Equity fund because it doesn’t go down as much. And because you’ve kept corpus intact.

That’s the other thing. Again, I think it was Russ Kinnel, who said, “I make people money by losing less.” The compounding effect of having corpus to invest and grow on the next leg up allows the ending value of Special Equity to be higher.

Very important for endowments, for anyone who has a spend rate, anyone who has to take money out annually, whether it’s individuals with their retirement funds or it’s an endowment—anyone that has that needs to consider the volatility, the standard deviation of returns, downside-capture ratio. The journey getting to the endpoint is important because, again, you may find yourself needing to take money out at an unpleasant time in the market.