Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges, and philosophies and security selection. I'm David cone I, lead mutual fund and active research at Bloomberg Intelligence. Today my co host is Michael Casper, sector and small cap strategist at Bloomberg Intelligence. Mike, thanks for joining me today.
Thanks dude.
So you wrote a note last week talking about small caps in the election, and so you know, I think our audience would probably love to hear or how the election has affected small cap stocks.
Yeah. So from a technical standpoint, I'll go over that first. The Russell two thousand has broken out of pretty much it's twenty twenty four range and is approaching all time highs pretty much. That's the only resistance that we're seeing in the chart for the Russell two thousands to the upside. RSI is still a little bit shy of where it tops out, typically above a seventy handle. We're currently sitting at about a sixty seven handle on RSI, and mac
D has crusted over the signal line and positive. So everything, at least from a technical standpoint looking pretty good. We did a little bit of analysis though on Trump's first term and how small caps did. Of course, his initial election back in twenty sixteen caused some hope for the Rust of two thousand going into his first term about tax reform and maybe some protectionist policies that could help
a reshoring effort towards small caps. We really saw that play out from twenty sixteen into early twenty eighteen, where small caps had a big cycle of outperformance, but from then on it was a bit more rocky for the Russell two thousand. Fundamentally, this definitely did show up in revenue growth numbers. They exceeded the S and P five hundreds revenue growth for a pretty good stretch from twenty
seventeen to twenty eighteen. So kind of hoping that some of that comes back, But again a bit of a bumpy ride at least from when Terra started getting announced onwards, and of course there was a lot of monetary policy and other stuff going on at the same time, so it can't be all attributed to Trump's trade and fiscal policies.
It'll be interesting to watch, but I think we'll talk a little bit more about small caps with our guest today, and with that, I'd like to welcome David Green. David is a principle of Hotchison Wiley and a portfolio manager on the small cap value, value Opportunities and international value portfolios. David, thanks for joining us today.
It's my pleasure great to be here.
I'm sure our listeners would love to hear how you got your start in the investment business.
Well, I got my start at a very young age. My dad was a physicist by trade, but he loved to invest in the stock market. And I grew up here in Los Angeles, and the market opens about six thirty. It opens at six thirty in the morning here, and he would have me sit in front of the TV. It wasn't there was no CNBC, there was no Internet.
But when he was getting ready for work and before I went to school, he would say, can you just watch these tickers and tell me you know what g is when it comes by, or what Coca cola is when it comes by.
And so before I.
Knew it, I went from not only following the box scores of all my Major League of the Major League Baseball teams, but the stock quotes and the newspapers the next morning, and I got very interested. I then went on to college at Berkeley and I studied economics, and then I went first to Potential Investment Corp, then to Goldman Sachs, and then to Hotchkison Wiley, were I've been for twenty seven years now, and all but one year of that time I've been on the public market side.
So I was able to turn what cultures started as a as a spark from a hobby that my dad had into my own passion and make.
A career out of it.
Great. Well, you know you mentioned Hodgkisson Wiley, and you know that's what we're going to be talking about today. Could you kind of give us a brief overview of the equity investment philosophy of the firm?
Sure?
So.
Hotkinson Wiley was founded by John Hotchkinson George Wiley in nineteen eighty and they founded on it on a value philosophy. And if you go back, you know, well before Hotchkinson Wiley's founding, we have data that goes back actually to nineteen twenty six, almost one hundred years now. Value has been a very powerful force of outperformance in the market. Notwithstanding sort of the recent past but even if you include that recent past and you still go back, it's
still significantly outperforms. And the idea is that if you buy a stock with a at a low price, you've got a built in margin of safety and it's very hard to predict the long term future. But when investors are paying very high prices for growth, oftentimes that growth does not materialize. And if you're buying something at a low valuation, you have you know, you have better chance that your downside is supported. And so that was the philosophy that originally started with the firm, and it's the
DNA which continues to the firm. In the firm to this day, forty four years later. I would also say, as the firm has matured, we have spent an inordan amount of resources and investment on the research process. Today I I I. If you think about Hotchkisson, while I always say there's three things to think about. The first is value, the second is research, and the third is culture. And each one of those is integral and important to
sort of who we are as a firm. But the research on the research side, we have twenty three people focused exclude on research, and this is a firm with under seventy people in the total firm, and in addition to those twenty three people, we also have six research associates, so we've got twenty nine people. Were almost half the firm focused exclusively on research, and it's really how we
define ourselves. And when you think about a value stock, you always want to be careful that just because something is a low price doesn't necessarily make it a value. You don't want to end up with newspaper stocks that have a very bleak future. You don't want to end up with retail stocks that Walmart could be coming into their neighborhood. So the research side is very important because it says just because something is trading at a low price doesn't necessarily make it a value. So we spend
a lot of time thinking about quality. And then the third thing is culture, and culture is very important and culture at our firm, and we have a very collegial firm. As I said, I've been there twenty seven years and the average employee ten year is very very long. People rarely leave Hotchkisson whilely. In fact, when we interview new people, one of the things they always ask is what do you do that you keep your people so long, and
I think there's a couple of things. First of all, we spend a lot of time on the front end making sure we get the right person. But who is
the right person? It's somebody who is very intellectually curious, wants to spend a lot of time doing research and thinking about things, but also is willing to work in a collegial team environment and understanding that if you have a long term view and you can keep your emotions at bay and always be respectful, that will lead to very good investment decisions over long periods of time.
That's great.
So I like to dig a little deeper. I know you're manager on three funds, but I think for the purpose of this discussion, we'd kind of want to focus in on more than domestic strategies. So if you could kind of give us kind of an idea of what the investment process is for the value opportunities and small cap value funds.
Sure.
So it's interesting, especially when you include small cap, because there's literally thousands of stocks out there to choose from, and so oftentimes when we're trying to find a stock, it will start with screens and we'll be screening on valuation things like priced to earnings, price to book. I would say the most important screen in my mind is
something called enterprise value to operating income. Enterprise value being the market cap plus the debt minus the cash, because that will take into account sort of the entire balance sheet, and so we look at screens. In addition, we have these analysts who are so well versed in their individual coverage universe that they're constantly meeting with management teams, they're
talking to suppliers, they're talking to competitors. So there's oftentimes stocks that will come that for some reason, it falls through the screens at bad data or whatever, and it will come in through the analysts will say, this is actually something that I discovered on my own, and so that will augment stocks that we add to the process.
Once we've identify certain candidates that we think are interesting, the analyst will be tasked with putting In the short term, maybe it's under earning because the cycle is against it, and we expect that cycle to normalize.
But over five years.
Time, we think that we can normalize the earning's power. And also by looking out five years, it's long enough that we can normalize the cycle, but short enough that we have pretty good visibility. After five years, it gets tougher and tougher to project out, so the analysts will project that earnings for five years. In addition, we have built a proprietary scoring system called our Fundamental Risk rating system,
and we look at three different things. In our fundamental risk rating system, we look at the quality of the business, we look at the balance sheet, and we look at the governments. And so the analysts will also be tasked with scoring according to this fundamental risk grading system. And there's a huge matrix that goes with each one of those individual components, and they will bring in that sort of deliverable to one of our six sector teams depending
on where I it's in. And the six sector teams we have are capital, goods, consumer, healthcare, Energy, financials, and tech. So wherever it fits in, they'll bring it in and that sector team will then review peer review the financial model and the fundamental risk ratings. And I think what's unique here is the ANALYSI is not coming in with the recommendation. They're not saying you should buy X Y
and Z stock. They're coming in they're saying, I think X Y and Z stock is going to earn you three dollars a share, and my margine assumption is they're going to do a ten percent ten percent operating margin and that will be what the debate is around. And because of the debate is all around sort of the financial projections and the matrix according to for the fundamental risk ratings, it doesn't end up being an emotional you
should buy you should not buy. It ends up being a very almost like intellectual exercise, if you will, with some very healthy debate. And so once that is done, and once the earnings power is established by the sector team and the fundamental risk ratings have been established, it will then be up to the portfolio manager to decide where and how much that stock fits into the portfolio.
So lots of people right now are worried about multiples, especially in the S and P five hundred. Do you share that concern or are you more in the camp that you know maybe the max seven gets add some productivity gains to lower that multiple. And kind of a second part of that is how do you think about valuations? Are there any specific metrics you like to use? I know you mentioned pees and price to books, but like to pick your brain on that one.
Yeah, So when you look at the Magnificent seven, and first of all, we group and men I think there each one has its own individual story on individual.
You know, opportunities and risk.
But as a group, they clearly are well above the valuation both of the rest of the market and well above the valuation that they have been historically. And I think the biggest risk to that part of the market. They're clearly excellent companies. But the biggest risk is part of the market is you are pricing in a lot of growth for many, many years to come in order to justify that valuation, which means essentially that that's a
very very long duration asset. And there's two things that could significantly upend the prospects for the for the valuation.
There.
Number one, the growth may not come come to fruition as people expect. And it's very hard to project out very long periods of time. I mean, it's hard to imagine. But in nineteen ninety nine, General Electric was the largest market cap, and you know, obviously there's you know, Cisco was one of the largest market caps. So things change, so trying to project out for long periods of time
is difficult. In addition, if we do get a rise in interest rates when you have an asset that is that long duration, arise in interest rates will have a severe impact on the present value of that earning string. And so they'reible, They're susceptible from sort of two elements. And so I think that as a group, and again I'm speaking as a group, because each individual stock will have its own risks and merits. But as a group, I think I would say there is a lot of
risk that in that part of the market. With regard to the rest of the market, the rest of the market in general looks like it's trading at about in line with its historical averages. So it's not which is very reasonable. And what is notable is not what the rest of the market is trading it relative to its own history. It's what the rest of the market is trading relative to the Magnificent seven.
And do you think the election results changed the calculus at all for for small versus large? I kind of went to my shpiel before about the whole Trump first term, but interested to get your thoughts.
Yeah, you know where I really think it's it's going to make a difference, is I think with regard to mergers and actuitions, and what you saw recently under the current administration was a really strict regulatory environment. Companies were either not allowed to merge or they saw what was going on and they chose not even to pursue an acquisition because they think they didn't think it would get
through the regulatory agencies. So I think the fundamental difference be with the Trump administration is you're going to have much less regulation or much less onerous regulation with regard
to companies merging. And for small caps that's important because when you think about how you can get your performance from small caps, one of the ways is if you have a stock that has a low valuation, there's always the opportunity that it can get bought and that a larger company can come by and say, you know, this doesn't make any sense. You know, I'm trading at a fifteen pe and this small cap stocks at an ape.
I could buy it at a twelve pee and give fifty percent return to the small cap sharehold, and yet I can still buy something at a discount to my own stock price. So I think that's where will be one of the fundamental sort of opportunities for small caps that they really have not enjoyed in the recent last four years.
I kind of want to go back to your process, and you know, kind of what you were talking about kind of sounds bottom up to me, and so I was kind of wondering, if you know, if you do consider macro themes as part of your evaluation or portfolio management.
Yeah, it's interesting.
So we don't start with the macro, but a lot of times the macro will drive certain themes within the portfolio. There was a time I remember when in the top ten we had three trucking stocks. Again, we weren't trying to buy trucking stocks, but that was what the macro was causing that part of the market to be out of favor. You might have a situation where let's say, like oil, is oil price as well normal. Let's say
it's a forty or fifty dollars a barrel. It's not there today, but if it were, and people were investors were pricing oil as if it was going to stay there, when we would do our normal, which would be our normal right now assumption for oil as seventy five dollars a barrel, so at forty we would expect the price to come up because at forty people wouldn't invest. Likewise, if oil was one hundred and twenty dollars, we would expect it to revert down because people would invest and
bring a lot of supply in. So when it's when the market is somehow divorced from its normal kind of where equilibrium, that will lead to situations where multiple stocks can get interesting. And so you might have if everybody was pricing in energy stocks at forty for a long period of time, you might have a situation where that part of the market would be. Energy stocks in general
will be interesting to us. And it's not again that we would start with the macro, but it's that we would be led there by what the market is giving us.
Are there any sectors right now that you find particularly compelling?
Yeah, there's a couple. It's interesting.
So, you know, when I talked about the research team and what we look for, we're looking for as high quality of business, we're looking for new things. We're looking for low valuation and high quality business. And it won't surprise anyone probably that the highest amongst the highest quality businesses we found are software businesses. Once you have a client, if it's if it's the right, software which is hard to get off of you tend to have very low
schurn and very high gross margins. And interestingly enough, there are a couple of software companies that we own, Workday and F five, which we think are really interesting because people are not appreciating the fact that even though they have very high gross margins, they're operating margins are understating where they will be in normal and why is that.
That's because they're spending a lot of money on marketing, so they're selling their product and they're spending a lot of money on sales, and they're also spending a lot of money on research and development. Both of those costs are going through the income statement. They're not being capitalized. If it was a chemical plant, you'd put it, it would be capex and it would be capitalized and it wouldn't go through the income statement until the plant was up and running.
It was being depreciated over time.
So this sort of quirk of accounting, if you will, has led us to an interesting part of the market, and I think that that is not totally understood. And then I would say the other area that is also interesting to us is there are certain energy stocks which right now, given how weak oil has been and how much the rest of the market has gone up, that are also interesting to us right now.
And are there any signposts that you're looking for to signals shift from tech leadership to broaden to the rest of the stocks.
So I think if the economy stays strong general economy, because tech has the leadership in tech has been a little bit of its own sort of sub sector, driven in many cases by AI. But if it brought if the economy stays strong in general, that will allow sort of the rest of the market to do well. And then the other thing I would say is if you want to look at where it could cause the multiples
to compress relative to each other. Again, if you have interest rates increase, I think that will put pressure on the Magnificent seven relative to the rest of the market.
I think I saw in the perspectives for their funds it did mention ESG, and so I was curious, you know, if ESG factors into the research at all.
Yeah, So, you know, when you think about all of the risks that we're trying to compile, and we have our fundamental risk rating system, ESG is embedded in our fundamental risk rating system in the sense that if you have environmental consc NS. If a company is polluting, that is a true cost to the business and a true risk of the business. If a company in social is not treating its employees properly, that's true that business will have a difficult time sustaining itself if a company has
bad governance. In fact, interestingly enough, in our fundamental risk rating system, governance is one of the three pillars that we actually it has its own pillar, and that's especially true when you talk about small caps, because governance is so varied.
In small caps.
You have the founder who started the company and took it public and he's still working, you know, twelve or fourteen hour days. He's taking a small salary, and he owns a lot of stock, and he's doing all the right things. To the founder who's cashed out, he's at the golf course, his children are running it and he may they may or may not be competent. But the point is you've got and he yet he still controls
the board. And you have to do your due diligence and find out where each company fits in along that governance spectrum.
And so we spend a lot of time doing.
That, I also do want to ask about another type of risk. You know, the portfolios don't have you know, a huge amount of stocks in them, so I guess I was just wondering how you handle concentration risk.
Yeah, that's a great question.
And when we think about concentration risk, so what you want is when you do find a really compelling idea, you want to put a lot of capital into it. But what you don't want if you have a lot of capital in is you do not want to take a company specific risk when that exists. So there's really five things that we look at that we have to get comfortable with when we want to take a concentrated position. So the first is are we going in the stock
at a significant discount to intrinsic value? Do we have good valuation? Because good valuation itself will serve as a margin of safety. So that's the first thing we look at. The second thing we look at is does the company have financial strength? Doesn't have a good balance sheet? I mean, just in the recent past, we've been through a financial crisis, we've been through a pandemic. Things can happen, and what you don't want is you might have a really undervalued stock.
You might have a high quality business, but if it has a bad balance sheet and it comes into a problem, you still might get diluted significantly at the bottom, in which case you're going to lose a lot of money. So we want to make sure that the company has financial strength. The third is does the company have a high quality business model? If we turned off our Bloomberg's for five or ten years and came back and didn't look at a quote, what would the business look like?
If we can't really figure that out, if we're like, well, they've got one or two customers and those customers could possibly go elsewhere, or they don't have the business they're competing in has ten competitors and right now they're in fourth place.
That could be in sixth place, whatever it is.
If they don't have a high quality business model, then we don't want to put a lot of capital into it because we won't have confidence of where they're going to be. The fourth thing is is management doing the right thing with the capital? Are they investing wisely? Are they thinking about a high cost merger or buying somebody
else that will destroy our undervaluation. Are they investing in a plant that maybe is very risky, or are they husbanding their capital buying backstock using their capital with it they're not using to buy backstock to invest wisely?
Are they doing the right things?
And then the fifth thing is is there liquidity in the underlying security? So as we think about small caps, the further we go down in the market cap, the less liquidity we usually have buying and selling that stock. And so if we're going to have a big position in something, we want to make sure there's sufficient liquidity for us to get out of it if we change our mind, if something changes, So you know, it's more risky to be a big have a big weight in a small cap which is less liquid than in a
large cap. So those are the things that we look at when we think about concentration. But if we do find a situation that really meets all of our criteria, then it becomes very interesting, and then you want to have concentration there because then you've you've looked at the risks and when it's not it's very difficult to find the things we're looking for, which is a very high
quality company trading at a very low valuation. When you do find that, and your risks are somewhat mitigated or mostly mitigated.
That's when you want to take a big position.
So as a as a fundamental strategist myself, you know, I have some fair value models and basically looking out and putting in economist estimates, you get the rustle somewhere around twenty three fifty or so, so a little bit north of today's price. I'm just interested to get what your thoughts might be on where small caps might be going into twenty twenty five.
Yes, so I think it's funny if you look back again. We've done this where you look back going back to nineteen twenty six, and we've broken it into quadrants, which is the value and growth, small and large by far, by a long ways, including again up until recently, so it includes all the growth out performance that you've seen recently. By far, small cap value is the best performing asset class.
Now it hasn't been recently, but I think again that valuation discount relative to the large cap market the SMP is quite large today, quite large relative to history, so
we think it's a very interesting place to be. In addition, small cap companies tend to be focused more on the domestic markets and the dollar has been very strong, so that will benefit them as opposed to a lot of these large cap multinational companies which are selling into Europe and selling into Japan, and the dollar has weakened, so those sales coming back into dollars are going to be more challenged.
You know, we've kind of talked about where you think about, you know, how you invest in a stock. What would need to happen for a company to become a candidate to sell.
Yeah, so's there's a few things. The ideal scenario is you invested in undervalued security, you had a thesis, the market wasn't recognizing what you saw. The thesis played out, the stock reached its value or close to its full value, and you sold it. So the first thing is does our discount to intrinsic value fall away? And when it does,
that's a sale. The second time we might sell is we invested in a stock we had a thesis, and as time has gone on, we've realized that the thesis we originally bought it under is not coming to fruition. And basically, either things changed or we were wrong, and we no longer have confidence that the thesis will play
out as we originally thought. And the third reason we might sell a stock is maybe maybe the we bought the stock at ten and still at ten, and maybe we think that thesis is still intact, but maybe the rest of the market got cheaper and all of a sudden we had other opportunities for our capital, and since capital is limited, we might we may decide to sell it because something else got more interesting. So those are usually the reasons that we would sell a stock.
And what do you think the biggest risks are for stocks going forward?
So I would say there's there's two risks.
One of them is, you know, the the geopolitical situation throughout the world is tenuous. There's essentially, you know, two wars going on, and you know, we have been so insulated over here, but it's we have to recognize that there is a difficult geopolitical situation that could spiral at any time.
Now it's hard to predict it.
We don't think it will, but it certainly is a risk. And the second risk is, you know, the government is running very large deficits and has a very large debt balance, and so up until now it really has not had an issue with funding that and with issuing debt. But if at some point trying to fund that deficit puts causes interest rates to go up because the government is borrowing so much. I think that would be the other thing that would put a big risk factor into stocks.
Okay, and do you have any major takeaways from the third quarter earning season?
Yeah, it was interesting.
It was an I would call this one of the most mixed earning seasons I've seen in a while. It was so interesting. We had companies report some up ten percent, depth some down ten percent, and there were I would say, you know, like we have some chemical companies that were more challenged, which are really tied to the economy, and so I would say that that the sort of the depth of strength of the economy was somewhat challenged. But then we had other pockets where that was there was
contradictory signals on that. So I would say this was probably one of the more mixed earning seasons that I've seen in a long time.
Well, I actually just have one more question before we let you go. You know, I think I know I do it. I'm sure Mike does, and I believe our audience would love to hear what your favorite investment investment books are yeah.
So when I started out in the business, and I think somebody must have given me this recommendation, but it was one of the best recommendations I had.
Again, it was before the internet. They said, go.
Call up Berkshire Hathaway and see if they'll send you all of their old annual reports. So I did that and they mailed all of their old annual reports to me, and I started reading them and now whenever, and it was an unbelievable education. I mean, Warren Buffett is, you know, the best investor there is. He's also in addition to being a great investor, he's also an incredible teacher, which you realize as you read these. And he's also a
fantastic writer. So whenever a young person says to me what should I read, I say, well, now you've got it easy. You just have to click on a few links and you could download all these shareholder reports and read the annual letters. But I would literally start from the first one and go up till the present day,
and that would be the first thing i'd recommend. The second thing i'd recommend, which is going in a little bit of a different direction, And I don't know if you would consider this an investment book or not, but it's one of my favorites because it has so many
themes that are similar to investing. Is the book Moneyball by Michael Lewis, which talks about the Oakland A's and how they were able to build a very competitive baseball team and make the playoffs even though they had a very low payroll, and they did it by taking advantage of factors that other people weren't valuing properly. And I think that's so relevant to how we try to invest in stocks.
And again, Michael.
Lewis also is a fantastic writer and a great storyteller. And then the third thing that I really enjoy is I really enjoy reading books kind of on business titans who've created these great businesses. So there's the book on Warren Buffett called The Snowball. There's the book Steve Jobs
by Walter Isaacson, and then there's Sam Walton's autobiography. So those three books I've really enjoyed because they give you insights into three individuals who created enormous companies from scratch and what their vision was and what their determination was and how they did it and how they thought differently and how are they able to do that? So those were those would be some recommendations I would give.
Well, it's definitely a great mix. This is a great discussion. I really appreciate having you on.
What was my pleasure?
And Mike, thank you for serving as my.
Co host today.
Yeah, thank you both.
Until our next episode, This is David Cohne with inside actor