Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into the processes, challenges, and philosophies and security selection. I'm David Cohne, i lead mutual fund and active research at Bloomberg Intelligence. Today my co host is Michael Casper, sector and small cap strategists at Bloomberg Intelligence. Mike, thank you for joining me today.
Thank you, David.
So, last week you wrote a research note titled What's priced into small Caps? After stocks Route? Do you give us a brief overview of how small cap stocks have been performing this month and what could happen if economic data softens.
Yeah. So it's obviously been a big downturn for the Russell two thousand this month, but what we're really seeing and what we try to get at, is it's priced into the market, and what we're seeing in our models, our fair value model, is that a credit crunch of
some sort was priced into the Russell two thousand. It seems just putting in consensus numbers for the two tens next twelve month sales growth and the change in the FED balance sheet kind of zeroing that out with the end of taper coming later this year, you get to about a five point eight percent high yeal to OS spread that was baked into the Russell two thousand at
its low in August. So that to give you some perspective, that gets you to a one point two seven times multiple on price to sales multiple in the Russell two thousand, So significant credit, you know, crunch priced in something it can to you know, the end of the SBB crisis, right, So twenty twenty three back to those highs if you
think about it. But on the revenue side, not a lot even changes if macro softens, right, So macro expectations we we commonly use economist forecasts in our model, those were already pretty weak, and if you just zero out GDP growth, for example, zero out new orders growth, you're still only at about a point five percent revenue contraction over the year ahead, and that's significantly lower than what
consensus expecting for the next twelve months. So there's not a lot of weakness that can be additionally priced, at least on the revenue side, and kind of any upside that we get from revenues could be a significant driver of the Russell two thousand going forward. The one thing I'll mention everybody asked me about recession case and what
that might look like for the Russell two thousand. We took the average recession experience and modeled how that affects each of the component variables in our fait value model. Putting that into the model, you get about a nineteen percent drop in sales growth, a drop in the multiple to one point one five times, and you end up around the October twenty twenty three low on the Russell two thousand. So at that point in time, the way I'm framing it at least is that significant economic weakness
was already paced into the Russell two thousand. So I think things are, you know, pretty well solidified on the downside. It's just how do we get to some of the more upside for the Russell two thousand.
Okay, Well, speaking of the Russell two thousand and small caps, i'd like to welcome Michael Coyin, manager of the Voye Small Cap Growth Fund. Mike, thank you so much for joining us.
Thanks for having me.
Well, before we get into your fund, i'd like to ask how portfolio managers got their start, So if you could just kind of give us an overview of how you got started in investing.
Yeah, sounds great. I started investing on the by side a couple of years out of college after doing an investment banking extint on Wall Street. Started at a private equity mezzanine fund in Boston with a particular focus on growth coupled with cash flow generation. Fast forward a couple of years, I started working at Columbia Management on the small cap growth team, and the Voya small Cap Growth
Team now is a derivation of that existing team. So we've been working on that team longer than I care to admit, twenty two years, but consistent investment of philosophy and process being applied over that entire timeframe, which is good because the experience I had at the private equity shop I worked at really was a good dovetail into what we do here from a fundamental analysis standpoint.
Well, that's actually kind of brings me to my next question is, could you kind of give us an overview of your investment process or philosophy. I know you mentioned cash flow.
Yeah, so our investment of philosophy is fairly simple. We look for companies that grow at a fifteen percent top and bottom line rate. At a minimum, and then look at what we consider sustainable valuations. And sustainable valuations I'll get into in a bit here. I know that we'll discuss that during the process, but ultimately we want to see a twenty percent upside to our price target when
we buy a stock in the portfolio. When I think about the process itself, it really comes down to fundamental analysis. We look at the market that a company addresses, it's market share. We look at competitive modes. Are they able to pass along price increases they're getting to their customers so they can see expanding margins over time. We do have a particular emphasis on operating cash flow as opposed to free cash flow because we are small cap growth investors.
We want to see our companies reinvest back into the flywheel that does allow them to grow as long as that flywheel produces acceptable rates of return, which is an excessive what their cost of capital is. So it's really not rocket science on the philosophy or process, but it's a lot of hard work and that's really what we've done over the two years I've been doing it. The process in philosophy actually predates me by seven years, so it's been applied for almost thirty years.
So we know how Russell defines their growth in to see is SMP defines it a little bit differently. You know, how do you define and search for growth companies? Do you have any favorite metrics that you like to use when you're you're looking for companies.
We certainly touched on a few of them already. You know, growth growth first. You know, you want to see companies that grow at an acceptable rate, whether that's organic growth or inorganic growth. We do like seeing organic growth over inorganic growth, but a lot of times companies do a very good job of showing both and producing strong growth
metrics by acquisitions as well. The other thing we look at, as I mentioned before, operating cash flow, And then we certainly want to see a balance sheet that is healthy and allows them the flexibility to go pursue ustment strategies that they want to pursue and doesn't hinder them. So we'd have some leverage metrics we look at as kind of an exclusionary metric for companies that we screen for.
And how do you think about valuations? Do you have any favorite metrics you mentioned operating cash flow, You might use a free cash flow yield or something like that. Do you have any favorite valuation metrics that you use?
So operating cash flow is really a proxy to determine the quality of earnings. Companies use adjusted net income, which is adjusted from gap. You have to validate those adjustments, and then we compare that adjusted net income to operating cash flow and would like to see operating cash flow in excess of that adjusted net income to validate that.
It's a metric we want to use going forward. The reason we do that is, as you know, management teams like to adjust for a lot of things that I don't want to adjust for and give them credit for because they want to see their stock price higher, and that's the main metric. So dovetailing into that and saying, answering your question, what are my favorite valuation metrics, we certainly look at p I don't love a revenue multiples, although some people use them, so I pay attention to them.
EBITDA would fit into the same category. I do like using earnings because it factors in all expenses. When you start looking at EBITDA and or revenue, it really does a factor in all the expenses. Interests and taxes are real expenses. As you know. So that's really why we try to at least balance our valuation perspective through a number of different metrics.
Well, you know, speaking of valuations, you had earlier mentioned sustainable valuations, how do you determine those?
So sustainable valuations we look at as a proxy for what the companies traded at in the past. First of all, we have to validate the fundamentals that have dictated that valuation framework in the past are still relevant. But assuming they are, we like to buy a stock in the
lower two thirds of its valuation range. And the reason for that is if you buy a stock and its peak valuation or close to its peak valuation, you're not only betting on the earnings growth that you've predicted, you are assuming that it's going to hold that high end of that valuation range. And those are two tough assumptions to make. In conjunction with one another, you have two ways to lose. You have valuation compression. You lose on
valuation compression, or you can miss on earnings misses. You want to mitigate the downside by really buying them at a fair price. And if a stock's not at a fair price, we put it on our watch list, and I've had stocks on my watch list for five days, five months, and in some cases five years. So it's just one of those things that you have to realize buying a stock correctly is an important part of the investment process.
And what sectors do you find the most interesting right now? Do you have any specific sector loads?
Yeah, you know, I think there's there's a lot of interesting things going off on the market right now. You know, we have had been overweight semiconductors for the first half of the year. I think there's still some interesting, interesting investment opportunities there, but we've been fading that group a
little bit and really been dusting off software. Software has been an underperforming industry over the first six months of the year and years, and what we're seeing is companies reassessing their expectations and now they seem more levels set. But as you talked about hard landing or recessionary risks, that's certainly only valid if we have a soft landing scenario,
So you know, we're we're being mindful of that. You know, with the FED being prospectively likely to lower rates, we're also looking some interest rate sensitive areas such as capital equipment, such as home building building products. Some financials have some tailwinds on that front. Some consumer names have some tailwins on that front, but I think that'll take a little longer to work its way out, specifically low end consumers.
You mentioned some technology industries. I know the strategy is bottom up, but do you look at macro factors at all or is it mainly just looking at the best opportunity or the best opportunities happen to be in a particular industry or sector.
We do not. We don't play macro economists when we're constructing the portfolio. We really let it flow from the bottom up. But that's not to say we don't consider or pay attention to macro factors. I think you have to be insane to not at least pay attention to what's going on around you when you're investing, especially in
small cap. But at the same time, it's not dictating solely what we're doing, uh, because ultimately we're here to pick stocks and outperform the market, and we feel like we can do that with a nice healthy balance of fundamental analysis, UH, good risk war judgment as well as macro considerations.
And I already opined on what I think caused last week's sell off a little bit. But what's your opinion on it? Do you think it meaningfully changes anything?
Well, it's interesting market psychology. I always say, you know, the my job is part art and part science, and I think the art part of it is very under appreciated and that the art part only comes with experience. But when you think about what's happened over the last six weeks, Uh, you had some data come out in early July, uh, you know, software CPI data and the FED signal that they are ready to cut, so that that proverbial you know, bad news was good news. Fast
forward a couple of weeks. You had a weaker PMI data, and you had weaker jobs data come out really the last week of July, first week of August, and bad news became bad news all of a sudden because the
risk of recessionary the recessionary economic backdrops increased precipitously. So I think the you know, and I think there was an overreaction in the market that was exasperated by something that was completely irrelevant to US fundamentals, in that the Japanese the Bank of Japan raised interest rates by twenty five basis points and expressed a willingness to do so
more through the balance of the years. So that really caused an unwind of the the yen carry trade, and so I think that really threw gasoline on the fire relative to the selloff. You saw a lot of risk based that sets sell off. So you talked about small cap really underperforming month to date, and I think that's part of what happened.
And do you have any opinion on where the Russell two thousand might be going from here? I know a lot of the growth drivers got removed back in the Juneery constitution, but any color you have on that.
Well, I've really I liked hearing what you said about your historical perspective on the October lows, the October twenty twenty three lows, and I do agree with you. At that point in time, we were adding to names and adding to companies that had higher growth profiles because in higher growth being companies that had twenty forty percent type of top line growth because they were priced at a discount. That time is pasted. I don't think we're at those
levels now, but we're certainly selling off. You know, there's two factors that are going to determine where we go. Are we going to go into a soft landing scenario or a hard landing scenario landing scenario. I think small caps have a pocket of underperformance ahead of us, and that will be a challenge until you know, we reach the determination that we're in that environment and then they'll
start out performing in a soft landing environment. I think we're already in the outperformance timeframe now with obviously what we've seen recently as a hiccup to that.
One thing you mentioned earlier, and the kind I think it ties into the discussion is you know, risk and reward and how that factors in? How do you evaluate risk and reward or you know, should I say what keeps you up at night?
Risk and reward? You know? Again, this goes back to that art and science part of the job. But the science part of it, which is probably what you're more interested in, and I'll get into the art part here in a second, is really evaluating what a stock can do and the fundamentals of a company can do in a variety of scenarios. It's really a probability matrix. If you will, you can do a two point probability matrix
or have one hundred point probability matrix. I don't have the time to do one hundred point probability matrix, so we tend to do a three point probability matrix. A base case, barecase, a gold case, not dissimilar from a lot of other folks. And what's the backdrop there, and what's the multiple structure that that's going to yield, And
so we look at an upside downside scenario. Now, when we're in the middle of making evaluations on companies that are trading in the marketplace, what we use as as a instructive tool is watching how stocks react to different news, and that's the art part of this job. It's really the price discovery process. If you see a company miss
and guide down the stocks flat or up. A lot of times bad news is priced in, at least for the near term, and so that's something to take a mental note of because if you like that company, it's probably not a bad time to start buying it, and understanding the market already has really tepid expectations there and if they can produce any sort of upside that's likely going to be good for the stock price.
What are you seeing from earning season and fundamentals. Are there any major takeaways that you have.
I think the major takeaway is that cyclicality is being is certainly being demonstrated in earnings. I mean, they're the cyclical companies are are certainly feeling the economic slowdown, the interest rate tightening that the Fed's done. You know, since kind of that twenty twenty three timeframe is certainly or twenty two time frame really is certainly taking hold. And so what you're what we're seeing there is a challenged backdrop for many companies that are dependent on access to capital.
And so when when we see that and the FED is too tight in which in my opinion, they're a little bit too tight right now. They need to start loosening. Are we behind the curve potentially? I don't think they're too far behind the curve here, so I think they can catch up, but I think I think they need to start moving in September.
I'd like to ask managers some reflective questions in your opinion, you know, what do you think or how has small cap investing changed since you started in the business.
You know, it's an interesting question. I think the private equity arena being able to be so well funded over the last twenty two years since I've been doing small gap specifically, they've been able to fund companies far longer than they've previously been willing to fund them. And so in some cases that you know, good companies have bypassed. My definition of small gap is that doesn't happen frequently, but it happens. That's probably the biggest difference. You obviously
have a lot of different types of investors. You have high frequency traders, you have AI driven investment investment managers. However, the core fundamental evaluation backdrop of investing is still relevant, and our investment philosophy and process has produced between four hundred and four hundred and fifty basis points of outperformance
over a twenty nine year timeframe. So it's still relevant, and it's still useful to have somebody with their hands on the steering wheel instead of putting it into a computer and just letting it run. So I'm talking to my own book here, but that's my opinion.
So you mentioned with private equity, are you seeing I guess less opportunities with companies not going as you know, public as often as they used to.
I would say on the on the margin. You might see one or two companies that fit the description of what I'm saying, but instead of a company coming public at five hundred million, they may come public at one point five to two billion. Still small cap. The definition of small cap has certainly gone up from a cap perspective,
but so has large cap. I mean, we have a handful of three trillion dollar market cap companies, or did at one point in time, and you look at small cap or our range of small cap is really kind of that five hundred million to call it seven billion on an entry point basis. And you know, our ability to buy a stock is really determined by liquidity. One of the big things we look at from a risk
perspective is liquidity. We want to make sure that we can trade in and out of a stock in an acceptable period of time.
Okay, well, this is great. I really appreciate you coming on, Mike and Mike. Thank you so much for joining me today.
Thank you well, David and Mike, thanks for having me. Appreciate it, and we'll do it again sometime.
Soon, definitely until our next episode. This is David Cone with Inside Active