Investing in small-caps? Don’t pick up any cigarette butts

Value may be en vogue, but it’s growth that ultimately delivers returns for shareholders…by David Kimberley

US small caps have had a volatile couple of years. Quantitative easing policies adopted during the pandemic helped drive share prices to record highs. Subsequent rate hikes amid rising inflation have had the opposite effect, pushing valuations back down to levels that are more in line with historical norms.

Predicting future outcomes feels like a fool’s errand under most circumstances but even more so today, replete as our world is with the turmoil of an energy crisis, inflation and the most serious conflict in Europe since the end of the Second World War.

That being the case, it is hard to say if the market for US small caps has bottomed out or not, as there could always be further headwinds that materialise. However, for investors that do believe in the market’s long-term potential, there may be some room for optimism.

Just as the more speculative investment we saw during the pandemic lifted share prices to irrational highs, so too has this year produced selloffs that haven’t been discriminating in their scope. The result is that share price drops may have provided some opportunities for managers that are willing to stick out current volatility.

Navigating these choppy macroeconomic waters isn’t a straightforward task but the managers at Brown Advisory US Smaller Companies (BASC) have some experience dealing with market downturns.

Portfolio manager Chris Berrier has run the US small cap strategy at Brown Advisory since 2006, helping investors to weather the fallout from the financial crisis shortly after he took up the role. He was also working as a small cap analyst at T Rowe Price when the Dot Com bubble burst at the start of the 2000s.

Experience such as this shouldn’t be overlooked today, with plenty of managers only entering their roles during the bull run and period of ultra-low interest rates that we’ve lived through over the past decade or so.

Chris’s approach to the market has remained consistent over the years, with the BASC team looking for companies that have what they call “3G” characteristics – durable growth, sound governance, and scalable ‘go-to-market’ strategies. The idea here is that companies which display these traits are more likely to be able to generate compounding returns for shareholders over the long-run, as they move from small cap to large cap status.

As the growth ‘G’ suggests, this does mean that BASC tends to have a more growth-oriented tilt to its portfolio. In a year where value has started to perform well after a long period in the doldrums, that may not sound as appealing as it once did. But it’s worth keeping in mind a couple of factors here.

One is that BASC’s focus on growth does not mean buying at massive valuations or engaging in speculation. To the contrary, valuations remain important and must be balanced against earnings growth prospects and how well a company is managed. So even if a company has good growth prospects, the managers aren’t going to invest if its valuation is overinflated.

BASC is also focused on delivering over the long-term, not catering to market trends. Value may be having its day in the sun at the moment but it’s far from clear that will continue, nor is it easy to see how smaller companies with limited growth prospects can deliver meaningful compounding returns for shareholders over prolonged periods. Indeed, this is something Chris touched upon when he spoke at one of our recent events.

“If you’re going to invest over the long-term, you can’t walk around picking up cigarette butts,” he noted. “You have to focus on businesses that have enduring qualities that are going to last. And that means they have to be able to grow.”

Finding these sorts of businesses at the moment can seem like a daunting task, purely because it’s so hard to look through the macroeconomic noise. But Chris has made several additions to the BASC portfolio in the second half of the year, believing that the long-term potential for some companies remains positive.

Pinterest is one example of this. The image sharing platform’s share price reached astronomical levels during the pandemic but has since fallen back, as interest rate hikes drove more speculative valuations out of the market.

A fall in valuation is what enabled BASC to take a position in the company, with the managers confident the firm will be able to deliver earnings growth in the years ahead. Pinterest delivered its first full year of profitability in 2021, with $355m in net income. The company also brought in Bill Ready as CEO in June of this year. Ready was previously responsible for developing Google’s commerce products and shareholders are hoping he’ll be able to grow Pinterest’s sales numbers, with more ad revenue and expansion into new markets.

It’s a similar story with Mister Car Wash (MCW), another recent addition to the portfolio. Since going public last year, the company has, like Pinterest, seen a marked decline in its share price. Despite that, the Brown Advisory team believe the underlying business looks strong and the fall in valuation has prompted BASC to take a position in the company.

Operating around 400 carwash sites may not sound like the most exciting business but MCW has managed to deliver exceptional growth over the past decade. From 2010 until the end of 2021, the company increased its annual revenue more than six-fold, with an annualised growth rate of 18%. It has continued that into 2022, with sales for the first half of the year up 19.3% compared to the equivalent period last year.

Growth has been driven in large part by offering customers monthly subscriptions to its ‘Unlimited Wash Club’. In the first half of the year, approximately two-thirds of MCW’s revenues were derived from subscribers to the service and the number of subscribers also grew by close to 185,000 over the same period. Aside from driving more sales, this model means revenue figures are smoother and more predictable than they would be if the company was offering a regular service, where customers just turn up and pay.

Both MCW and Pinterest capture the ‘3G’ characteristics which BASC looks for, as well as illustrating how valuations are factored into the investment process – yes, the two companies look capable of delivering compounding returns in the future, but the managers only took a position in them once their share prices had fallen from their inflated highs.

This process may still be susceptible to near term volatility but, over the long run, it could be more likely to deliver superior returns to shareholders. It certainly has in the past, with Chris’s strategies delivering returns ahead of the benchmark for investors since 2006. We’ll have to see if it’s the same over the next few years, but it certainly seems as though his approach has proven over time to avoid the cigarette butts.

View the latest research on BASC here >

Disclaimer

Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by Brown Advisory US Smaller Companies. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.