Derek Izuel of HighMark Capital Management recently joined Evan Cooper of InvestmentNews Content Strategy Studio to discuss the role small-cap investments play in a portfolio.
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Cooper: What's the case for actively managed small caps?
Izuel: Smaller-cap companies are relatively neglected in the marketplace and aren't covered as much as large caps. That provides an opening for active investors like us to add value, because it gives us a better chance to obtain an information edge.
Cooper: How does this information edge affect HighMark's overall perspective on small-cap investing?
Izuel: The heart of our approach is knowledge-based investing. We use our analytical tools to figure out who in the marketplace has good information, and we monitor their activity to see what we can glean from that data. We assemble it to get an idea of how likely it is that a stock will perform better or worse than the market.
A lot of funds are based on one methodology — value or momentum investing, for example — which tend to go in and out of favor. With knowledge-based investing, we draw on sources with different perspectives.
Cooper: What kind of information is important?
Izuel: We concentrate on three things when considering specific companies. We call it inside, outside, upside. First, what's management doing — both with the company and their own assets? Second, what are informed investors doing, particularly on the short side, where most trading and investing is information driven? And what do industry analysts say about this company and where it's headed?
Cooper: Can you describe what goes into your risk assessment?
Izuel: We look at some of the predominant market forces that often drive big groups of companies to perform differently in the market. We want to make sure that we're not overexposed to any of those forces. Balancing our exposure helps smooth out returns and ensure that we're getting compensated for any risk we take. That's the heart of what we do in small-cap investing.
Cooper: Small-cap stocks outperform historically, but isn't their problem volatility?
Izuel: That has not been as true in the past few years. The way to neutralize their added volatility is for investors to include small cap stocks in a well-diversified portfolio of multiple asset classes.
Cooper: We keep hearing about indexes. How does active management help here?
Izuel: Active large- and mid-cap managers have struggled to beat their benchmarks over the last decade. But the average small cap manager has outperformed significantly. You're leaving money on the table in the small cap space by not choosing an active manager.
Cooper: What's the sell discipline?
Izuel: Every stock in our portfolio has two attributes: It's likely to outperform the market, and it contributes to the overall risk profile. If it doesn't, we'll be looking for a replacement.
Cooper: How much small cap does an investor need to get the benefits without being overexposed?
Izuel: With the alpha available, an allocation to small caps of 15% to 20% is appropriate for the U.S. equity portion of an investor's portfolio. You're taking on a little more volatility, but you want to have a big enough position that the alpha advantage makes a difference in the portfolio.
Cooper: Is credit quality a significant factor in your decision making?
Izuel: We want to make sure we're using every bit of risk properly. Even within small caps, credit is a bigger part of some businesses than others. A shale driller is going to take on a lot of debt and be sensitive to spreads, for instance, while a service provider probably doesn't have a lot of borrowing needs.
Therefore, I can hold both of these companies. It's not about whether they have a lot of debt or not, but I want to balance that exposure so that the portfolio has an overall net benefit.
Cooper: Where does micro cap end and small cap begin?
Izuel: Micro cap is the smallest half of the small cap Russell 2000 index with an additional 500 or so stocks below that. The Russell Microcap index, which we use for our microcap strategy, has some 1,500 companies and a median market cap of around $200 million compared to the Russell 2000's median market cap of about $800 million.
Cooper: Is it harder to follow or understand tech startups given their complexity?
Izuel: It's a valid concern, but there's a certain simplicity in that the capital structure of these firms is pretty straightforward. They're generally financed by equity.
It's more a question of whether the technology will succeed and of the company's potential if it does. That's also where our evaluation of management comes in. How do they spend? How much are they allocating to research and development?
Cooper: How much has the dearth of new issues hurt small caps?
Izuel:The dearth of new issues has presented minor challenges in terms of liquidity. Nothing major at this point and we've been able to adjust by modifying some of our trading practices.
Private equity has been buying new issues and draining liquidity. But it's like anything else: The private market can hold only so much. That trend is likely to reverse sometime in the next several years, and more companies and liquidity will be available to investors.
Cooper: Do many companies 'graduate' to mid-cap status?
Izuel: 'Graduate' is the perfect term, and a lot of them do graduate. We'll generally let them grow for a bit. In fact, we have one stock in the portfolio that's almost a large cap now and still very attractive. After they've stepped up, we ultimately have to cut back the position or sell. This goes on all the time. We update our small-cap lists monthly. And, of course, it's great if a company is purchased when we have a position.
Cooper: How much does a company's potential as an acquisition target enter into your analysis?
Izuel: We don't specifically look for it, and a lot of related information is widely available in the marketplace: a company's stock price is down, it has a lot of cash on the balance sheet or has a particular business that's valuable. Somebody's going to gobble them up. The obvious candidates already have a lot of that priced in.
What we're looking for is that extra level of analysis that might tell us more about the timing or where to find the unexpected candidates.
Cooper: How are you different from, say, a hedge fund manager in terms of what you know and do?
Izuel: Most managers in that space have to have demonstrated a considerable amount of skill in order to get assets from investors, but there's often a lot more at risk. It's the same with derivative traders, who are usually hedging exposures for those with a lot of risk. As a result of the amount of risk being taken, there's generally more information.
These short-side investors get the stocks they need to short from institutional investors. We also provide supply. The supply and demand dynamic between the short and the long side gives us a lot of information about where a stock is going.
We've found that short-side investors will outperform the market by a couple of percent a year on average. That's what we're trying to tap into.
HighMark, an SEC-registered investment adviser, is a wholly owned subsidiary of MUFG Union Bank, N.A. (MUFG Union Bank). HighMark manages institutional separate account portfolios for a wide variety of for-profit and nonprofit organizations, public agencies, public and private retirement plans, and personal trusts of all sizes. It may also serve as sub-adviser for mutual funds, common trust funds, and collective investment funds. MUFG Union Bank, a subsidiary of MUFG Americas Holdings Corporation, provides certain services to HighMark and is compensated for these services. Past performance does not guarantee future results. Individual account management and construction will vary depending on each client's investment needs and objectives. Investments employing HighMark strategies are NOT insured by the FDIC or by any other Federal Government Agency, are NOT Bank deposits, are NOT guaranteed by the Bank or any Bank affiliate, and MAY lose value, including possible loss of principal.
This article is for general information only and is not intended to provide specific advice to any individual or institution. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations.
