CEO Sessions: Innovation and valuation – why small caps are back in focus

Ali Dibadj: Hi everybody, it’s Ali. We’re here at the Madrid Investor Summit. Lots of buzz in the audience, lots of energy. We’re talking a lot about geopolitics and changes in the world right now. I couldn’t be more pleased to be here with two of my partners here at Janus Henderson. Jonathan Coleman, who runs our US small cap business, and Nick Sheridan, who runs our global small cap business.

I’m very happy to have you here. You guys have been talking to lots of investors around the world, and certainly here, give us a sense of the interest in small cap around active management and small cap, Jonathan.

Jonathan Coleman: Well, when we look at the small cap universe, we think it’s really tailored perfectly to active management because it’s, in the US, a group of 2,000 companies globally, maybe over 5,000. And it’s a very heterogeneous universe of businesses. Some will probably stay small cap forever; others will grow to become mid cap and large cap over time. And so, I think that’s really where the value of active management plays is that there are diverse competitive positions, diverse skills of management teams, diverse returns on capital. And if we dig deep, we can ascertain the companies that are likely to outperform.

Nick Sheridan: I’d actually add to that the fact that it’s under researched. So, you’re looking when no one else is looking. I always liken it to that Star Trek moment where, you know, you see the Enterprise disappears, the disembodied voice “to boldly go where no one’s gone before.” And that’s effectively what we’re doing in small cap. So, it is a really, really good area of the market in which to be an active manager.

Dibadj: Well, one of the things you guys do so well is understand the company sometimes better than the management teams who work there in the companies themselves. You had a CEO on stage just a moment ago to talk about that relationship, how that’s formed.

Coleman: I think what we want to do is understand how management teams are thinking about operating in what is inherently uncertain environment.

It feels like this current environment is more uncertain, but the reality is go back in history, there’s always shades of grey and trying to understand how CEOs and CFOs and other leaders of companies are planning for that uncertainty. They’re planning for the long term and understanding how they can operate their businesses to create value, even though they can’t accurately predict the future because nobody can do that.

Dibadj: Now, one of the uncertainties that we’ve been talking about quite a bit is geopolitics. And  you think about this globally, Nick, give us a sense of how you think about the political change and how you invest.

Sheridan: Okay. Well, I think, from a geopolitical perspective, what you’re seeing at the moment, credit conditions in the US better than anywhere else, credit conditions in Europe getting better, credit conditions in Asia and China slightly worse.

But I think the important thing about small caps is the innovation, the ability to bring a new product to market and grow. And I think that that obviously has always been really good in the US, because the US doesn’t mind failure. The rest of the world seems to have a thing about, you know, if I don’t try, I won’t fail.

Europe’s getting its act together, post-Draghi. So, there’s a lot of money flowing into innovation funds. Lots of regulation pulling back, which you haven’t seen in Europe for a long time because post 2008, one of the problems in Europe is we overregulated. So, I think from an innovation expectation, it’s really good.

Dibadj: Where do you see the interest coming from the client perspective on small mid-cap? I mean, I have conversations a lot of times around private equity not delivering on their promises and not being liquid and costing a lot and all that sort of stuff. How do you guys see the opportunity in small cap and the public markets?

Coleman: What pains me to say it a little bit as a dedicated manager, but small cap investing now has become a little contrarian. That’s a positive, because I think there are a lot of, investors who are thinking about where the ball could be in the future and wanting to follow that. The reality is that while small caps have underperformed large caps over the last decade, the absolute returns in  small caps have not been bad. Historically, they’ve been kind of high single digits, but that has paled in comparison to the large cap return.

As a result, our starting point is exceptionally attractive because the relative valuation of small caps compared to large is really at historic lows. And I think many astute investors are looking at that as an opportunity. In fact, in the United States, we’ve seen the small cap market start to outperform the large cap market for the last three months.

And so, I think that’s adding a little fuel to the fire. And we see an increasing amount of interest from asset allocators as a result.

Sheridan: Well, I think as Jonathan’s client this morning was saying, you know, small caps is all about being innovative, all about being able to grow quicker to move into those niche markets when they need to.

And, as Jonathan says, on a relative basis, compared to large cap global small caps are on their back. But therein lies the opportunity, because you get the growth rate, and you get the operational return. Hopefully as we progress over the next few years, you get the valuation multiple expansion. So, you get both sides of the total return equation from a client’s perspective. And I think that is really attractive.

Dibadj: Well, you’ve heard it here from Nick and Jonathan. There’s a lot of world uncertainties. But a way to pierce through that is to find innovation, particularly in the smaller companies where active asset management here at Janus Henderson really plays out. Thanks for watching.