US SMALLER COMPANIES MAY SHINE AS RATES RISE

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1 US SMALLER COMPANIES MAY SHINE AS RATES RISE Nicolas Janvier Portfolio Manager nhistorically, when Treasury yields rise US smaller companies tend to outperform their large company counterparts npresident Trump s tax reforms have provided a tailwind for a smaller-companies rebound nactive managers will have an edge if greater dispersion continues US smaller and mid-size company stocks have risen more than twice as much as their larger counterparts over the first half of the year, and there are convincing reasons to believe this could be just the beginning. Studies of US equity market history, and current economic conditions, suggest this may be the start of a sustained period of outperformance. Over the first six months of 218, the Russell 2 was up 7.7% from its level at the start of the year, compared to 2.7% for the S&P 5 Index. This outperformance signals a significant shift in sentiment given smaller companies lagged the broader market in If underlying conditions remain supportive, we could also be at a turning point for active US small company managers, many of whom have struggled to beat the benchmark in recent years. Stock market cross-correlations appear to be decreasing. Should this trend continue, active managers will gain an edge over their passive challengers as judicious stock pickers have the conditions to shine. Several factors support the view that this rebound is more than just a short-term blip. Empirical evidence shows that smaller companies tend to lag large caps when interest rates fall, but outperform in a rising rate environment. Since 1962, the furthest back we can go for reliable data, there have been three distinct interest rate periods, with three correspondingly distinguishable small cap outcomes and we are potentially entering a fourth (see Figure 1). 1 Bloomberg, 218.

2 Figure 1: 1-year Treasury note (% yield) Period 1: Rising Rates Years Source: Hotchkis & Wiley/Columbia Threadneedle, 217/18. Period 2: Falling Rates Years Period 3: Low Rates years Period 4: Rates begin to rise again 216-current 2 years Firstly, between 1962 and 1981/82 1-year US Treasury yields rose from around 4% to 15%, and US smaller companies significantly outperformed: the S&P 5 returned 7.6% per annum while smaller companies delivered 13%. 2 Secondly, from 1982 to the time of the dotcom crash in 21, Treasury yields dropped back from 15% to around 4% (see Figure 2). As interest rates declined, smaller companies returned 13% per annum while the S&P 5 returned almost 17%. 3 Figure 2: 1-year Treasury yield versus small and large cap performance % Indexed performance % 14% 12% 1% 8% 6% 4% 2% % S&P 5 (left axis) Russell 2 (left axis) US 1-year Treasury (right axis) Source: Bloomberg/Columbia Threadneedle, Hotchkis & Wiley, Bloomberg, 218.

3 Then we come to the third period. Since 23, Treasury yields have been stuck in a relatively narrow range and outperformance has seesawed between smaller companies and large caps, giving an inconclusive picture (see Figure 3). Figure 3: 1-year Treasury yield versus small and large cap performance % Indexed performance % 6% 5% 4% 3% 2% 1% % S&P 5 (left axis) Russell 2 (left axis) US 1-year Treasury (right axis) Source: Bloomberg/Columbia Threadneedle, 218. An alternative way to slice the data is to divide the entire 56-year period into two groups: those months when interest rates rose and those months when rates fell. This analysis again points to smaller companies shining when rates rise (see Figure 4). Figure 4: Annualised performance all rising rate months 2% 18% 17.9% 16% 14% 12% 1% 11.2% 1.1% 8% 6% 4% 2% 4.9% 6.1% % Large cap value Large cap growth Small cap value Small cap growth S&P 5 Source: Hotchkis & Wiley,

4 In the months that interest rates went up, the S&P 5 returned 6.1% and smaller companies returned 14%; conversely, in the months when interest rates fell large caps returned 14.9% and small caps delivered 1%. 4 WHY RISING RATES FAVOUR SMALLER COMPANIES Why, though, should smaller companies outperform large caps when rates are rising? The explanation is partly attributable to their exposure to the domestic US economy. Smaller companies are highly leveraged to US economic conditions, and steadily rising Treasury yields signal growing confidence. Small companies earn around 8% of their revenues domestically, while for large companies the equivalent figure is much lower, around 55%-6% (see Figure 5). In other words, smaller companies are proxies for domestic economic performance while large companies tend to be more reflective of the global backdrop. Figure 5: Breakdown of foreign sales exposure by index Mega Caps (Dow 3) S&P Mega Caps (Top 1) S&P 5 R1K Large Caps S&P Mid Cap S&P Small Cap U.S. Revenue Exposure by Index Foreign Revenue Exposure R2K Small Caps Source: Evercore, 217. The current macro backdrop is supportive of improving earnings growth, which bodes well for small company returns. Longer term, small company performance is highly correlated with earnings growth. Economic data such as ISM Manufacturing, industrial production, purchasing manager indices and GDP tend to be good leading indicators of earnings trends, and all paint an improving picture. A further reason why rising rates and small cap outperformance tend to coincide is the makeup of the indices. In the US, financials make up a large chunk of the small company indices, and within financials there is a long tail of small regional banks. 4 Hotchkis & Wiley, 217.

5 Banks benefit hugely from two conditions: one is an improving economy that drives loan demand; the second is an upward sloping Treasury curve, because banks borrow short and lend long (so a steeper yield curve boosts their net interest margin). Both are usually present in a rising rate environment. In essence, small company indices have greater representation of companies that benefit from rising rates. ENTERING PERIOD 4: TAX CUTS OFFER A TAILWIND Smaller companies have also been major beneficiaries of President Trump s recently enacted tax reforms. Percentage-wise, the average tax rate previously paid by small cap companies was in the low 3s versus the mid-2s for S&P 5 companies. But small cap cashflows have improved dramatically as the statutory tax rate has been cut to 21%. At some point, rates could rise high enough to result in multiple compression. However, with the 1-year treasury rate currently just shy of 3%, we believe there is headroom for rates to rise further before reaching the point at which high interest rates should be a negative. In the meantime, there will be scope for the superior qualities exhibited by small and mid-size companies to shine; qualities such as stronger earnings growth: in developed markets, small- and mid-cap businesses grow earnings meaningfully faster per year than their large cap counterparts. 5 Smaller company management also benefits from more cash-rich balance sheets with which to deliver shareholder value, be it by investing in research and development, paying dividends or through M&A activity. As management are commonly stakeholders in smaller companies, they have more incentive to deliver that value. Given these qualities, it should be no surprise that small and mid-size companies have historically outperformed large caps over the longer term, not just in the US but in every region of the world. ACTIVE ADVANTAGE Another simultaneous shift in the market environment could also be significant for small company investors, although whether it is long-lasting will only become apparent with hindsight. Given that there are more than 2,5 US smaller companies, and significantly less analyst coverage and thinner liquidity than in the large cap universe, a long-term, active approach should be an advantage. However, for the better part of 16 years the US market has been consistently characterised by very high cross-correlations. Stocks, as a group, have largely moved up and down together, irrespective of company fundamentals, frustrating active managers attempts to beat the market. Since late 216, though, cross-correlations of stock prices have reduced. Year-to-date, this has been one of the best periods for US active managers for some time. If investors are becoming more discriminating, and the market is moving into a regime of greater dispersion, we are likely to be entering a more promising environment for stock pickers. 5 Evercore-ISI, 217.

6 That said, if we have entered a rising rate regime it will be uncharted territory for many professional investors. As we have seen, the US hasn t experienced a prolonged period of rising rates since the early 198s and few, if any, fund managers have experience of managing money in such an environment. Given this backdrop, we believe our study of history, supported by deep research capabilities, will increase our potential for maximising returns. Our investment approach focuses on capturing alpha by investing in companies that can grow and compound cashflows at a higher rate than average. The market s often short-sighted view of the operating cycle, which may be exacerbated by a move into an unfamiliar rate regime, will likely create value opportunities. As an active manager there are many reasons to be positive on smaller companies. CONCLUSION Through studying the history of US equity markets, we have identified a correlation between periods of rising interest rates and the outperformance of smaller US companies versus their large cap counterparts. This is partly attributed to their greater exposure to the US economy, and the fact that steadily rising interest rates signal growing confidence. For example, from the early 196s to the early 198s, when interest rates were generally rising, US smaller companies returned 13% per annum compared to 7.6% for the S&P 5; while during the subsequent 2 years, when interest rates fell, the S&P 5 returned almost 17% per annum compared to 13% for smaller companies. 6 Given that we are likely entering a more promising environment for stock pickers, with the cross-correlation of stock prices between indices reducing, our active approach coupled with a rising rates regime will, we believe, increase our potential for maximising returns. 6 Bloomberg, 218.

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