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; QE 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 more in line with historical norms.

Predicting future outcomes feels like a fool’s errand under most circumstances but even more so today, with the turmoil of an energy crisis, inflation and the most serious conflict in Europe since the end of WW2.

So, it is hard to say if the market for US small caps has bottomed out; there could always be further headwinds that materialise, but for investors that believe in the market’s long-term potential, there may be some room for optimism.

Just as more speculative investment during the pandemic lifted share prices to irrational highs, so too has this year produced undiscriminating selloffs, which may provide opportunities for managers willing to stick out current volatility.

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

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

Such experience shouldn’t be overlooked, as plenty of managers only entered their roles during the Bull Run and period of ultra-low interest rates of the past decade or so.

Chris’s approach 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 being that companies which display these traits are more likely to be able to generate compounding returns over the long-run, as they move from small cap to large cap status.

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

BASC’s focus on growth does not mean buying at massive valuations or speculating; valuations remain important and must be balanced against earnings growth prospects and how well a company is managed.

Even if a company has good growth prospects, the managers won’t invest if its valuation is overinflated.

BASC is also focused on delivering over the long-term, not catering to market trends.

Value is having its day in the sun, 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 - something Chris touched upon when he spoke at our recent event:

“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 businesses can seem a daunting task, because it’s hard to look through the macroeconomic noise.

But Chris has made several additions to the portfolio in the second half of the year, believing the long-term potential for some companies remains positive.

Pinterest is one example; 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 enabled BASC to take a position, with the managers confident the firm will deliver earnings growth in the years ahead.

Pinterest delivered its first full year of profitability in 2021, with $355m in net income, and brought in Bill Ready as CEO in June of this year. Ready previously developed Google’s commerce products and shareholders hope he’ll be able to grow Pinterest’s sales, with more ad revenue and expansion into new markets.

It’s similar with Mister Car Wash (MCW), another recent addition. Since going public last year, the company has seen a marked decline in its share price.

However, the Brown Advisory team believe the underlying business looks strong and the fall prompted BASC to take a
position.

Operating 400 carwash sites may not sound exciting, but MCW has delivered exceptional growth over the past decade; the company increased its annual revenue more than six-fold, with an annualised growth rate of 18%.

It continued that into 2022, with sales for the first half of the year up 19.3% compared to last year.

Growth has been driven in large part by offering monthly subscriptions to its ‘Unlimited Wash Club’; approximately two-thirds of MCW’s H1 revenues came from subscribers to the service and the number of subscribers grew by close to 185,000.

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, and illustrate how valuations are factored into the investment process – yes, the two companies look capable of delivering compounding future returns, but the managers only took a position in them once their share prices had fallen from 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 >

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.

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