Historically, the quality approach to small-cap investing has delivered attractive risk-adjusted returns. Griff Noble, CFA and Co-Head of the U.S Small/Mid-Cap Team, believes that "today’s current valuations point to a compelling, possibly generational, investment opportunity."
Noble reflects on his early career when he was advised not to "miss the forest for the trees," emphasizing that while understanding individual businesses is important, macro factors such as economic data and interest rates can overwhelm business fundamentals. However, he questions whether this advice has been taken too far.
He argues that many investors today focus insufficiently on individual stocks or the construct of benchmarks they invest in. Instead, they concentrate on themes and allocations. According to Noble, passive flows and short-term focus have eroded the overall small-cap market.
Research indicates that quality small caps are now cheaply valued compared to large caps. Noble suggests active management could identify quality small caps poised to outperform.
The majority of equity flows today go into passive vehicles investing in either broad benchmarks or subsets thereof. This approach assumes accurate valuation by enough participants will ensure an accurately priced benchmark. However, as fewer investors value individual stocks independently, inefficiencies may emerge.
Noble notes that retail investors often use short-dated options or thematic funds for individual stock purchases. These tools encourage short-term thinking rather than focusing on long-term prospects. He cites Benjamin Graham: "In the short run, the stock market is a voting machine. But in the long run, it is a weighing machine." The current environment entices many into short-term thinking instead of long-term focus.
One example of these issues is in U.S. small caps where significant capital flows into index funds despite deteriorating business quality among many small-cap companies. While traditional drivers like better growth prospects still apply to some extent, many businesses remain unlikely to grow significantly.
Despite challenges faced by small caps, passive allocators seek full exposure leading to market distortion with capital flowing equally towards poor-quality companies as well as great ones. Noble mentions that during past story-driven markets like Nifty Fifty1 era and tech bubble similar valuation distortions occurred within small caps.
He emphasizes an active quality-driven approach stating over 30 years higher-quality subsets within Russell 2000 Index outperformed both S&P 500 and broader Russell 2000 Index based on return-on-capital measurements.
Noble concludes that proliferation of new equity investment instruments encourages short-termism weakening investor insight into benchmarks' diverse components adding significant value through differentiated durable company investments: "Historically this quality approach delivered attractive risk-adjusted returns...today’s valuations point towards compelling opportunity."