WHERE DO SMALL-CAPS GO FROM HERE? – JUNE 2022
Why is now a good time to be allocating to well-capitalized, small-cap companies?
- Unprecedented liquidity injected into financial system over past few years.
- Large cap stocks and highly levered companies have disproportionately benefitted
- Recent shareholder letters have shown historic outperformance by large cap stocks relative to small caps.
S&P Total Return Minus Russell 2000 Total Return Last Ten Years
- Much to our dismay, leveraged companies have benefitted as well. Recent data published by Jefferies illustrated that the most highly leveraged companies in the Russell 2000 Index far outperformed the least levered companies recently.
- Low leverage companies had outperformed until the Spring of 2020, yet 20 years of outperformance has been wiped out in the past two years. That’s illogical in our opinion.
LOW DEBT/CAPITAL VS. HIGH DEBT/CAPITAL
Source: Jefferies, Russell 2000 Index, FactSet
Methodology: accumulated monthly performance of the Russell 2000’s lowest debt to capital quintile versus highest quintile.
Why do we feel that the Third Avenue Small-Cap Value Fund is uniquely positioned for the current environment?
- The unwinding process may have already begun in 2022 as high multiple companies are coming back to earth and credit markets are tightening given higher yields and a dearth of high yield debt issuance in 2022.
- Third Avenue has a rich history of being value investors with a “balance sheet first philosophy”.
- The Small Cap Value Fund’s positioning speaks for itself. The net debt to capital ratio of the Fund (ex-financial companies) is just 9.1% percent vs 28.3% for the Russell 2000. It’s notable that Index debt to capital ratios are near historic highs. In addition, over one third of the companies (ex-financials) in the Small Cap Value have net cash positions.
- We are attracted to contrarian management teams that use their strong financial positions to deploy capital when others who did not plan for more challenging times need capital.
NET DEBT TO CAPITAL IN SMALL-CAP
Weighted Median, Ex Financials
Note: Figures reflect weighted median, excluding financial companies. Third Avenue Small-Cap Value Fund data point reflects position weights as of 3/31/22.
How would you compare the current environment to the 1970’s?
- Given recent events, we believe investing in well-capitalized small cap value equities will be attractive alternative as markets adjust to higher interest rates and wider credit spreads.
- There are many similarities between the current period we are experiencing and the 1970’s. It’s striking that when you study the high inflation period during the 1970’s, it was a golden age for small cap value equities as they returned double the rate of inflation and was the best performing asset class from 1974 to 1982.
US CROSS ASSET RETURNS IN 1970S AND US CPI
Sources: BofA Global Investment Strategy, Bloomberg, Ibbotson, FamaFrench growth/value series, Case-Shiller, Bureau of Economic Analysis, Homer & Sylla, A History of Interest Rates.
- Given what has taken place over the past few years, history could repeat itself and if it does, we believe we are prepared.
- It’s a credit to our investment approach.
- The volatility of the Third Avenue Small-Cap Value Fund, as measure by standard deviation, has historically been lower than the benchmark.
- The Fund’s investment philosophy is well-equipped for a period of higher interest rates, tighter credit and normalizing economic growth.
Sources: Factset Portfolio Analytics. Based on equity holdings only.
Past performance is no guarantee of future results; returns include reinvestment of all distributions. The above represents past performance and current performance may be lower or higher than performance quoted above. Investment return and principal value fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. Click here for standardized performance.
FUND RISKS: Please be aware that small-cap investments are subject to higher volatility and lower financial resources than large-cap investments. The markets for these securities are also less liquid than those for larger companies. For a full disclosure of principal investment risks, please refer to the Fund’s Prospectus.
Third Avenue Funds are distributed by Foreside Fund Services, LLC.
The Russell 2000® Value Index measures the performance of small-cap value segment of the US equity universe. It includes those Russell 2000® companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000® Value Index is constructed to provide a comprehensive and unbiased barometer for the small-cap value segment. The index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set and that the represented companies continue to reflect value characteristics.
S&P 500 Index – The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
Debt-to-Capital Ratio – The debt-to-capital ratio is a measurement of a company’s financial leverage. The debt-to-capital ratio is calculated by taking the company’s interest-bearing debt, both short- and long-term liabilities and dividing it by the total capital.
Standard Deviation – Standard deviation is the statistical measure of market volatility, measuring how widely prices are dispersed from the average price. If prices trade in a narrow trading range, the standard deviation will return a low value that indicates low volatility.