Why small caps are at early stages of recovery

Portfolio manager says there continues to be attractive opportunities and stresses the need for time in the market

Why small caps are at early stages of recovery

Small caps are in the early innings of playing catch-up to large cap stocks, according to a portfolio manager.

David Barr, who manages the Pender Small Cap Opportunities Fund, which has enjoyed a quarterly performance of 43% and a performance for 2020 of 47%. This trend continued into January with the fund up 7.3%. PenderFund Capital Management’s Pender Value Fund also enjoyed a return of 11% in December, taking its 2020 performance to 20.1%.

The key to these results: its focus on small cap stocks and the technology sector. Barr also revealed that the rapid appreciation in the value of companies held by the funds has changed the angle of questions from clients.

He explained: “Last summer and into the fall the question we received was ‘why should we continue to hold small cap stocks?’ Many have heard us talk about the valuation and performance disconnect between large and small cap stocks on more than one occasion. That extended underperformance had people questioning whether small cap stocks would ever be popular again.

“As countless teenage dramas have shown us, popularity can change quickly overnight. Q4 looks to be that moment in the small-cap market.”

Now when asked why the funds should continue to hold small cap stocks, Barr replies that even with the recent strong performance in the funds, we continue to see attractive opportunities.

He added: “We believe that small cap stocks are still in the early innings of playing catchup to the large cap stocks. On top of that we are seeing a very attractive M&A setup. There is a lot of pent-up M&A demand right now and, with capital flooding into IPOs and SPACs, our view is that the number of potential buyers increase by the day.”

Overall, Barr said the lesson from the past year is that it’s not about timing the market but about time in the market. Stocks can be lumpy and being invested when they come is vital, although this is put to the test when everyone around you is losing their heads (and money). With that in mind, Barr continues to be near fully invested.

Portfolio defence is focused on short duration special situations, either SPACS, merger arbitrage or credit opportunities which, with a weighting still under 10% in both funds, serves as a potential volatility buffer and source of cash if markets change.

Barr said: “If a business is low quality and expensive, we will usually exit the position and reinvest in better opportunities. If a business is high quality with a high valuation, we usually do not exit the position immediately. We find most of the time high quality businesses tend to be undervalued by markets and our intrinsic estimates can be too conservative, therefore we choose to trim the position and maintain a more modest exposure.

“On the other hand, if a business is low quality and inexpensive, we will usually hold the position and wait for catalysts to happen to close the discount. On the buy side, we believe that the best opportunities exist where businesses are high quality and undervalued or misunderstood by the markets. This is where we want to fish and strike for the full weight.”