Small-cap investing requires a disciplined process




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By J. Griffith Noble, CFACo-Director of US Small Cap Equity, Eaton Vance Management and Mike McLean, CFA Co-Director of US Small Cap Equity, Eaton Vance Management

Boston - Eaton Vance and its affiliates seek to actively capitalize on opportunities presented by volatile investor sentiment, while ensuring that the portfolio risk profile remains appropriate for the specific strategy. The following are excerpts from a recent conversation with Michael D. McLean, CFA, and J. Griffith Noble, CFA, Co-Directors of US Small Cap equity for Eaton Vance Management.

What we are seeing: The market tumult in recent weeks has highlighted, in our view, the potential value of active management in the small-cap universe. Going back two weeks to March 16, small-cap stocks saw their steepest one-day decline in the history of the benchmark Russell 2000® Index — plunging over 14%. As of March 18, the index was down 41% from its near-term high on February 20. At one point, more than 25% of benchmark holdings were priced under $5 a share. We haven't seen pricing like that since the 2008 global financial crisis. In the past, we have referred to the long tail of unprofitable businesses in the Russell 2000 — those with too much debt and historically high leverage late in the business cycle. The stocks of these companies have really suffered in this sell-off. Fast-forward to March 27, and the Russell 2000 finished up over 12%. Clearly, the announcement of the government's large stimulus package had a positive market impact. At the same time, however, the largest number of initial jobless claims in history were filed. Along with tremendous humanitarian concerns, the COVID-19 crisis has created vast uncertainty and volatility in the market and a lot of volatility in small caps, but, decidedly, not in our philosophy, approach and discipline.

What we are doing: We continue to be anchored to our definition of quality, valuation and time (QVT). What that means right now is that we are looking for companies with strong balance sheets and favorable competitive positions that are pricing in significantly negative outcomes over prolonged periods. We believe these types of companies will be positioned to come out stronger on the other side, whenever that may be. We do not favor businesses where negative outcomes are not properly reflected in their valuations. Instead, we favor companies where we believe severely depressed valuations do not reflect their inherent, longer-term value. The number of stocks in our portfolios has crept up, reflecting the drop in share prices. We want to hold a wide range of stocks opportunistically and remain nimble during these volatile times.

What we are watching: The scale of the monetary and fiscal response to the economic contraction is a clear positive, especially when we consider that these actions are happening coincident with job loss and demand destruction, rather than being reactive to it. While the stimulus will help certain industries recover in the short term, we are spending some time assessing potential long-term impacts and structural shifts that may take place once the global public health crisis has passed. What will future air travel look like? Will the ongoing shift to e-commerce accelerate? Will office jobs move from cities to less dense areas? Understanding how industries may be impacted in the the long run will be critical to identifying the best long-term opportunities.

Bottom line: These challenging times highlight the importance of having a compass and a disciplined process. We have a clear definition of quality and nothing about the types of companies we favor today is different from a month ago. We believe our emphasis on downside protection and disciplined application of (Q)uality, (V)aluation, and (T)ime positions us for strong relative performance in turbulent times.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.