March 6, 2025 • 43 mins
Dive into the intricacies of small-cap investing as Michael Gayed and Brian Drubetsky explore the current economic landscape and its implications for market opportunities. With interest rates being a pivotal factor for many small-cap firms, our discussion unpacks the latest trends in earnings growth and the potential for favorable shifts in monetary policy.
From analyzing the essential characteristics that can help small-cap stocks thrive, to recognizing the undervalued opportunities in sectors like consumer discretionary and real estate, this episode aims to equip you with the knowledge to recognize and seize upcoming market trends. As we uncover the transformative influence of technology and automation on small caps, listeners will gain a better understanding of how to navigate this often-overlooked segment of the market effectively.
Join us as we dissect key questions surrounding the future of small caps, from their historical performance to robust strategies for capitalizing on growth. Don't miss this insightful episode—subscribe, leave a review, and share your thoughts! Your engagement is invaluable as we continue to explore the evolving world of finance together.
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Episode Transcript
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Speaker 1 (00:00):
Right now the market's pricing in two and a
half cuts.
I think even if you get one cut, small caps could do well.
And even if we don't get anycuts, I think rates could
eventually come down if therestarts to be labor weakness.
So, importantly, the mortgagerate is usually about 150 basis
points ahead of the 10-year andright now mortgage rates are
(00:20):
close to 6, 7, the 10 yearsaround 4, 2.
Mortgage rates are close to 6,7, the 10 years around 4, 2.
So that's almost a 250 basispoint spread where it's usually
150 basis points, and I thinkthere's a lot of uncertainty of
Fed policy and whether it's inthe tariffs or how they're going
to respond to inflation.
But that spread should narrowand it doesn't really take rate
cuts to happen.
(00:41):
It just needs more policycertainty what's going to happen
with tax cuts?
And I think, importantly, forthe small cap stocks to work and
we haven't really talked aboutthis much yet but you need
earnings growth and accelerationto come and in the fourth
quarter of last year we finallyhad positive earnings growth.
Speaker 2 (00:59):
This is a very timely topic.
If you've been following me fora while, you know that I, in a
very annoying way, continuouslysay small caps, hold the key.
I think it's a very importantpart of the marketplace and one
that potentially has a lot ofopportunities.
With all that said, my name isMichael Guyatt, publisher of the
Lead Lag Report.
Joining me here is BrianJaresti Schaefer Cullen.
Brian, a lot of people who aretuning in may not be familiar
(01:20):
with who you are, so introduceyourself what's your background?
Speaker 1 (01:27):
what have you done throughout your career?
What are you doing currently atSchaefer Collin?
Yeah, sure Thanks for having me, michael, and yeah, so I
started my career at KPMG and Ihold an MBA from Columbia.
I've been with Schaefer Collin,my current firm, for 12 years
and prior to this role, I was ata long short equity hedge fund.
So here at Schaefer Cullen, Imanage our small cap value
strategy, as well as our smalland mid dividend focused
(01:49):
strategy.
The small cap value strategy isavailable as an SMA as well as
a mutual fund, and this middividend right now is available
as a separate managed account.
Speaker 2 (02:00):
Since you mentioned the experience with the long
short equity hedge fund, I amcurious because if you're going
to be doing long-short portfoliopositioning, you really have to
kind of know your stuff on whatit is that you're trying to
short right and be very careful,obviously, on fundamental
analysis as well.
Talk to me about how theexperience at the long-short
equity hedge fund maybe shapesyour way of how you think about
(02:23):
individual companies.
Speaker 1 (02:24):
Yeah, sure.
So we spent about most of thetime investing on the long and
short side on small andmedium-sized companies.
So I think there's an edge thereon really doing the fundamental
analysis.
So most of our strategies hereat Schaefer Cullen are long only
(02:45):
but we're fairly concentrated,so our portfolios have between
30 and 40 names typically in theportfolio and that allows us to
do deep research and that'sreally required both on the long
side and on the short side.
And a lot of the work that wedo here is really figuring out
(03:05):
what the key investment factorsare for the stock to work, but
understanding what the risks are, because as value investors
there's certainly a lot of valuetracks and I think, having had
experience on looking at thecompany from a lens of which
ones could be short, whetherthey're accounting issues or
whether the company or thesector is in structural decline
(03:27):
and a lot of what we do atSchaefer Cullinan we're looking
at a stock is figuring out isthis something that is
cyclically challenged and thisis going through a cycle, or is
there something structurallywrong where you could get
conviction in staying away forthat reason?
So I think on the short side ithelped me in just looking out
(03:49):
for value traps.
Speaker 2 (03:51):
I want to focus on that point about deep research,
because I think you and I bothknow that most people's
impression of deep research ishere's a chart and it's going up
and to the right.
That's deep research for mostpeople.
What goes into the kind ofresearch process that you follow
, Meaning?
What kind of things are youlooking at when we say the word
deep?
How deep is deep there?
Speaker 1 (04:12):
Yeah, sure.
So looking at companies andfollowing companies, there's the
maintenance work, but alsodoing the pre-work and a lot of
the initial research is reallydeciding again what are the key
investment factors and what isour variant perception.
And if you think back to thehigh school days of science, you
(04:33):
have a hypothesis.
You want to test thathypothesis and, if possible, try
to refute it, going beyond ofjust reading the sell side
reports and meeting withmanagements, reading the
transcripts, but also speakingto industry experts that either
worked at the company prior orworked at competitors and really
getting an edge.
(04:54):
And in small caps there reallyaren't as many analysts on the
sell side covering the names,whereas if you have an analyst
covering community, coveringApple or Meta or NVIDIA, there
might be 50 analysts.
In small cap the average isabout five analysts and in many
of the companies there are noanalysts covering the stock, so
(05:14):
they're really left for dead,which creates an opportunity for
us.
Speaker 2 (05:18):
Which gets into the most important question from my
standpoint, which is this pointabout small cap volatility.
Why is it that small caps havejust struggled, really since the
2021 peak, at least in theRussell 2000?
I mean, you look at the market.
Most people obviously definethe market as the S&P 500, but I
(05:38):
think the market is much biggerthan that.
It's just from the standpointof the number of companies, many
more small cap names than largecap names, and a lot of small
cap names are still way belowtheir after inflation adjusted
peaks from 2021.
So what's going on in that partof the world?
Speaker 1 (05:54):
Yeah, small caps have certainly struggled and it's
gone beyond 2021.
It's really seven consecutiveyears that they have lagged
large caps and I think there area multitude of factors.
One, it's the industry or thesector index.
Construction Technology hasbeen a big driver of returns for
large cap indices and small capjust doesn't have as many
(06:18):
technology companies in theindex.
So if you take the S&P 500,technology is about 30% and the
Russell 2000 is 12.
And then if you add oncommunication services, that's
another 12% for the S&P and it'ssomething like 4% or 5% for the
Russell 2000.
So that's one reason.
(06:39):
On top of that, you've had highinterest rates and a lot of the
small cap companies rely ondebt financing and variable debt
is approximately 65% of theirdebt structure, where that's
only about 30 for large capcompanies.
So the cost of debt has beenkind of an issue for small cap
(06:59):
companies that need to financethemselves.
Now, how we invest is muchdifferent than the small cap
index, the Russell 2000.
And we focus on companies thathave really strong balance
sheets.
So financing is not so much ofan issue, but on index level it
has been.
And while we're talking aboutindices, I think the whole
passive movement has alsocontributed to the lag of small
(07:21):
cap versus large cap.
I mean, it's been selffulfilling a lot of the fund
flows come in and allocationsget set and builds on itself and
a lot of times small cap is notgetting those flows.
I think small caps have seenoutflows when you combine mutual
funds and ETFs for somethinglike the last 15 years and
that's finally, I think,starting to abate.
(07:43):
Where people are looking to getout of maybe some areas that
they're concentrated in whetherthat's large caps or
technologies and lookingelsewhere whether that's small
caps value international.
But I think we're starting tosee that rotation occur and it
has had full starts Number offactors that I think have kept
small caps underperforming.
(08:04):
And then there's labor costs,inflation but those are starting
to abate and higher interestrates have certainly hurt them
for the last couple of years.
Speaker 2 (08:14):
I think also you can argue that, at least when you
look at indices like the Russell2000,.
What's helped a lot of thatback have been in the biotech
space and in the regional bankfinancials space.
In the biotech space and in theregional bank financial space
obviously post what happened inMarch of last year or the year
before that, my memory's gettingfuzzy right on the regional
bank crisis.
How much co-movement is therewithin the small cap space
(08:39):
Meaning?
Is it that investors broadlyallocate into small caps or is
there a more sector specifictype of best that typically
occur in small cap?
Speaker 1 (08:50):
Yeah.
So financials are a bigindustry as well as industrials.
So it's financials, industrialsin small cap value.
There's even a largerproportion of stocks that fall
into the financials category.
Biotech is more on the Russell2000.
It does play a role in theRussell 2000 value.
But I'll have to say that ifyou look at the constituents of
(09:15):
both, a lot of the companiesdon't earn any money, so
earnings are negative.
But if you dig down furtheryou'll see about 40% of those
companies that don't make anymoney.
They're coming from thesebiotech companies and we don't
invest in biotech.
It's not our knitting.
But if you invest in the indexyou're investing in about 40% of
(09:38):
the companies that don't makeany money and a lot of that is
coming from biotech.
Speaker 2 (09:41):
Yeah, and that's always a hard place to position.
I think a lot of the biotechweakness you can argue was just
because everyone got sodistracted by the GLP-1 craze
and just forgot about all theseother biotech companies.
Okay, so let's talk about someof the work that you do at
Schieffer Cullen as far as thecomposites and the fund in
general.
First of all, deep diveresearch.
(10:04):
You mentioned a small number ofstocks.
Is there any particularspecific overweight in any
particular sectors in the SMAcomposite?
Speaker 1 (10:13):
Yeah.
So right now we're overweightconsumer discretionary in real
estate.
We think those are two areasthat have lagged recently and we
see a lot of opportunities forgrowth there.
So if you look at why we thinksmall caps are set up to do well
now, I did mention their higherinterest rates, but we also
have our higher interest ratemargins from the banks because
(10:37):
of the yield curve has beensteepening, so the 10-year now
is at under 4.3.
I mean, most recently it was atunder five, but we are starting
to see a steepening of theyield curve.
So we are overweight regionalbanks.
We're overweight consumerdiscretionary.
There are names there in therestaurant industry.
But one of the themes that we'replaying and are excited about
(10:58):
over the next 12 to 18 months isthis normalization of interest
rates, and I think a lot of thebeneficiaries there are going to
be housing related.
So housing has been decimated.
The cost of a mortgage to movehas been prohibitive.
So we're invested in brokerageslike Douglas Elliman, lead
(11:18):
generators like LendingTree,which helps with mortgage
origination as well asrefinancing, loan Depot, which
does the originations, and thenin our other portfolios we also
have plays like Whirlpool, whichis a maintenance as well as a
housing movement story wherethere's a lot of opportunity as
(11:39):
rates come down.
Now I think the whole discussionof rates moving down, it's been
pretty controversial.
Some think that the 10-year isgoing to go back up and others
think that we're going to getback under four.
But I think eventually we'llget back to this normalized
level and we hold stockstypically for three to five
years.
So we're trying to be patientand willing to wait.
But if you look at ourcomposition, we have a lot of
(12:04):
interest rate beneficiaries asrates come down, so I'll pause
there.
Speaker 2 (12:08):
Yeah, and that's going to be the interesting
dynamic.
Now I guess the pushback thatI've heard on that is why would
rates come down when inflationstill looks like it's fairly
sticky?
Sure, the Fed wants to cutrates, but the futures market
seems to not be betting, atleast right now, that there's
going to be some aggressivecutting cycle.
(12:28):
So If the thesis is that youneed to have rates going down
for small caps to our reform,how much lower do rates have to
go?
Can it just be incrementallyenough that you don't need to go
and cut rates by a significantamount?
Speaker 1 (12:43):
Yeah.
So right now the market'spricing in two and a half cuts.
I think even if you get one cut, small caps could do well and
even if we don't get any cuts, Ithink rates could eventually
come down if there starts to belabor weakness.
So, importantly, the mortgagerate is usually about 150 basis
points ahead of the 10-year andright now mortgage rates are
(13:04):
close to 6, 7, the 10-yearsaround 4, 2.
So that's almost a 250 basispoint spread where it's usually
150 basis points.
And I think there's a lot ofuncertainty of Fed policy and
whether it's in the tariffs orhow they're going to respond to
inflation.
But that spread should narrowand it doesn't really take rate
cuts to happen.
(13:24):
It just needs more policycertainty what's going to happen
with tax cuts?
And I think, importantly, forthe small cap stocks to work and
we haven't really talked aboutthis much yet but you need
earnings growth and accelerationto come and in the fourth
quarter of last year we finallyhad positive earnings growth.
It actually beat expectations.
(13:45):
It came in at mid-single digits.
The consensus was at 2%.
We need earnings growth to comein stronger than large cap EPS
growth for 2025.
So analyst estimates for theS&P for 2025 are around 13%.
But if you look at the S&P 600,which is the higher quality
(14:07):
small cap index where you haveto be a positive earning company
to be included, analystsexpecting 21%.
I don't think we need to get to21% earnings growth this year
for small caps to work.
But if we get double digitearnings growth, the valuations
are way too cheap and right nowour portfolios are trading about
(14:31):
12 times.
Small caps are closer to 18times.
So there's about six turns ofPE of opportunity to narrow that
spread.
If you look at where small capstrade versus large cap
historically, you have to goback to the tech bubble in the
late 1990s, early 2000s, andsmall caps as a universe are
only 4% of the entire stockmarket.
(14:53):
The last time it was such asmall percentage like that goes
back to the 1930s.
So I think earnings growth isgoing to be important and the
earnings estimates tend to comedown from the beginning of the
year and then analysts start tocut them.
But I think right now earningsfor small caps look good and if
we do get interest rate cuts,that's only going to further the
(15:14):
case for small caps.
Speaker 2 (15:15):
On the earnings growth and the acceleration side
.
I think one thing that maybeyou've already been missing is
all the supposed benefits thatAI should be giving to its users
.
I've made that argument before.
It's like well, if AI is real,then you would think small caps
should be the next big winnerbecause you should have some
margin improvement then as AI isintegrated.
(15:36):
Am I off on that idea that AIshould really be wildly bullish
for small caps?
Speaker 1 (15:44):
Yeah.
So I think small caps aredefinitely well positioned to
benefit from AI.
We haven't seen it to greatextents yet and we've been
tracking this and B of A did arecent analysis of earnings
calls and what they found wasthat about 50% of companies in
the large cap universe havementioned AI on their calls,
where less than 25% did if theywere a small cap company.
(16:07):
I think that number for smallcaps is going to go up and I
think there's more opportunityto take out labor costs and
really benefit from productivity.
So if you look at kind of whatdrives GDP growth and it's
supposed to be out two and ahalf percent, something that
could come down and decline lessthan two.
But productivity will be keyfor small caps and I think we're
(16:29):
starting to see, even fromplaces that we go out to lunch,
solid places have automatedmachines.
Now that's not so much AI butthe automation and AI combined,
I think could be revolutionary.
And small caps are just way toocheap and in terms of their
margins, if they do seeincremental margins from this
(16:49):
and they have a lot of operatingleverage, boy these small cap
stocks could do well.
Speaker 2 (16:55):
So you'd mentioned banks.
That was the value side.
I think we should talk aboutgrowth versus value when it
comes to small caps versusgrowth versus value when it
comes to large caps.
How do they differ when itcomes to the small cap space in
terms of sector allocations, andwhy small value versus small
growth?
Speaker 1 (17:12):
I think it comes down to cyclicality and I consider
cyclical sectors.
You have to immediately thinkof industrials, financials,
materials.
Some think technology iscyclical, some don't bucket it
that way, but the growth indicesare so concentrated in
technology and healthcare and alot of these stocks have done
(17:34):
really well.
I think they're just priced tooexpensive versus the
opportunity set that we see Now.
It comes down to a stock bystock basis for us and I think
if you look at the regionalbanks and the ability for them
to grow loans, increase theirnet interest margins because of
the steepening yield curve andget costs out and consolidate, I
(17:57):
think that's a big opportunityand a lot of times you have
growth companies makingacquisitions of other, maybe
value, companies for thestability of free cash flow.
So that's another way that weinvest.
I haven't talked about this muchyet, but for those who know our
investment style, we're verymuch focused on PE and value.
So what does that mean?
(18:17):
We're typically running screenson companies that have about
PEs that are 20 to 30% on thebottom.
So the ninth and 10th decile,if you will, on cheapness,
whether it's PE price to book,if we're looking at financials
with strong balance sheets thatgenerate a lot of free cash flow
and I think a lot of timespeople overpay for growth and
(18:40):
growth stocks could do reallywell and they have their runs.
But I think what people forgetis that, whether it's small cap
or large cap, things move incycles and growth can outperform
for a decade and then value canoutperform for a while, and I
think we're just in one of thoseperiods, for the reasons that
you and I were talking aboutearlier in this webcast, that
(19:02):
small caps, just for structuralreasons, for macroeconomic
reasons, fiscal policy reasons,have just underperformed.
But everything has a price and Ithink value is just set up to
do really well.
And lastly, I think M&A andthis corresponds to this
administration, where we are inthe interest rate cycle I think
we'll see more in M&A and ourportfolios have benefited a lot
(19:25):
from takeouts.
Since 2020, our small cap valuestrategy have had 12 names
taken out and this is aportfolio where we hold
typically 35 names.
So it's not something we lookat saying we're only going to
look out for companies that aregoing to be taken over, but it
does come into our processthinking like what's the
(19:46):
asymmetric reward and what's thedownside and could this company
be bought out?
Because a lot of times theyhave strong balance sheets,
they're generating cashflow andthey're synergistic to a larger
company, whether it's anothervalue company or a growth
company.
Speaker 2 (20:00):
Let's talk about the actual portfolio itself and
pause it.
I'm going to share my screenhere to show it.
But you've had some pretty goodresults under your stewardship
using the process that you'vebuilt out.
Schaefer-cullen, Give me just asecond, Let me pull that up
here.
So if we look at the small capvalue equity fact sheet here, if
(20:26):
those are curious, you can goto Schaefer-Cullen's website to
get access to this as well.
Firm of dollars have beenaround for a while and that's A3
, story history 23 billion AUM.
I want you to talk a little bitabout the portfolio
characteristics here.
You mentioned the PE ratio alittle bit earlier, but let's go
through some of the pointsabout valuation in general here.
Speaker 1 (20:47):
Yeah, sure, so our portfolio typically is under the
market benchmark.
For the last several yearswe've been somewhere about that
six turns cheaper than thebenchmark.
But this is not to say thatwe're just buying deep value
stocks.
We're looking for stocks withcatalysts that have good
(21:08):
earnings, growth potential and,just going back in terms of our
philosophy and kind of how weinvest, we're looking for stocks
that are misunderstood, thatare maybe going through a
cyclical downturn, but there'snothing structurally wrong with
them.
They're not going out ofbusiness and sometimes they have
zero analysts covering them andit'll just take eventually
(21:30):
maybe six months, it could belonger where eventually people
run screens and say, hey, thiscompany is just too cheap or
another company in the sameindustry might acquire them, and
they're the only ones that arereally doing the homework, and
that's fine too.
It's nice to get that 20% pop,but typically we're looking for
a larger return than that andwe've had strong returns
(21:52):
focusing on this discipline, andthat's what Schaefer Cullen
does.
We are tried and true investorsthat stick to our value
discipline and free cash flow.
Yield, you could see, is higherthan the index here and, like I
said, we're not investing inoverly levered companies that
are needing you know the banksand to be able to finance
(22:14):
themselves.
So net debt to EBITDA abouthalf of what the benchmark is,
and so, yeah, we think we'rewell positioned based on these
characteristics.
Speaker 2 (22:26):
Yeah, and the free cash flow yield obviously a big
deal.
Again, going back to that,you're automatically screening
out zombie companies.
Obviously when you're focusingon the cash flow side of things.
Let's talk about the sectorbreakdown on the composite,
financials obviously being thebig overweight alongside
discretionary.
I'm curious do you think thatunder the Trump administration,
(22:49):
if he's serious aboutderegulation, that the market is
really underappreciating howmuch room financials have to run
, because it seems like that'simportant?
You need to have some greaterdegrees of freedom, especially
for the regional banks, toreally get some increased margin
.
Speaker 1 (23:05):
Yeah, so there's been a consolidation story for the
banks going for the last 20years.
It's slowed down.
With the Biden administration Ithink we'll see a pickup.
It just makes logical sense.
I still think we have too manybanks in this country.
20 years ago we may have had6,000.
Now there's 3,000.
And that's just too many.
And I mentioned in thisstrategy we've had 12 companies
(23:28):
acquired.
I think three or four of themhave been banks and there's a
lot of opportunity to take costsout.
I don't have to tell youthere's probably, you know every
corner.
There's so many banks and noweven with tellers you know being
you know probably half theamount of tellers there were
before.
People are using the internetand banks really have been
(23:51):
overburdened with regulation andthe larger banks haven't been
able to be as acquisitive.
But I think with the Trumpadministration that's so much
not longer in play and I thinkwe'll see opportunities on the
banking side.
Speaker 2 (24:05):
Yeah, I mean, I agree 100%, and you could argue it's
also related to discretionary,because to the extent that
there's more lending activity,then consumers will have more
ability to lever up, even thoughyou can argue they're already
pretty lever, at least on thecredit card side.
So I think that's aninteresting dynamic.
And then, of course, thebiggest underweight there is
healthcare, which I think goesback to the earlier conversation
(24:25):
around biotech.
Speaker 1 (24:27):
Yeah, no, exactly.
So there's just not manyopportunities that we find
attractive that are disciplinedin healthcare.
Speaker 2 (24:34):
We've been larger in healthcare when there are
opportunities and we've hadsuccess in takeouts in
healthcare as well compositeagainst the Russell 2000 value
(24:55):
and you know to get 140 basispoints annualized of extra
performances pretty remarkable,especially over that full 15
year type of track record.
Do you think that there aremore opportunities to generate
alpha now than before?
Because, to your point, there'sjust not that many active
managers that are allocatingthere, because all the flows
have been passive towards largecap, market cap waiting.
Speaker 1 (25:16):
Yeah, I do so just for reference and transparency.
I've been co-managing theportfolio for about eight years,
so I think like that seven yeartrack record is kind of a good
way to look at it and sinceinception we've kept the same
strategy and disciplinethroughout and really we stuck
to our knitting.
We're not overpaying for stocks, we're benefiting from takeouts
(25:39):
and also investing with a themefocus.
So I think, looking at theopportunities today, we're
excited about this housing themeand the recovery in nearshoring
and reshoring, as well aselectric infrastructure plays.
We've invested in companieslike Quanta Services, which has
(26:00):
graduated to the mid-cap, andI'd like to talk a little bit
about the other strategy,eventually the SMIT and mid-cap
strategy, where some of thosecompanies that graduate can be
bought in those other ones.
Vistra, we've owned for fiveyears and that company has done
really well.
It's in the news a lot.
It's definitely benefiting fromthe AI demand story for energy,
(26:21):
but the energy infrastructurein this country is really poor
and we have plays on that.
So combining the disciplinewith theme thematic approach has
really, I think, helped ouropportunity set and it just it
continues to be underfollowed,neglected, misunderstood, and
therein lies the opportunity, inour opinion.
Speaker 2 (26:41):
Let's talk about SPID .
I've heard more and more arguethat in general, mid-caps are
kind of the, you know, even moreof a sweet spot than small caps
, for a lot of different reasonsvaluations, less risk of
bankruptcy, dynamic zombiecompanies.
Let's make the case formid-caps over large caps and
then, if there is a case ofmid-caps maybe on par or maybe
(27:04):
even slightly ahead of smallcaps, yeah.
Speaker 1 (27:07):
So look, mid-caps are kind of this neglected child,
right, the middle child.
People are looking at large,people looking at small and
sometimes they just are notfocused on mid caps.
But there are a lot of qualitycompanies and by quality again I
mean companies that aregenerating double digit free
cash flow yields, that don'thave really over bloated balance
(27:29):
sheets, that are tradingattractive valuations, that have
graduated from the small cap.
So if a small cap has been inthe index for 30 years and
hasn't graduated to the mid-capindex, sometimes those are just
not good companies.
They didn't get taken out, theydidn't graduate to the mid-cap
sector, so sometimes thoseopportunities can be found in
(27:52):
mid-cap.
So that's where we started thesmall mid-cap focused fund.
It's run very much like thesmall cap strategy.
It has a dividend component, sothe yield is close to 4%, with
strong double-digit dividendgrowth but attractive free cash
yield over 6% and we've hadtakeouts there.
(28:13):
So we started the strategy in2020.
If you want, you could pull upthe fact sheet from our website,
cullenfundscom, and we've beenable to find names that either
graduated from the small cap,that became mid caps, but really
also play into these themes ofinterest rates, normalizing,
reshoring, infrastructure playsand, looking at the opportunity
(28:38):
set, it's really quiteattractive.
Where all the focus has been onlarge caps and when you can
combine the opportunities of thereally small cap companies that
are not followed by analystswith mid cap companies that just
fall between the cracks oflarge and small, I have to tell
you it's an exciting opportunityset.
So we build this portfoliobetween 30 and 40 companies and
(29:00):
I think what's misunderstood ishow many companies in the small
and mid-cap space pay a dividend.
So about 45% of the companiesin the Russell 2500 value pay a
dividend and 40% of those 45%have a dividend yield that's
over 4%.
So, as rates come down andpeople are looking for income,
(29:20):
that's just another way to bedefensive and provide an income
source in markets that arevolatile.
So it's defensive, but alsoreally an opportunity to
participate on the upside, and alot of times these large cap
companies buy these mid cap andsmall cap companies, as we've
talked about.
Speaker 2 (29:38):
So for those reasons, we think it's a good
opportunity that really gets youthat breadth and valuation and
it also looks pretty, uh, youknow, on par to a relative
inexpensive risk with the smallcap uh composite.
Speaker 1 (29:50):
Yeah, correct, um, so it's.
It's also trading at ameaningful discount.
The index for the Russell 2400value is at 20 times, we're at
12.
Our free cash flow yield isdouble than what the index is
and again, we're below on netdebt to EBITDA.
And we invest typically incompanies that are up to 15
billion in market cap, as low as100 million, as long as the
(30:11):
liquidity is there.
And I think it's alsomisunderstood how many sectors
actually have attractivelypaying dividend companies.
So, whether it's real estate,financials, utilities, consumer
discretionary and we can look atthe breakout there you can see
we're overweight.
Consumer discretionary.
There's just been so many nayshave been pummeled over concerns
that the consumer is slowingdown, but I think the consumer
(30:34):
just needs to take a breath.
I mean, there's been a lot ofstimulus that's run through, but
wages are still strong, peoplehave jobs and there's some noise
on the Fed side and a lot ofFed workers potentially could
lose their jobs, whichperversely, I think could lead
the Fed to lower interest rates.
I mean, treasury SecretaryBesant is really focused on the
(30:57):
10-year now.
Well, how are they going to getthe 10-year lower If they cut
enough jobs from the federalgovernment which they can
control much more than theprivate sector.
That might get the Fed to cutrates and it might bring
interest rates low and thathelps homebuyers and companies
in our portfolio to financethemselves.
Speaker 2 (31:14):
I had mentioned that on a post on X that went a
little bit viral, somethingalong the lines of you know,
trump is laying off all thesefederal workers to get the Fed
to cut rates.
So I think Possible.
You know 4D chess or not, butyou know, it seems like it's a
possible direction.
Speaker 1 (31:29):
When the deficit's so large and your interest expense
is greater now than yourdefense budget, it plays a role.
Speaker 2 (31:38):
And the performance.
Same story has beenmeaningfully outperforming since
inception against the Russell2500 value.
Speaker 1 (31:47):
Yeah, yeah.
So we've had strong performanceabout 25% versus 19% for the
benchmark.
Our upside capture is over 100%it's about 104% and our
downside capture is 86%, soproviding good downside
protection in periods of marketvolatility.
(32:07):
Because they have the free cashflow yield, they have stable
businesses.
We've owned companies that arein the banking that have been
rumored to be taken out, likeFirst Horizon.
Elizabeth Warren didn't wantthat deal to go through by TD.
They're located in a reallyattractive area in the Southeast
, where they're based inTennessee and they have branches
(32:29):
in Florida, so a lot ofopportunities for growth.
Speaker 2 (32:34):
I know you're doing deep dive research, obviously,
but let's say that there'sconcerns around an economic
slowdown, right, and it's timeto play somewhat defensive in
the small cap and smith space.
I'd argue it's a lot easier toplay defense with large caps
because you can just go intoutilities and you know lower
(32:54):
beta, consumer staples, names.
But if you're going to try toplay defense, if you have a
macro view that you want tointegrate into the portfolio,
what's the best way to do thatwith small and mid-cap names?
Speaker 1 (33:05):
yeah, I think, just on a portfolio construction
basis.
It has to start there.
Then you can do sector based onthe portfolio construction
basis.
It has to start there, then youcan do sector-based On the
portfolio construction.
You want companies that areready trading at cheap
valuations Not to say that theycan't get cheaper, but the high
flyers, I think, are just goingto get put it this way hurt more
than companies that are tradingclose to trough valuations.
(33:28):
So a lot of times we're lookingat how the companies are trading
versus their own tenure historyas well as to their peer group.
And then companies that canreturn high free cash flows as
well as high returns on equity.
So with good balance sheets,leverage cuts both ways.
So companies that are overlevered are going to get crushed
in a macroeconomic downturn andwe haven't seen credit spreads
(33:50):
blow out.
But credit spreads totallytypically blow out when the
crisis is starting already.
It's not really a goodpredictor.
So you can look at creditspreads and see what the CDS
rates are, but at the end of theday you want to own quality
companies.
And then on a sector basis,consumer staples, utilities,
telecom these are all areas thatare pretty defensive and you
(34:14):
could find companies also thathave a yield and people want
that income in periods of marketvolatility.
So I would say those are thethree sectors that we gravitate
towards when we think thatthere's potential risk on the
macro side.
But we're fundamentals,bottom-up investors, but we do
take macro into consideration.
Speaker 2 (34:31):
Yeah, I think I was like how can you not take macro
to some extent intoconsideration, just given how
much flows have driven theeconomy and asset allocation in
general?
Do you look at the?
I'm just curious do you look atthe bond market side when
you're doing analysis on thesmall cap stock?
End of things?
Speaker 1 (34:50):
Yeah, we do, but we're not.
Yeah, you're doing analysis onthe small cap stock end of
things.
Yeah, we do, but we're notcredit experts.
So we do look at where thingsare trading.
Speaker 2 (34:58):
Just to get a sense of some strain or disconnect
right From a default riskpotential.
Speaker 1 (35:02):
Yeah, same way as we look at the short interest like
what are we missing?
What's the bear case?
And a lot of times we usecredit research to see also on
an aim.
It's always interesting to seewhat, like, a sell side credit
analyst thinks of a name, ifthey do follow it.
Speaker 2 (35:17):
How do you?
What's the?
What is the sell discipline?
What causes a company tototally just bomb out of the
portfolio?
Speaker 1 (35:24):
Yeah, good question.
So typically three things.
One is that we got the thesiswrong, right.
So I mentioned you kind of putthe hypothesis there.
You test the hypothesis andthen we try to do the pre-work
and really just what thepre-mortem is.
But if something's going wrongand the thesis has changed,
(35:44):
we'll sell it.
Our turnover typically is 30%on a name basis.
It's lower, but we sold namesearlier than our typical holding
period of three to five yearswhere we're just flat out wrong
and it's a humbling business.
You're going to be wrong.
Other times just therisk-reward isn't so attractive.
Typically we like thisthree-to-one risk-reward ratio.
(36:07):
Let's say stock could be up 60but down 20.
And we like the probabilisticweight kind of outcomes.
If that has really compressedand we see other opportunities
elsewhere, whether it's in thatsector or not, we'll swap that
out.
And other times we just thinkit's dead money.
There's no catalyst anymore.
(36:28):
The catalyst has played out andwe're not going to wait around
for like a 10% upside in thestock if we see other
opportunities.
Speaker 2 (36:35):
So you've got the SMAs Talk to me a little bit
about the fund itself.
Any kind of key differences?
Typically, do you find thatinvestors prefer, when dealing
with small caps, that's simply amanaged account of vehicle
versus a mutual fund dealingwith small?
Speaker 1 (36:52):
caps.
That's simply a managed accountvehicle versus a mutual fund.
It really depends on the holderand the investor and how they
want you to manage theirholdings and their strategy.
So one thing I would say is wewant to stick to our discipline
and we want our financialadvisors and institutions to be
able to plug us into whatevermodel they're running and just
rely on us to be the small capvalue manager or the SMID
(37:15):
manager in their books.
So that's one thing.
Whether they choose SMA ormutual fund, it's really up to
them.
We have both vehicles availablefor small cap value.
The SMID right now is in theseparate managed account form
and whether it's if people wantto manage taxes differently or
(37:36):
have some exclusions that theydon't want allocations to like
tobacco or other things, theymay use a separate managed
account.
But the minimums have come downso much for separate managed
accounts compared to what theywere 20 years ago where
oftentimes you could have anaccount holder that is larger in
the mutual fund than it is in aseparate managed account
vehicle.
Speaker 2 (37:55):
You talked to a lot of advisors individuals, I'm
sure as well just about marketsand small caps in general, and
I'm sure you get a lot of thingsthat people say to you which
are outright wrong, that makeyou want to totally counter
those arguments, outright wrongs, that make you want to totally
counter those arguments.
What are some of the the morepopular myths out there about
(38:16):
investing in small cap?
Speaker 1 (38:17):
Yeah, one that comes to my mind is you really need a
recession and a total marketblowout to make small caps
attractive, where you're goingto get paid for the risk, and I
just don't think that's true.
There's been a lot of periodsand it goes back to cycles right
when small caps can outperformfor seven to 10 years and it
didn't require a recession, abust, to get that attractive
(38:41):
entry point.
I think there's alwaysuncertainty of when is the right
time to pivot and get out ofsomething that's worked, because
momentum is strong, but I thinkwe're starting to see some
breaks there.
So I think that's probably oneof the misnomers.
And two is like small caps theydon't make any money.
They're terrible companies, andI think that's partially true,
(39:04):
depending on which index youinvest in.
If you're investing in anactive manager that invests in
fewer than 50 stocks, let's say,that has a discipline that can
follow the companies, know wherethe bodies are buried and knows
the space well and is willingto do the work, I think you
could find out performance there.
Speaker 2 (39:25):
Brian, for those who want to learn more about
Schaefer Cullen and who might beinterested in either the SMAs
or the mutual fund, where wouldyou point them to?
Cullenfundscom.
And that's also for the SMAseries.
So same center.
Speaker 1 (39:37):
Correct.
You can find all our strategieslisted there.
Both are at CullenFundscom.
You just select whether you'rea financial advisor or a private
investor and it'll lead you tothe right path.
You could also find us onLinkedIn, where we post some of
our research and findings andwe're happy to start a
conversation.
(39:58):
But reach out to your advisorthat you could find and it
automates who that is based onyour region.
Speaker 2 (40:03):
Hopefully everybody enjoyed the conversation.
I personally think it was veryinteresting.
I still maintain small capshold the key, myself quite
optimistic on small caps,certainly on a relative basis.
I think we are way overdue forsome broader leadership and I do
believe, like you do, brian,that there's a lot of alpha
potential there.
And congrats on all theperformance.
(40:24):
Again, folks, it was asponsored conversation by
Schaefer Cullen.
This is LeadLag Live.
Learn more about SchaeferCullen at cullenfundscom and
I'll see you all on the nextepisode.
Thank you, brian, appreciate it.
Thank you, michael.
Cheers everybody.
Right now the market's pricing in two and a
half cuts.
I think even if you get one cut, small caps could do well.
And even if we don't get anycuts, I think rates could
eventually come down if therestarts to be labor weakness.
So, importantly, the mortgagerate is usually about 150 basis
points ahead of the 10-year andright now mortgage rates are
(00:20):
close to 6, 7, the 10 yearsaround 4, 2.
Mortgage rates are close to 6,7, the 10 years around 4, 2.
So that's almost a 250 basispoint spread where it's usually
150 basis points, and I thinkthere's a lot of uncertainty of
Fed policy and whether it's inthe tariffs or how they're going
to respond to inflation.
But that spread should narrowand it doesn't really take rate
cuts to happen.
(00:41):
It just needs more policycertainty what's going to happen
with tax cuts?
And I think, importantly, forthe small cap stocks to work and
we haven't really talked aboutthis much yet but you need
earnings growth and accelerationto come and in the fourth
quarter of last year we finallyhad positive earnings growth.
Speaker 2 (00:59):
This is a very timely topic.
If you've been following me fora while, you know that I, in a
very annoying way, continuouslysay small caps, hold the key.
I think it's a very importantpart of the marketplace and one
that potentially has a lot ofopportunities.
With all that said, my name isMichael Guyatt, publisher of the
Lead Lag Report.
Joining me here is BrianJaresti Schaefer Cullen.
Brian, a lot of people who aretuning in may not be familiar
(01:20):
with who you are, so introduceyourself what's your background?
Speaker 1 (01:27):
what have you done throughout your career?
What are you doing currently atSchaefer Collin?
Yeah, sure Thanks for having me, michael, and yeah, so I
started my career at KPMG and Ihold an MBA from Columbia.
I've been with Schaefer Collin,my current firm, for 12 years
and prior to this role, I was ata long short equity hedge fund.
So here at Schaefer Cullen, Imanage our small cap value
strategy, as well as our smalland mid dividend focused
(01:49):
strategy.
The small cap value strategy isavailable as an SMA as well as
a mutual fund, and this middividend right now is available
as a separate managed account.
Speaker 2 (02:00):
Since you mentioned the experience with the long
short equity hedge fund, I amcurious because if you're going
to be doing long-short portfoliopositioning, you really have to
kind of know your stuff on whatit is that you're trying to
short right and be very careful,obviously, on fundamental
analysis as well.
Talk to me about how theexperience at the long-short
equity hedge fund maybe shapesyour way of how you think about
(02:23):
individual companies.
Speaker 1 (02:24):
Yeah, sure.
So we spent about most of thetime investing on the long and
short side on small andmedium-sized companies.
So I think there's an edge thereon really doing the fundamental
analysis.
So most of our strategies hereat Schaefer Cullen are long only
(02:45):
but we're fairly concentrated,so our portfolios have between
30 and 40 names typically in theportfolio and that allows us to
do deep research and that'sreally required both on the long
side and on the short side.
And a lot of the work that wedo here is really figuring out
(03:05):
what the key investment factorsare for the stock to work, but
understanding what the risks are, because as value investors
there's certainly a lot of valuetracks and I think, having had
experience on looking at thecompany from a lens of which
ones could be short, whetherthey're accounting issues or
whether the company or thesector is in structural decline
(03:27):
and a lot of what we do atSchaefer Cullinan we're looking
at a stock is figuring out isthis something that is
cyclically challenged and thisis going through a cycle, or is
there something structurallywrong where you could get
conviction in staying away forthat reason?
So I think on the short side ithelped me in just looking out
(03:49):
for value traps.
Speaker 2 (03:51):
I want to focus on that point about deep research,
because I think you and I bothknow that most people's
impression of deep research ishere's a chart and it's going up
and to the right.
That's deep research for mostpeople.
What goes into the kind ofresearch process that you follow
, Meaning?
What kind of things are youlooking at when we say the word
deep?
How deep is deep there?
Speaker 1 (04:12):
Yeah, sure.
So looking at companies andfollowing companies, there's the
maintenance work, but alsodoing the pre-work and a lot of
the initial research is reallydeciding again what are the key
investment factors and what isour variant perception.
And if you think back to thehigh school days of science, you
(04:33):
have a hypothesis.
You want to test thathypothesis and, if possible, try
to refute it, going beyond ofjust reading the sell side
reports and meeting withmanagements, reading the
transcripts, but also speakingto industry experts that either
worked at the company prior orworked at competitors and really
getting an edge.
(04:54):
And in small caps there reallyaren't as many analysts on the
sell side covering the names,whereas if you have an analyst
covering community, coveringApple or Meta or NVIDIA, there
might be 50 analysts.
In small cap the average isabout five analysts and in many
of the companies there are noanalysts covering the stock, so
(05:14):
they're really left for dead,which creates an opportunity for
us.
Speaker 2 (05:18):
Which gets into the most important question from my
standpoint, which is this pointabout small cap volatility.
Why is it that small caps havejust struggled, really since the
2021 peak, at least in theRussell 2000?
I mean, you look at the market.
Most people obviously definethe market as the S&P 500, but I
(05:38):
think the market is much biggerthan that.
It's just from the standpointof the number of companies, many
more small cap names than largecap names, and a lot of small
cap names are still way belowtheir after inflation adjusted
peaks from 2021.
So what's going on in that partof the world?
Speaker 1 (05:54):
Yeah, small caps have certainly struggled and it's
gone beyond 2021.
It's really seven consecutiveyears that they have lagged
large caps and I think there area multitude of factors.
One, it's the industry or thesector index.
Construction Technology hasbeen a big driver of returns for
large cap indices and small capjust doesn't have as many
(06:18):
technology companies in theindex.
So if you take the S&P 500,technology is about 30% and the
Russell 2000 is 12.
And then if you add oncommunication services, that's
another 12% for the S&P and it'ssomething like 4% or 5% for the
Russell 2000.
So that's one reason.
(06:39):
On top of that, you've had highinterest rates and a lot of the
small cap companies rely ondebt financing and variable debt
is approximately 65% of theirdebt structure, where that's
only about 30 for large capcompanies.
So the cost of debt has beenkind of an issue for small cap
(06:59):
companies that need to financethemselves.
Now, how we invest is muchdifferent than the small cap
index, the Russell 2000.
And we focus on companies thathave really strong balance
sheets.
So financing is not so much ofan issue, but on index level it
has been.
And while we're talking aboutindices, I think the whole
passive movement has alsocontributed to the lag of small
(07:21):
cap versus large cap.
I mean, it's been selffulfilling a lot of the fund
flows come in and allocationsget set and builds on itself and
a lot of times small cap is notgetting those flows.
I think small caps have seenoutflows when you combine mutual
funds and ETFs for somethinglike the last 15 years and
that's finally, I think,starting to abate.
(07:43):
Where people are looking to getout of maybe some areas that
they're concentrated in whetherthat's large caps or
technologies and lookingelsewhere whether that's small
caps value international.
But I think we're starting tosee that rotation occur and it
has had full starts Number offactors that I think have kept
small caps underperforming.
(08:04):
And then there's labor costs,inflation but those are starting
to abate and higher interestrates have certainly hurt them
for the last couple of years.
Speaker 2 (08:14):
I think also you can argue that, at least when you
look at indices like the Russell2000,.
What's helped a lot of thatback have been in the biotech
space and in the regional bankfinancials space.
In the biotech space and in theregional bank financial space
obviously post what happened inMarch of last year or the year
before that, my memory's gettingfuzzy right on the regional
bank crisis.
How much co-movement is therewithin the small cap space
(08:39):
Meaning?
Is it that investors broadlyallocate into small caps or is
there a more sector specifictype of best that typically
occur in small cap?
Speaker 1 (08:50):
Yeah.
So financials are a bigindustry as well as industrials.
So it's financials, industrialsin small cap value.
There's even a largerproportion of stocks that fall
into the financials category.
Biotech is more on the Russell2000.
It does play a role in theRussell 2000 value.
But I'll have to say that ifyou look at the constituents of
(09:15):
both, a lot of the companiesdon't earn any money, so
earnings are negative.
But if you dig down furtheryou'll see about 40% of those
companies that don't make anymoney.
They're coming from thesebiotech companies and we don't
invest in biotech.
It's not our knitting.
But if you invest in the indexyou're investing in about 40% of
(09:38):
the companies that don't makeany money and a lot of that is
coming from biotech.
Speaker 2 (09:41):
Yeah, and that's always a hard place to position.
I think a lot of the biotechweakness you can argue was just
because everyone got sodistracted by the GLP-1 craze
and just forgot about all theseother biotech companies.
Okay, so let's talk about someof the work that you do at
Schieffer Cullen as far as thecomposites and the fund in
general.
First of all, deep diveresearch.
(10:04):
You mentioned a small number ofstocks.
Is there any particularspecific overweight in any
particular sectors in the SMAcomposite?
Speaker 1 (10:13):
Yeah.
So right now we're overweightconsumer discretionary in real
estate.
We think those are two areasthat have lagged recently and we
see a lot of opportunities forgrowth there.
So if you look at why we thinksmall caps are set up to do well
now, I did mention their higherinterest rates, but we also
have our higher interest ratemargins from the banks because
(10:37):
of the yield curve has beensteepening, so the 10-year now
is at under 4.3.
I mean, most recently it was atunder five, but we are starting
to see a steepening of theyield curve.
So we are overweight regionalbanks.
We're overweight consumerdiscretionary.
There are names there in therestaurant industry.
But one of the themes that we'replaying and are excited about
(10:58):
over the next 12 to 18 months isthis normalization of interest
rates, and I think a lot of thebeneficiaries there are going to
be housing related.
So housing has been decimated.
The cost of a mortgage to movehas been prohibitive.
So we're invested in brokerageslike Douglas Elliman, lead
(11:18):
generators like LendingTree,which helps with mortgage
origination as well asrefinancing, loan Depot, which
does the originations, and thenin our other portfolios we also
have plays like Whirlpool, whichis a maintenance as well as a
housing movement story wherethere's a lot of opportunity as
(11:39):
rates come down.
Now I think the whole discussionof rates moving down, it's been
pretty controversial.
Some think that the 10-year isgoing to go back up and others
think that we're going to getback under four.
But I think eventually we'llget back to this normalized
level and we hold stockstypically for three to five
years.
So we're trying to be patientand willing to wait.
But if you look at ourcomposition, we have a lot of
(12:04):
interest rate beneficiaries asrates come down, so I'll pause
there.
Speaker 2 (12:08):
Yeah, and that's going to be the interesting
dynamic.
Now I guess the pushback thatI've heard on that is why would
rates come down when inflationstill looks like it's fairly
sticky?
Sure, the Fed wants to cutrates, but the futures market
seems to not be betting, atleast right now, that there's
going to be some aggressivecutting cycle.
(12:28):
So If the thesis is that youneed to have rates going down
for small caps to our reform,how much lower do rates have to
go?
Can it just be incrementallyenough that you don't need to go
and cut rates by a significantamount?
Speaker 1 (12:43):
Yeah.
So right now the market'spricing in two and a half cuts.
I think even if you get one cut, small caps could do well and
even if we don't get any cuts, Ithink rates could eventually
come down if there starts to belabor weakness.
So, importantly, the mortgagerate is usually about 150 basis
points ahead of the 10-year andright now mortgage rates are
(13:04):
close to 6, 7, the 10-yearsaround 4, 2.
So that's almost a 250 basispoint spread where it's usually
150 basis points.
And I think there's a lot ofuncertainty of Fed policy and
whether it's in the tariffs orhow they're going to respond to
inflation.
But that spread should narrowand it doesn't really take rate
cuts to happen.
(13:24):
It just needs more policycertainty what's going to happen
with tax cuts?
And I think, importantly, forthe small cap stocks to work and
we haven't really talked aboutthis much yet but you need
earnings growth and accelerationto come and in the fourth
quarter of last year we finallyhad positive earnings growth.
It actually beat expectations.
(13:45):
It came in at mid-single digits.
The consensus was at 2%.
We need earnings growth to comein stronger than large cap EPS
growth for 2025.
So analyst estimates for theS&P for 2025 are around 13%.
But if you look at the S&P 600,which is the higher quality
(14:07):
small cap index where you haveto be a positive earning company
to be included, analystsexpecting 21%.
I don't think we need to get to21% earnings growth this year
for small caps to work.
But if we get double digitearnings growth, the valuations
are way too cheap and right nowour portfolios are trading about
(14:31):
12 times.
Small caps are closer to 18times.
So there's about six turns ofPE of opportunity to narrow that
spread.
If you look at where small capstrade versus large cap
historically, you have to goback to the tech bubble in the
late 1990s, early 2000s, andsmall caps as a universe are
only 4% of the entire stockmarket.
(14:53):
The last time it was such asmall percentage like that goes
back to the 1930s.
So I think earnings growth isgoing to be important and the
earnings estimates tend to comedown from the beginning of the
year and then analysts start tocut them.
But I think right now earningsfor small caps look good and if
we do get interest rate cuts,that's only going to further the
(15:14):
case for small caps.
Speaker 2 (15:15):
On the earnings growth and the acceleration side
.
I think one thing that maybeyou've already been missing is
all the supposed benefits thatAI should be giving to its users
.
I've made that argument before.
It's like well, if AI is real,then you would think small caps
should be the next big winnerbecause you should have some
margin improvement then as AI isintegrated.
(15:36):
Am I off on that idea that AIshould really be wildly bullish
for small caps?
Speaker 1 (15:44):
Yeah.
So I think small caps aredefinitely well positioned to
benefit from AI.
We haven't seen it to greatextents yet and we've been
tracking this and B of A did arecent analysis of earnings
calls and what they found wasthat about 50% of companies in
the large cap universe havementioned AI on their calls,
where less than 25% did if theywere a small cap company.
(16:07):
I think that number for smallcaps is going to go up and I
think there's more opportunityto take out labor costs and
really benefit from productivity.
So if you look at kind of whatdrives GDP growth and it's
supposed to be out two and ahalf percent, something that
could come down and decline lessthan two.
But productivity will be keyfor small caps and I think we're
(16:29):
starting to see, even fromplaces that we go out to lunch,
solid places have automatedmachines.
Now that's not so much AI butthe automation and AI combined,
I think could be revolutionary.
And small caps are just way toocheap and in terms of their
margins, if they do seeincremental margins from this
(16:49):
and they have a lot of operatingleverage, boy these small cap
stocks could do well.
Speaker 2 (16:55):
So you'd mentioned banks.
That was the value side.
I think we should talk aboutgrowth versus value when it
comes to small caps versusgrowth versus value when it
comes to large caps.
How do they differ when itcomes to the small cap space in
terms of sector allocations, andwhy small value versus small
growth?
Speaker 1 (17:12):
I think it comes down to cyclicality and I consider
cyclical sectors.
You have to immediately thinkof industrials, financials,
materials.
Some think technology iscyclical, some don't bucket it
that way, but the growth indicesare so concentrated in
technology and healthcare and alot of these stocks have done
(17:34):
really well.
I think they're just priced tooexpensive versus the
opportunity set that we see Now.
It comes down to a stock bystock basis for us and I think
if you look at the regionalbanks and the ability for them
to grow loans, increase theirnet interest margins because of
the steepening yield curve andget costs out and consolidate, I
(17:57):
think that's a big opportunityand a lot of times you have
growth companies makingacquisitions of other, maybe
value, companies for thestability of free cash flow.
So that's another way that weinvest.
I haven't talked about this muchyet, but for those who know our
investment style, we're verymuch focused on PE and value.
So what does that mean?
(18:17):
We're typically running screenson companies that have about
PEs that are 20 to 30% on thebottom.
So the ninth and 10th decile,if you will, on cheapness,
whether it's PE price to book,if we're looking at financials
with strong balance sheets thatgenerate a lot of free cash flow
and I think a lot of timespeople overpay for growth and
(18:40):
growth stocks could do reallywell and they have their runs.
But I think what people forgetis that, whether it's small cap
or large cap, things move incycles and growth can outperform
for a decade and then value canoutperform for a while, and I
think we're just in one of thoseperiods, for the reasons that
you and I were talking aboutearlier in this webcast, that
(19:02):
small caps, just for structuralreasons, for macroeconomic
reasons, fiscal policy reasons,have just underperformed.
But everything has a price and Ithink value is just set up to
do really well.
And lastly, I think M&A andthis corresponds to this
administration, where we are inthe interest rate cycle I think
we'll see more in M&A and ourportfolios have benefited a lot
(19:25):
from takeouts.
Since 2020, our small cap valuestrategy have had 12 names
taken out and this is aportfolio where we hold
typically 35 names.
So it's not something we lookat saying we're only going to
look out for companies that aregoing to be taken over, but it
does come into our processthinking like what's the
(19:46):
asymmetric reward and what's thedownside and could this company
be bought out?
Because a lot of times theyhave strong balance sheets,
they're generating cashflow andthey're synergistic to a larger
company, whether it's anothervalue company or a growth
company.
Speaker 2 (20:00):
Let's talk about the actual portfolio itself and
pause it.
I'm going to share my screenhere to show it.
But you've had some pretty goodresults under your stewardship
using the process that you'vebuilt out.
Schaefer-cullen, Give me just asecond, Let me pull that up
here.
So if we look at the small capvalue equity fact sheet here, if
(20:26):
those are curious, you can goto Schaefer-Cullen's website to
get access to this as well.
Firm of dollars have beenaround for a while and that's A3
, story history 23 billion AUM.
I want you to talk a little bitabout the portfolio
characteristics here.
You mentioned the PE ratio alittle bit earlier, but let's go
through some of the pointsabout valuation in general here.
Speaker 1 (20:47):
Yeah, sure, so our portfolio typically is under the
market benchmark.
For the last several yearswe've been somewhere about that
six turns cheaper than thebenchmark.
But this is not to say thatwe're just buying deep value
stocks.
We're looking for stocks withcatalysts that have good
(21:08):
earnings, growth potential and,just going back in terms of our
philosophy and kind of how weinvest, we're looking for stocks
that are misunderstood, thatare maybe going through a
cyclical downturn, but there'snothing structurally wrong with
them.
They're not going out ofbusiness and sometimes they have
zero analysts covering them andit'll just take eventually
(21:30):
maybe six months, it could belonger where eventually people
run screens and say, hey, thiscompany is just too cheap or
another company in the sameindustry might acquire them, and
they're the only ones that arereally doing the homework, and
that's fine too.
It's nice to get that 20% pop,but typically we're looking for
a larger return than that andwe've had strong returns
(21:52):
focusing on this discipline, andthat's what Schaefer Cullen
does.
We are tried and true investorsthat stick to our value
discipline and free cash flow.
Yield, you could see, is higherthan the index here and, like I
said, we're not investing inoverly levered companies that
are needing you know the banksand to be able to finance
(22:14):
themselves.
So net debt to EBITDA abouthalf of what the benchmark is,
and so, yeah, we think we'rewell positioned based on these
characteristics.
Speaker 2 (22:26):
Yeah, and the free cash flow yield obviously a big
deal.
Again, going back to that,you're automatically screening
out zombie companies.
Obviously when you're focusingon the cash flow side of things.
Let's talk about the sectorbreakdown on the composite,
financials obviously being thebig overweight alongside
discretionary.
I'm curious do you think thatunder the Trump administration,
(22:49):
if he's serious aboutderegulation, that the market is
really underappreciating howmuch room financials have to run
, because it seems like that'simportant?
You need to have some greaterdegrees of freedom, especially
for the regional banks, toreally get some increased margin
.
Speaker 1 (23:05):
Yeah, so there's been a consolidation story for the
banks going for the last 20years.
It's slowed down.
With the Biden administration Ithink we'll see a pickup.
It just makes logical sense.
I still think we have too manybanks in this country.
20 years ago we may have had6,000.
Now there's 3,000.
And that's just too many.
And I mentioned in thisstrategy we've had 12 companies
(23:28):
acquired.
I think three or four of themhave been banks and there's a
lot of opportunity to take costsout.
I don't have to tell youthere's probably, you know every
corner.
There's so many banks and noweven with tellers you know being
you know probably half theamount of tellers there were
before.
People are using the internetand banks really have been
(23:51):
overburdened with regulation andthe larger banks haven't been
able to be as acquisitive.
But I think with the Trumpadministration that's so much
not longer in play and I thinkwe'll see opportunities on the
banking side.
Speaker 2 (24:05):
Yeah, I mean, I agree 100%, and you could argue it's
also related to discretionary,because to the extent that
there's more lending activity,then consumers will have more
ability to lever up, even thoughyou can argue they're already
pretty lever, at least on thecredit card side.
So I think that's aninteresting dynamic.
And then, of course, thebiggest underweight there is
healthcare, which I think goesback to the earlier conversation
(24:25):
around biotech.
Speaker 1 (24:27):
Yeah, no, exactly.
So there's just not manyopportunities that we find
attractive that are disciplinedin healthcare.
Speaker 2 (24:34):
We've been larger in healthcare when there are
opportunities and we've hadsuccess in takeouts in
healthcare as well compositeagainst the Russell 2000 value
(24:55):
and you know to get 140 basispoints annualized of extra
performances pretty remarkable,especially over that full 15
year type of track record.
Do you think that there aremore opportunities to generate
alpha now than before?
Because, to your point, there'sjust not that many active
managers that are allocatingthere, because all the flows
have been passive towards largecap, market cap waiting.
Speaker 1 (25:16):
Yeah, I do so just for reference and transparency.
I've been co-managing theportfolio for about eight years,
so I think like that seven yeartrack record is kind of a good
way to look at it and sinceinception we've kept the same
strategy and disciplinethroughout and really we stuck
to our knitting.
We're not overpaying for stocks, we're benefiting from takeouts
(25:39):
and also investing with a themefocus.
So I think, looking at theopportunities today, we're
excited about this housing themeand the recovery in nearshoring
and reshoring, as well aselectric infrastructure plays.
We've invested in companieslike Quanta Services, which has
(26:00):
graduated to the mid-cap, andI'd like to talk a little bit
about the other strategy,eventually the SMIT and mid-cap
strategy, where some of thosecompanies that graduate can be
bought in those other ones.
Vistra, we've owned for fiveyears and that company has done
really well.
It's in the news a lot.
It's definitely benefiting fromthe AI demand story for energy,
(26:21):
but the energy infrastructurein this country is really poor
and we have plays on that.
So combining the disciplinewith theme thematic approach has
really, I think, helped ouropportunity set and it just it
continues to be underfollowed,neglected, misunderstood, and
therein lies the opportunity, inour opinion.
Speaker 2 (26:41):
Let's talk about SPID .
I've heard more and more arguethat in general, mid-caps are
kind of the, you know, even moreof a sweet spot than small caps
, for a lot of different reasonsvaluations, less risk of
bankruptcy, dynamic zombiecompanies.
Let's make the case formid-caps over large caps and
then, if there is a case ofmid-caps maybe on par or maybe
(27:04):
even slightly ahead of smallcaps, yeah.
Speaker 1 (27:07):
So look, mid-caps are kind of this neglected child,
right, the middle child.
People are looking at large,people looking at small and
sometimes they just are notfocused on mid caps.
But there are a lot of qualitycompanies and by quality again I
mean companies that aregenerating double digit free
cash flow yields, that don'thave really over bloated balance
(27:29):
sheets, that are tradingattractive valuations, that have
graduated from the small cap.
So if a small cap has been inthe index for 30 years and
hasn't graduated to the mid-capindex, sometimes those are just
not good companies.
They didn't get taken out, theydidn't graduate to the mid-cap
sector, so sometimes thoseopportunities can be found in
(27:52):
mid-cap.
So that's where we started thesmall mid-cap focused fund.
It's run very much like thesmall cap strategy.
It has a dividend component, sothe yield is close to 4%, with
strong double-digit dividendgrowth but attractive free cash
yield over 6% and we've hadtakeouts there.
(28:13):
So we started the strategy in2020.
If you want, you could pull upthe fact sheet from our website,
cullenfundscom, and we've beenable to find names that either
graduated from the small cap,that became mid caps, but really
also play into these themes ofinterest rates, normalizing,
reshoring, infrastructure playsand, looking at the opportunity
(28:38):
set, it's really quiteattractive.
Where all the focus has been onlarge caps and when you can
combine the opportunities of thereally small cap companies that
are not followed by analystswith mid cap companies that just
fall between the cracks oflarge and small, I have to tell
you it's an exciting opportunityset.
So we build this portfoliobetween 30 and 40 companies and
(29:00):
I think what's misunderstood ishow many companies in the small
and mid-cap space pay a dividend.
So about 45% of the companiesin the Russell 2500 value pay a
dividend and 40% of those 45%have a dividend yield that's
over 4%.
So, as rates come down andpeople are looking for income,
(29:20):
that's just another way to bedefensive and provide an income
source in markets that arevolatile.
So it's defensive, but alsoreally an opportunity to
participate on the upside, and alot of times these large cap
companies buy these mid cap andsmall cap companies, as we've
talked about.
Speaker 2 (29:38):
So for those reasons, we think it's a good
opportunity that really gets youthat breadth and valuation and
it also looks pretty, uh, youknow, on par to a relative
inexpensive risk with the smallcap uh composite.
Speaker 1 (29:50):
Yeah, correct, um, so it's.
It's also trading at ameaningful discount.
The index for the Russell 2400value is at 20 times, we're at
12.
Our free cash flow yield isdouble than what the index is
and again, we're below on netdebt to EBITDA.
And we invest typically incompanies that are up to 15
billion in market cap, as low as100 million, as long as the
(30:11):
liquidity is there.
And I think it's alsomisunderstood how many sectors
actually have attractivelypaying dividend companies.
So, whether it's real estate,financials, utilities, consumer
discretionary and we can look atthe breakout there you can see
we're overweight.
Consumer discretionary.
There's just been so many nayshave been pummeled over concerns
that the consumer is slowingdown, but I think the consumer
(30:34):
just needs to take a breath.
I mean, there's been a lot ofstimulus that's run through, but
wages are still strong, peoplehave jobs and there's some noise
on the Fed side and a lot ofFed workers potentially could
lose their jobs, whichperversely, I think could lead
the Fed to lower interest rates.
I mean, treasury SecretaryBesant is really focused on the
(30:57):
10-year now.
Well, how are they going to getthe 10-year lower If they cut
enough jobs from the federalgovernment which they can
control much more than theprivate sector.
That might get the Fed to cutrates and it might bring
interest rates low and thathelps homebuyers and companies
in our portfolio to financethemselves.
Speaker 2 (31:14):
I had mentioned that on a post on X that went a
little bit viral, somethingalong the lines of you know,
trump is laying off all thesefederal workers to get the Fed
to cut rates.
So I think Possible.
You know 4D chess or not, butyou know, it seems like it's a
possible direction.
Speaker 1 (31:29):
When the deficit's so large and your interest expense
is greater now than yourdefense budget, it plays a role.
Speaker 2 (31:38):
And the performance.
Same story has beenmeaningfully outperforming since
inception against the Russell2500 value.
Speaker 1 (31:47):
Yeah, yeah.
So we've had strong performanceabout 25% versus 19% for the
benchmark.
Our upside capture is over 100%it's about 104% and our
downside capture is 86%, soproviding good downside
protection in periods of marketvolatility.
(32:07):
Because they have the free cashflow yield, they have stable
businesses.
We've owned companies that arein the banking that have been
rumored to be taken out, likeFirst Horizon.
Elizabeth Warren didn't wantthat deal to go through by TD.
They're located in a reallyattractive area in the Southeast
, where they're based inTennessee and they have branches
(32:29):
in Florida, so a lot ofopportunities for growth.
Speaker 2 (32:34):
I know you're doing deep dive research, obviously,
but let's say that there'sconcerns around an economic
slowdown, right, and it's timeto play somewhat defensive in
the small cap and smith space.
I'd argue it's a lot easier toplay defense with large caps
because you can just go intoutilities and you know lower
(32:54):
beta, consumer staples, names.
But if you're going to try toplay defense, if you have a
macro view that you want tointegrate into the portfolio,
what's the best way to do thatwith small and mid-cap names?
Speaker 1 (33:05):
yeah, I think, just on a portfolio construction
basis.
It has to start there.
Then you can do sector based onthe portfolio construction
basis.
It has to start there, then youcan do sector-based On the
portfolio construction.
You want companies that areready trading at cheap
valuations Not to say that theycan't get cheaper, but the high
flyers, I think, are just goingto get put it this way hurt more
than companies that are tradingclose to trough valuations.
(33:28):
So a lot of times we're lookingat how the companies are trading
versus their own tenure historyas well as to their peer group.
And then companies that canreturn high free cash flows as
well as high returns on equity.
So with good balance sheets,leverage cuts both ways.
So companies that are overlevered are going to get crushed
in a macroeconomic downturn andwe haven't seen credit spreads
(33:50):
blow out.
But credit spreads totallytypically blow out when the
crisis is starting already.
It's not really a goodpredictor.
So you can look at creditspreads and see what the CDS
rates are, but at the end of theday you want to own quality
companies.
And then on a sector basis,consumer staples, utilities,
telecom these are all areas thatare pretty defensive and you
(34:14):
could find companies also thathave a yield and people want
that income in periods of marketvolatility.
So I would say those are thethree sectors that we gravitate
towards when we think thatthere's potential risk on the
macro side.
But we're fundamentals,bottom-up investors, but we do
take macro into consideration.
Speaker 2 (34:31):
Yeah, I think I was like how can you not take macro
to some extent intoconsideration, just given how
much flows have driven theeconomy and asset allocation in
general?
Do you look at the?
I'm just curious do you look atthe bond market side when
you're doing analysis on thesmall cap stock?
End of things?
Speaker 1 (34:50):
Yeah, we do, but we're not.
Yeah, you're doing analysis onthe small cap stock end of
things.
Yeah, we do, but we're notcredit experts.
So we do look at where thingsare trading.
Speaker 2 (34:58):
Just to get a sense of some strain or disconnect
right From a default riskpotential.
Speaker 1 (35:02):
Yeah, same way as we look at the short interest like
what are we missing?
What's the bear case?
And a lot of times we usecredit research to see also on
an aim.
It's always interesting to seewhat, like, a sell side credit
analyst thinks of a name, ifthey do follow it.
Speaker 2 (35:17):
How do you?
What's the?
What is the sell discipline?
What causes a company tototally just bomb out of the
portfolio?
Speaker 1 (35:24):
Yeah, good question.
So typically three things.
One is that we got the thesiswrong, right.
So I mentioned you kind of putthe hypothesis there.
You test the hypothesis andthen we try to do the pre-work
and really just what thepre-mortem is.
But if something's going wrongand the thesis has changed,
(35:44):
we'll sell it.
Our turnover typically is 30%on a name basis.
It's lower, but we sold namesearlier than our typical holding
period of three to five yearswhere we're just flat out wrong
and it's a humbling business.
You're going to be wrong.
Other times just therisk-reward isn't so attractive.
Typically we like thisthree-to-one risk-reward ratio.
(36:07):
Let's say stock could be up 60but down 20.
And we like the probabilisticweight kind of outcomes.
If that has really compressedand we see other opportunities
elsewhere, whether it's in thatsector or not, we'll swap that
out.
And other times we just thinkit's dead money.
There's no catalyst anymore.
(36:28):
The catalyst has played out andwe're not going to wait around
for like a 10% upside in thestock if we see other
opportunities.
Speaker 2 (36:35):
So you've got the SMAs Talk to me a little bit
about the fund itself.
Any kind of key differences?
Typically, do you find thatinvestors prefer, when dealing
with small caps, that's simply amanaged account of vehicle
versus a mutual fund dealingwith small?
Speaker 1 (36:52):
caps.
That's simply a managed accountvehicle versus a mutual fund.
It really depends on the holderand the investor and how they
want you to manage theirholdings and their strategy.
So one thing I would say is wewant to stick to our discipline
and we want our financialadvisors and institutions to be
able to plug us into whatevermodel they're running and just
rely on us to be the small capvalue manager or the SMID
(37:15):
manager in their books.
So that's one thing.
Whether they choose SMA ormutual fund, it's really up to
them.
We have both vehicles availablefor small cap value.
The SMID right now is in theseparate managed account form
and whether it's if people wantto manage taxes differently or
(37:36):
have some exclusions that theydon't want allocations to like
tobacco or other things, theymay use a separate managed
account.
But the minimums have come downso much for separate managed
accounts compared to what theywere 20 years ago where
oftentimes you could have anaccount holder that is larger in
the mutual fund than it is in aseparate managed account
vehicle.
Speaker 2 (37:55):
You talked to a lot of advisors individuals, I'm
sure as well just about marketsand small caps in general, and
I'm sure you get a lot of thingsthat people say to you which
are outright wrong, that makeyou want to totally counter
those arguments, outright wrongs, that make you want to totally
counter those arguments.
What are some of the the morepopular myths out there about
(38:16):
investing in small cap?
Speaker 1 (38:17):
Yeah, one that comes to my mind is you really need a
recession and a total marketblowout to make small caps
attractive, where you're goingto get paid for the risk, and I
just don't think that's true.
There's been a lot of periodsand it goes back to cycles right
when small caps can outperformfor seven to 10 years and it
didn't require a recession, abust, to get that attractive
(38:41):
entry point.
I think there's alwaysuncertainty of when is the right
time to pivot and get out ofsomething that's worked, because
momentum is strong, but I thinkwe're starting to see some
breaks there.
So I think that's probably oneof the misnomers.
And two is like small caps theydon't make any money.
They're terrible companies, andI think that's partially true,
(39:04):
depending on which index youinvest in.
If you're investing in anactive manager that invests in
fewer than 50 stocks, let's say,that has a discipline that can
follow the companies, know wherethe bodies are buried and knows
the space well and is willingto do the work, I think you
could find out performance there.
Speaker 2 (39:25):
Brian, for those who want to learn more about
Schaefer Cullen and who might beinterested in either the SMAs
or the mutual fund, where wouldyou point them to?
Cullenfundscom.
And that's also for the SMAseries.
So same center.
Speaker 1 (39:37):
Correct.
You can find all our strategieslisted there.
Both are at CullenFundscom.
You just select whether you'rea financial advisor or a private
investor and it'll lead you tothe right path.
You could also find us onLinkedIn, where we post some of
our research and findings andwe're happy to start a
conversation.
(39:58):
But reach out to your advisorthat you could find and it
automates who that is based onyour region.
Speaker 2 (40:03):
Hopefully everybody enjoyed the conversation.
I personally think it was veryinteresting.
I still maintain small capshold the key, myself quite
optimistic on small caps,certainly on a relative basis.
I think we are way overdue forsome broader leadership and I do
believe, like you do, brian,that there's a lot of alpha
potential there.
And congrats on all theperformance.
(40:24):
Again, folks, it was asponsored conversation by
Schaefer Cullen.
This is LeadLag Live.
Learn more about SchaeferCullen at cullenfundscom and
I'll see you all on the nextepisode.
Thank you, brian, appreciate it.
Thank you, michael.
Cheers everybody.
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