‘Keeping Small Caps on a Short Leash:’ The Sell Discipline Key to CTSIX’s Building a Portfolio of ‘Big Winners’

Small cap growth? It’s an exciting asset class early in what could be a multi-year leadership cycle. Few believe this more strongly than Brandon M. Nelson, CFA, Senior Vice President and Senior Portfolio Manager. (And for more, see this post.)

But, as made clear on Tuesday’s CIO Conference call, Nelson isn’t one to sugarcoat the opportunity: “Small caps can be squirrely, they can test your patience. They can be volatile, and the business models and income statements can surprise you both positively and negatively.” (To listen to the August 10 call, go to www.calamos.com/CIOsmallcap-8-10.)

What small cap investments need, according to Nelson, is to be “kept on a short leash.”

“Inevitably,” he continued, “we're going to have problems, we're going to have some stinkers. And when that happens, you’ve just got to get out of the way, as soon as possible. Recognize that as quickly as possible, and then just take action. Don't fall in love with these companies. They’re stocks, they're not family members.”

'Jaw-dropping' Historical Outperformance 

From September 2020 through the end of February—the start of small caps assuming leadership over large caps—smaller companies returned 41.7% (Russell 2000 Index) versus the 11.8% return of larger companies (Russell 1000 Index). Such an outsized difference is to be expected, according to Nelson. “When small caps beat large caps, the magnitude of outperformance is somewhat jaw-dropping. It’s about five to one.”

Since March, small caps have lost ground, which is also typical. Nelson describes it as a “routine, two steps forward, one step back pullback.”

Even so, to date in 2021, CTSIX gained 11.81% through July 31 versus the Russell 2000 Growth Index return of less than half of that, or 5.01%. This follows 2020, when CTSIX gained 63% versus the index’s 35% (see post).

The fund’s strict sell discipline partly explains the performance gap between the fund and its benchmark. Nelson has commented on the fund’s sell discipline multiple times before (see this post and these videos).

On this week’s call, he quantified the value added year to date. The portfolio includes 12 stocks that added at least 50 basis points of relative performance, year to date. Just two stocks cost at least 50 basis points—one stock 51 basis points and the other 50 basis points.

“Our sell discipline provides a lot of damage control to the portfolio. It creates a risk buffer,” said Nelson. “The crux of what we do is all about finding big winners, and then deploying damage control on losing situations so that they leave no more than a scratch on us, as opposed to a much more severe injury. We're not going to let one stock ruin the whole year.”

In fact, 2021 is a year that Nelson said he expects big things from, citing historical data. Since 1989, in years when small caps were up over 10% during the first six months of the year (the broader Russell 2000 Index was up 17.5% at the halfway mark), they continued to rise in the second half of the year, on average by another 12%.

Past performance is no guarantee of future results, Nelson acknowledged. But, he said, “as we sit here today, for the second half of the year since June 30, small caps are down about 3%. So, you've got to make up the 3% plus go up another 12%. If history repeats itself, we could be looking at a 15% return from here until the end of the year,” he said.

Q2 Earnings

Small caps are continuing to report their second quarter earnings, and Nelson described the season as a “mixed bag” so far. “We think we've found some really special situations, where we have been rewarded meaningfully.” But, he continued, “For the most part, I feel like the market is selectively rewarding companies for beating and raising. It's being somewhat picky.”

CTSIX looks for companies demonstrating fundamental momentum, whose growth is both strong and underestimated (see box at right). Such “winners” are typically re-rated higher as they progress through a beat and raise cycle over consecutive quarters—“rinse and repeat,” as Nelson said.

“A typical CTSIX stock might be trading at two or three times sales when the beat and raise cycle begins, but after several strong quarters of solid execution, that stock might be trading at nine or 10 times sales.

"We want to go along for that valuation expansion ride," Nelson said.

The market’s response is “always a wildcard,” he acknowledged. “Is the market going to actually pay us for the strong fundamental performance? There are certain times when it's very willing to pay you. And there are other times where it doesn't put as much weight on that. That’s usually when the market is obsessed with more macro bigger picture issues.”

Here again he returned to the team’s discipline. “We just keep doing our thing.”

Secular Growth Powers Through

While the discussion and a few questions asked by investment professionals touched on macro considerations including inflation and the impact of the Delta variant of COVID-19, Nelson stressed that the fund is focused on secular growth companies “that are able to power through.”

“There's a lot going on right now in the economy. There’s a lot of pent-up demand, you've got a lot of stimulus still in the system. That's sort of turbocharging some of the macro trends.”

But Nelson said, “We don't want to be dependent on the macro.

“At the end of the day, we're focused on bottom-up, company-specific situations where companies are in charge of their own destiny, and they've got something special, a unique service or a unique product and the market’s embracing it. Whether inflation is 3% or 4.5% isn't really going to matter much to what happens with that company.”

“I look at the whole portfolio,” he continued, “and I see several stocks that have the potential to double, to triple, to quadruple over the next few years. They have open-ended growth in front of them. As long as they execute on their business plan and meet and exceed expectations and sustain growth at a high level, we think they've got the makings for big appreciation.

“That's how we spend our time,” said Nelson, “trying to find those types of companies and sniff out those big winners.”

Investment professionals, for more on Nelson’s perspective and CTSIX, reach out to your Calamos Investment Consultant at 888-571-2567 or email caminfo@calamos.com. For more on the small cap market, subscribe to the Calamos Small Cap Market Snapshot.