Price Momentum, Fundamental Strength and An Inexpensive Asset Class—What’s Not to Love About Small Caps Today?

This is a unique period to be investing, according to Calamos Senior Portfolio Manager Brandon M. Nelson, because “there are so many factors enabling growth.”

“We’re coming out of a recession, we have a dovish Fed, there’s so much stimulus, we see a lot of operating leverage for a lot of different companies in a lot of different sectors. Companies got lean during the downturn and now their revenues are coming back and that is resulting in explosive margin expansion,” Nelson said on yesterday's CIO call (listen to the call here).

While acknowledging others’ concerns about equity valuations, he said, "Valuations are high, but they should be high given the low interest rate environment. Additionally, it’s important to remember that many companies are under-earning now as we come out of recession. This under-earning is temporarily inflating valuation multiples until earnings catch up with stock prices."

"Importantly, on the subject of valuation," Nelson added, "small caps continue to look very inexpensive vs. large caps, despite the recent rally in the asset class.”

This overall bullishness provided a backdrop for Nelson’s specific update on small cap outperformance that began in early September. Although his Calamos Timpani Small Cap Growth Fund (CTSIX) was well ahead for the year by then, the small cap asset class underperformed for the first three quarters of the year, staged a record-breaking November for the Russell 2000 Index and finished 2020 just about even with the S&P 500 (19.96% versus 18.4%, respectively). CTSIX finished with a 63.27% return for the year.

“We think the Q4 rally marked a significant regime change for small caps,” Nelson said. “When a regime change like that takes place, history shows us that it tends to sustain for long periods of time—on average seven years. We’re in the fifth month of what could be a multi-year move. The shortest [period of small cap outperformance] was 3.5 years. We have much longer to go here, if history repeats itself.” (See this post.)

It’s important to note, he said, “that long term, small caps tend to win. It’s easy to forget that for the last 9.4 years large caps have outperformed, we’ve been lulled into thinking that’s normal. The opposite is what’s normal,” adding that valuations are stretched on the basis of many metrics (see this post for more).

“You put together price momentum, fundamental strength and an inexpensive asset class. That’s a possible hat trick that could result in further price momentum,” said Nelson.

Buy Ideas Outnumber the Sell Ideas

The CTSIX team, in particular, is finding plenty of stocks that meet the fund’s fundamental momentum objective. The portfolio is diversified, with exposure to nearly every sector but tilted more toward secular stocks, where sustainable growth is more commonly found in technology, health care and consumer discretionary sectors, for example. Cyclical stocks “with sizzle” in financials, industrials, materials have been added at the margin.

Currently, Nelson said, the CTSIX team finds itself in a “lopsided” position where the buy ideas outnumber the sell ideas.

“We have a diversified portfolio where there’s a lot of exciting things going on in several different pockets of the economy,” said Nelson. “Honestly, our biggest challenge day to day is what are we going to sell to fund the purchase of this other great idea that we want to own, or to fund the purchase of getting bigger in an existing holding. It’s a constant struggle to figure out what to reduce exposure to.”

Nelson also mentioned the fund’s relatively small size ($187 million in assets under management as of 12/31/20) as an advantage over larger small cap funds. “In an environment like this, where we think we’re in the early stages of a small cap regime, further down the market cap spectrum is where the action is.”

The fund’s average market cap was $2.98 billion as of 11/30/20. This compares to the Morningstar Small Growth category average of $5.48 billion and Russell 2000 Growth average of $3.12 billion. “We’re already there and we can get there in a bigger way if we want to,” said Nelson, noting that large funds don’t have similar flexibility.

“Let’s face it,” he said, “there’s more inefficiency further down the market cap spectrum. The opportunity to find home runs is greater.”

Investment professionals, for more information about CTSIX, contact your Calamos Investment Consultant at 888-571-2567 or caminfo@calamos.com.