Why CTSIX’s Nelson Is Optimistic About the Recovery, Corporate Profitability and Small Caps

In a turbulent period for the markets, Calamos has been hosting a Calamos CIO Conference Call series for investment professionals. Below are notes from a call Tuesday, April 21, with Brandon Nelson, CFA, Senior Portfolio Manager of the Calamos Timpani Small Cap Growth Fund (CTSIX). To listen to the call in its entirety, go to https://www.calamos.com/CIOsmallcap-4-21

For the March commentary, see this post.

One month after the depths of the equity market decline, Brandon Nelson expresses optimism about the prospects for the country’s health, corporate profitability and what he calls “exciting” small companies in the Calamos Timpani Small Cap Growth Fund (CTSIX) portfolio.

He’s encouraged, he said, that the virus metrics are dropping, the health care community is becoming better equipped to properly deal with the virus, and that potential treatments and vaccines are progressing. He described the monetary and fiscal stimulus as “shockingly robust.”

“These positive data points, combined with extremely oversold market conditions, have been the recipe for a powerful recent surge in the stock market,” he said.

Profits Could Recover Faster

Nelson acknowledged the lack of consensus about the shape of the eventual economic recovery. But he believes profits could recover faster than expected—“even if the recovery takes longer to materialize or is less robust than expectations.”

To illustrate, Nelson offered this example:

Let’s say that a consumer company pre-virus was generating $10 million of revenue and 50 cents of profit per share. The virus hits and revenues collapse to $6 million, and profits go to zero. Now, fast-forward a few months into the recovery. Because of the expense reductions and improved efficiencies, coming out of the downturn, the company is generating 50 cents per share once again, but this time, with only $9 million of revenue. In such a case, the trajectory of the profit recovery is steeper than the trajectory of the revenue recovery.

“I think we are going to see a lot of this, and it will have meaningful, positive implications for the stock market, given that profitability is such a key valuation metric,” he said.

The Outlook for Small Caps

Nelson commented on the fact that small caps have lagged meaningfully for multiple years versus large caps. He called the asset class “especially compelling” today, citing three points:

• Small caps’ historic significant outperformance—1400 basis points, as shown below—in the first 12 months of a new bull market following an economic downturn.
• Long-term, small caps have produced the highest rates of return versus large and mid-caps.
• Small caps are the cheapest they’ve been in more than 20 years.

“I’m not saying that today is the bottom for small caps versus large caps. In the short term, things are messy, but if you’re an asset allocator it’s hard not to be intrigued with the intermediate- to long-term outlook for small caps,” said Nelson.

CTSIX Positioning and Q1 Review

As an update on positioning, Nelson confirmed that the fund remains tilted toward secular growth but has some select exposure to high quality cyclical names as well. “Given the macro uncertainty and many moving parts, this diversification is especially prudent,” he said.

On the March 24 call, he’d highlighted a few secular growth themes that continue in the portfolio, including:

• In technology, cloud-based communication enabling companies that target business customers (examples: RingCentral, NICE, Five9 and Audiocodes).
• Within health care, sleep apnea diagnostics and treatment solutions (examples: Inspire Medical and Itamar Medical).

Today he introduced a new theme: Public Safety Technology, which he considers “especially well-positioned in the current environment of potential social unrest.”

Three stocks in the CTSIX portfolio are:

• Everbridge, a rapidly growing subscription software company providing critical events management solutions to government and business customers. Some examples of critical events include workplace violence, IT and power outages, critical equipment failures, natural disasters, and pandemic viruses like COVID-19.
• Axon Enterprises, which sells Tasers and body cameras to police departments, and also subscription technology services that manage data produced by the hardware. The collected data plays a critical role in courtrooms and when there are questions about the use of best practices relating to police engagement with citizens.
• ShotSpotter, a subscription-based gunfire detection technology whose customers include domestic and international law enforcement. Studies show most gunfire goes unreported to authorities as people generally don’t want to get involved. With ShotSpotter technology, in less than one minute after shots are fired, police departments are given notification regarding the number of shooters, the types of weapons being used, and the exact location of the gunfire. Such intelligence is critical for officers arriving at the scene.

Finally, Nelson commented on the fund’s first quarter performance, when CTSIX produced a return that was almost 800 basis points better than the Russell 2000 Growth Index.

“Our process usually works,” he said. “It’s time-tested, consistent, proven and, most importantly, it’s repeatable. What my team and I are good at is finding and staying with big winners, and reducing our exposure to losers.”

The first quarter was an example of that, according to Nelson. “No single stock cost us more than 40 basis points in relative performance. On the flipside, we had three stocks that each added over 100 basis points of relative performance.”

The team’s trading—with sells that were especially helpful—in the first quarter contributed almost 300 basis points to the return, Nelson added. Also see How CTSIX’s Active Management Provided a 776bps Advantage in a Deep Down Quarter for Small Cap Growth.