In the recent October swoon, small cap as a sector sold off more than mid and large-cap. The Russell 2000 Growth index peaked on August 31st and for the months of September and October was down 14.7%. Naturally, the question on everyone’s mind is: does the recent downturn signal a new bear market or is it a normal corrective phase in a long-term bull market? Investing is not complicated: earnings drive stock prices. Coming out of this recent selloff, we see many of our best holdings, companies whose potential earnings growth rates are significantly higher than the market’s, to be on sale now. Right now, small cap growth is trading at 22 times earnings. History has shown when small cap growth stocks are bought at or around these levels, future returns have been high.
Market corrections will always test the constitution of even the most seasoned investor, and the critical ingredient to navigating a correction successfully is having an investment philosophy and process to rely upon. Small cap stock performance has indeed been choppy and the recent drawdown painful, but our view is company fundamentals will win out and ultimately be recognized by the market. In spite of the cross-currents, bad headlines and gnashing of teeth from market commentators, the plain fact is the business cycle remains healthy.
An investment philosophy and process will neutralize your bad instincts and your reactions to short term volatility and guide you over the long term as you seek to maximize returns. The quotes above from legendary successful investors were chosen for a reason.
Our investment philosophy is simple: we seek to have a greater aggregate EPS growth rate than the benchmark and believe over time our portfolio’s value will reflect this better growth. Our first assessment during the recent volatility was to confirm nothing had changed in our outlook for strong corporate earnings growth from our portfolio companies for the remainder of this year and into next. Growth in 2019 will indeed slow from 2018 levels but will also still be strongly positive. As a result, we see recent market movements now as mere hiccups rather than a change to or end of the economic cycle and we expect to see a return to higher earnings growth rates as we move through 2019.
We manage concentrated portfolios because – properly run – concentrated portfolios outperform. They also demand a robust and reliable investment process. We need to understand our portfolio companies almost as well as the people running them. We meet or listen to management team presentations and conference calls multiple times each year for each company in which we are invested. Knowing the business investment case well – the core component of our investment process – allows us to determine if fundamentals have changed, or if the stock is simply moving more in reaction to some less salient headline. It’s not as simple as it sounds.
We have just come through a busy earnings season and have heard from most of the companies in our portfolio. Business remains good and management teams are executing well and delivering growing earnings streams in line with expectations. While that outlook could indeed change, right now the data we see leads us to the conclusion to stay the course. Now is a good time for investors to allocate to growth stocks.
In turbulent markets, technicians are fond of lifting their heads to warn of “death crosses” and other seemingly disastrous omens that should drive us all under the covers until they give the all clear signal. In fact, we’ve just had a “death cross” in small cap growth, where the 50-day moving average crossed below the 200 day. While that sounds ominous, the last time it happened was right before the 2016 presidential election. We know what happened after that. Of course, this time could be different, but we suspect China trade fears are the weight on stocks now. But that overhang could get resolved very quickly in a materially positive way for stocks.
We are later in a cycle than we were two years ago, but until the data starts to break down, our process suggests to us that the earnings picture indicates good value.