Why Small May be the Next Big Thing

“Being out of fashion ultimately enhances opportunities on the other side.”
—John Neff
Investor and Philanthropist
 

Second Quarter Market Discussion

The staying power of the bigger-is-better investing trend has been remarkable. For most of the past nine years the markets have taken a one-size (i.e. Large) approach to everything the economy has produced. Revenue is growing too slowly? Go mega. Tax cuts are coming? Buy large-cap growth. Rates are headed higher? Sounds like bigger is better.
 
The knee-jerk rush into large caps has left major swaths of equities out of favor and trading at attractive levels. But as Mr. Neff noted, meaningful upside can be had for those focused on the bargain bin. And while fashion can be fickle, we see reasons to be optimistic about small caps. Here are a few:
 
  • A stronger dollar and trade tariffs are a headwind for large corporations that sell products overseas but have minimal impact on small, domestic-focused businesses.
  • Tax reform is pro-growth and should reduce the burden on small companies and encourage business investment. 
  • Higher interest rates traditionally favor active management. Not all businesses are impacted the same by higher borrowing costs; it takes active analysis to separate the winners from losers.  
  • Regulatory relief. As the current administration revises existing policies, small businesses should find the environment more conducive to growth.
We’ve highlighted these themes in the past, and now market performance is leading others to take notice. Since the correction that knocked the S&P 500 off its highs set in January, the Index has yet to regain its momentum. The sideways move is striking in light of the 25% earnings growth the group posted during the first quarter. It’s also worth noting that during the period, as shown, small caps trounced their large-cap counterparts.
 
A Surge in Small
 

Heartland Advisors Value Investing R2 versus SP500 Chart
Source: FactSet Research Systems Inc., Russell®, and Standard & Poor’s, 1/26/2018 to 6/29/2018

Simply being small won’t be enough, however, we believe businesses with the following attributes are the most likely to be rewarded going forward:
 
  • They’ll serve unique niches
  • Strong balance sheets
  • Capable, committed management
  • Compelling valuations
Identifying these traits continues to be the focus of our work at Heartland—and we believe is a sound approach to capitalize on the opportunities Mr. Neff describes. 
 
We thank you for your continued trust and confidence.
 
Sincerely,
Your Heartland Team

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