A Bear, A Brexit, And A Welcome Start To 2016 by Chris Clark

The market’s pronounced shift toward companies with attractive to reasonable valuations, solid balance sheets, and strong profitability in the first half of 2016 helped many active managers, ourselves included.

A Bear, A Brexit, and A Welcome Start To 2016

We were happy to greet 2016 with a spirited “Hello” in the hope that certain emerging trends in the small- cap world would gain a firmer foothold in the new year.

We were very pleased, then, to see the market’s pronounced shift toward companies with attractive to reasonable valuations, solid balance sheets, and strong profitability—attributes found in many of our portfolio holdings—arrive in the year’s first half. And though domestic small-caps did modestly well in the first half, an achievement that looks more commendable in the context of the high levels of volatility that all equities faced in the first half of 2016, many active managers, ourselves included, did even better.

This was a welcome change. Both the absolute and relative health of domestic equities was in evidence during the first half of 2016. The Nasdaq Composite, which is home to a large number of biotechnology companies that corrected sharply in the first half after leading the market last year, was the only major U.S. index to finish the year-to-date period ended June 30, 2016 in the red.

A few non-U.S. indexes remained marginally positive in the first half, but most concluded the semiannual period with at least minor net losses. Among those that fell further behind was one that did notably well in 2015—European small-caps, whose more diminutive size made them most vulnerable to the post-Brexit sell-off.

But to participate in these strong first-half results for U.S. equities, investors needed the stomach for a wild ride that started with a steep and speedy initial drop followed by a far smoother, robust recovery.

The year began with a more dramatic extension of last year’s decline, and we initially failed to grasp that 2015 would, in the manner of Shakespeare’s best-known stage direction, “Exit, pursued by a bear.” From the June 23, 2015 small-cap peak through its year-to-date low on February 11, 2016, the Russell 2000 Index fell 25.7%, a truly ursine decline.

This seems to have been a remarkably quiet double-digit correction—a stealth bear market, as it were. Few outside the small- cap world have acknowledged it, never mind analyzed or discussed it. Yet it was the ninth biggest decline since the Russell 2000’s inception at the end of 1978, and the worst for small-caps since 2011.

It included many of the signs that typically accompany a bottoming-out process—panic selling in a number of sectors (most notably within the bio-pharma complex), small-caps losing more than large-caps, and greater resilience from value stocks—to us, the most significant development in the down phase.

This heightened volatility was triggered by the ongoing implosion of oil prices, struggles for other commodities, anxiety over possible bank defaults, and the devaluation of currency in China.

Together, these factors led to a few sessions in which hysteria ruled the equity markets. Like many bear markets (and unlike that of the more closely correlated collapse in 2011), it also solidified a rotation in leadership from small-cap growth to small-cap value.

Having invested through many previous small-cap declines (some pre-dating the Russell 2000), we sought to turn the downdraft to our advantage by looking for bargain-priced opportunities amid the volatility and to stay invested for the eventual recovery.

Our commitment was rewarded as the Russell 2000 rebounded sharply from its early February low, rising 21.6% by the end of June. During these tumultuous days, a shift in leadership could be seen clearly in the earnings outlook.

We first saw evidence for it in October 2015 and noted it again in February 2016. Many companies, including several of our holdings, reported decent earnings while also not revising guidance downward. This was viewed as a positive in that expectations had been so low, particularly for companies in more economically sensitive sectors, that “pretty good” or “not that bad” was in several instances much better news than people were expecting.

The general lack of downward earnings revisions both last fall and in the first half of this year has allowed for some recovery for these companies’ shares. Brexit, of course, tossed an already highly uncertain global economy into even stormier seas. While we see the vote as more of a political event for the United Kingdom and the European Union than an important economic event for the U.S., there’s no question it has made the already tenuous prospects for global growth that much shakier. Still, we do not see it having a lasting or meaningful impact on U.S. small-caps.

For the global economy, however, Brexit and other risks look likely to persist. At this writing, there are negative rates for long-term sovereign debt in Germany and Japan, ominous signals from the banks in Italy, and in both the U.K. and eurozone a political and economic situation that it would be an understatement to call “unsettled.”

Here at home, we have seen record lows for both 10- and 30-year Treasury yields. These more recent developments can be added to the older—that is, mid-June’s— list of concerns about the pace of growth in China and other important emerging markets, stabilizing but still volatile commodity prices, and the ambiguous state of the U.S. economy, in which housing and autos remain strong but consumer confidence, manufacturing, and the job market have been more

It is a daunting set of challenges, to be sure. Where we differ from some observers, however, is in our belief in the strength and resilience of the economy. This is rooted in our long-established practice of giving more weight to what we are hearing from the management teams we speak to every day than we do to fatalistic headlines and dire—or overly sunny—prognostications.

The corporate managers with whom we have been meeting are far more cautious and uncertain than pessimistic. Well aware of the fragility of current conditions, they have also offered some measured optimism in terms of growth picking up, however gradually or in fits and starts.

In terms of now widespread recession concerns, we also want to stress that, over its long history, the stock market has seldom, if ever, offered false positives—that is, shares do not rise when economic growth is about to contract.

And in all the tumult of the first half, most U.S. indexes rose, however modestly. The upshot is that, in the midst of heightened global uncertainty, the U.S. economy and markets look far healthier to us than what the rest of the globe has to offer.

Signs O’ The Times–The Significant Shift

Most notable to us as small-cap specialists with a value orientation was how thoroughly style drove results. The Russell 2000 Value Index outpaced the large- and mid-cap indexes year-to-date through the end of June, while the Russell 2000 trailed them, and the Russell 2000 Growth was negative.

Value indexes in fact did better up and down the market cap range, from micro- to large- cap, in the first half. Although small-cap leadership began to rotate following June 2015’s small-cap peak, the widening performance gap between small-cap value and growth has been the critical

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