US small caps still worth considering, says Janus

Nick Thompson is client portfolio manager on the investment team at Janus Capital. Working closely with the portfolio managers and analysts, he represents equity strategies to clients.

Before joining Janus in September 2006, Thompson served as portfolio specialist for the Pimco funds distributed by Allianz Global Investors. He developed distribution strategies for fixed-income portfolios and functioned as the link between the distributor and the investment team.

Outside the US, investors can buy two Janus products that offer US small/mid-cap exposure: its US small- and mid-cap fund and US all-cap fund. During a visit to Asia last week, Thompson talked to AsianInvestor about what investors should be looking at in the US small- and mid-cap market.

Can you give a quick overview of the US small- and mid-cap market currently?
We've seen a tremendous run in the small- and mid-cap market off the bottom, but what's important to recognise is that a sell-off led into that. So we've gained back a lot of what we'd lost.

Expectations for small/midcap P/E [price-to-earnings] ratios are definitely significantly higher than in the large-cap market. Part of it is that over the period that small-caps have been doing well, businesses have been very conservative with their guidance. So you've seen a lot of either not giving long-term guidance or any guidance at all, because they don't want to provide that guidance that might be inaccurate.

So there hasn't been a lot of transparency on the part of management teams into their business for investors, which has given us the opportunity to do really well, because we don't need transparency from the management teams. We generate our own insight into what the business looks like.

This has led to a wider range of outcomes and surprises that have been more to the upside than the downside, which has given a boost to this market.

How much of Janus Capital's small- and mid-cap products' AUM is sourced from the Asia-Pacific region, and to what extent do you see that increasing in the coming months or years?
Our flows are currently mainly from Europe. We have seen significant reduction in demand for US equities from outside the US immediately after the credit crisis. While that's not groundbreaking news, what's interesting is that recently we've seen a bit of a pick-up in demand from Europe potentially because of the headlines about sovereign risk issues there. That hasn't been the case from Asia-Pacific yet.

Presumably part of the reason for your trip here is to increase that proportion?
Right now in Asia, on the retail side, we largely sell our US fixed-income products and our US large-cap offering. In the institutional space, our focus has been on US large-cap and global equities solutions. We'd like to offer a wider opportunity set.

Being a bottom-up fundamental investor, we identify a lot of great companies. If you think about the nature of the US market, if you focus your energy only on US large-cap, it's a pretty narrow cross-section of the market. There are not that companies in the US that are $15 billion or $20 billion or more in market cap, there are a lot more smaller companies. So it makes sense to diversify our offering in Asia.

Why should Asian investors be interested in such stocks, given that many will probably feel it's too difficult to know much about them or their activities, particularly compared to either large-cap US stocks or Asian stocks overall?
If you want US exposure and you buy a US large-cap, you're getting exposure to US market. But generally US large-caps are global focused -- for example, Coca Cola gets nearly 80% of its revenue from outside the US. What you get with small-cap companies is both a larger pool of companies and a greater focus on the US markets.

Some people might say that's a bad thing, because the US market can be an outlet for sluggish growth, but you're operating with companies that have small market share in a very large market in many case. So if you have a company growing a 2% market share to 4%, that's not a heroic success, but it's doubling the size of the company. It would be harder for larger-cap companies to achieve similar type of growth.

So you can identify companies that have tremendous growth prospects even in the context of a market that maybe doesn't have tremendous opportunity for economic growth.

In addition, it's hard for US large-cap to compete with emerging markets on a performance basis, and the Asian investor base, particularly in the retail space, is very performance-orientated. Being able to offer small-cap, which potentially offer the performance characteristics of some emerging-market stocks. But then you also have the opportunity to combine US large-cap and small-cap to give a more holistic US exposure. However, it is important for investors to realise that with the added performance potential comes additional volatility. 

Many feel that higher-quality stocks are the way to go now, in view of the likely issues ahead, such as stimulus removal and so on. With such things in mind, where do you see value in small- or mid-cap stocks following the rally?
For us, it's less about sector rotation. Even in the rally we've seen, there hasn't been a lot of differentiation based on fundamentals. It's been a pretty strong beta rally and we think the market will be differentiated based on fundamentals, which plays to our strength.

You are seeing market P/E valuations upwards of 30 times 2011 Wall Street estimates. There are companies where those valuations are warranted, and those where it really doesn't make sense

How will small- and mid-caps deal with the likely problems that are to come from stimulus removal, such as lack of loan growth?
The removal of stimulus is less important for small- and mid-caps, because the good ones now have recognised what a lot of the issues were with credit availability, and they've termed out their loan structures so that they could be less sensitive today to credit markets going down.

Even in the heart of the credit crisis, if you had debt due in 2015, yes it was a problem, but investors were more worried about companies potentially going bankrupt. But now, because you've had this opening of the credit markets, the good companies have been able to term out their structures, so that even if credit tightens up people aren't going to be as concerned about it.

It is stock-by-stock analysis that drives what we do. Some companies have the potential to perform regardless of macro factors like economic stimulus.

Which areas/sectors would you be most concerned about if credit were to tighten?
The deleveraging consumer has pretty significant implications for US retail. I'm not saying you completely avoid that sector, but you identify the companies that are taking the right kind of actions on their cost lines -- whether it's, say, reducing their store count, sourcing cheaper input goods -- recognising that the revenue line is probably not going to be where it was from 2003 to 2007.

Your competitors in the small- and mid-cap market would presumably be the likes of AllianceBernstein and Neuberger Berman?
Yes and there are also some more unique, niche managers, which you're probably not as familiar with that distribute primarily in the US. There are a lot of dedicated small-cap managers in the US that only cover that market [such as Royce & Associates and Turner Investment Partners]. There can be an advantage to that I guess, but our view is that having an integrated research platform with small and large-cap analysts working together gives you a lot of information.

Because if you think about researching a small-cap company, one of the biggest dangers for a small-cap is that a big-cap company with deeper pockets will be able to spend a significant amount of money on R&D and capitalise on opportunities that small-cap companies are trying to take advantage of. So understanding what's happening in with large-caps is very beneficial to know what to avoid in the small-cap market.

Small-cap tends to be an island in a lot of shops, but with us it's fully integrated.