Insights on Exploiting the Inefficiencies in Small-Cap Stocks

A recent article in Advisor Perspectives outlines an interview with Judd Peters, a portfolio manager of the Hotchkis & Wiley Small Cap Diversified Value Fund.

Here are some highlights:

  • Investment process: Peters explains that his team uses a two-step process to find “opportunities in companies that are temporarily under-earning relative to their long-term potential, either due to industry cyclicality or company-specific situations.”
  • According to Peters, “investors often overreact both positively and negatively to short-term financial results” and markets tend to extrapolate short-term performance into the future. His team sets out to capitalize on these tendencies.
  • Peters argues that some valuations are “lofty”, particularly in large-cap tech but also to some degree in small-cap growth.
  • On managing risk, Peters asserts that the two most important controls at the company level are balance sheet strength and valuation support. “Balance sheet strength is critical,” he says, “because we are often investing in companies with temporarily depressed profitability. Valuation support, he adds, is crucial because “owning the assets and earnings power of a business at a discount provide you with an anchor, regardless of short-term volatility in the stock price.”
  • Peters delves deeper into his team’s investment style and allocations. He says, “We don’t set out to overweight or underweight a sector based on a top-down theme. With that said, we are currently finding the most opportunities in consumer discretionary, industrials and energy.”
  • Peters says that since much of the trading volume for any particular stock is “now done by passive investment strategies,” this means that certain stocks can remain mispriced for longer periods than “when passive managers played a smaller role in the market. In the short run, this contributes to volatility. In the long run, this inefficiency created greater opportunities for active managers, particularly valuation-based managers, to outperform.”