Doug Basile, Portfolio Specialist with the Heritage Growth Equity team at Wells Fargo Asset Management, lends insight into what makes small-cap growth stock appealing now and over time.

 

Laurie King: I’m Laurie King, and you are listening to On the Trading Desk®.

Today’s guest, Doug Basile, Portfolio Specialist with the Heritage Growth Equity team at Wells Fargo Asset Management, believes small-cap equities are appealing in today’s economic environment. This interview is based on an AdvantageVoice® blog post in November of 2018 called “Innovation: Does Small Growth = Large Opportunity?” It was authored by Doug and was helped along by my colleague Matt Alexander, a thought leadership manager here at Wells Fargo Asset Management. Matt, welcome to On the Trading Desk!

Matt Alexander: Thanks for having me, Laurie.

Laurie: So Matt, you’ve been covering the Heritage Growth Equity team, and helped them to bring their blog post to market.

Matt: Yes.

Laurie: We’re going to listen to a conversation you had with Doug highlighting that article. Before we do, as a means of setting up your interview, can you explain the play on words that the title asks: Does small growth = large opportunity?

Matt: Sure, Laurie. I think the title really captures the essence of investing in small cap growth companies. They represent the first real opportunity for most investors in public markets to take an ownership stake in tomorrow’s leading companies. They can be a ground-floor opportunity.

Laurie: Great! Let’s hear that conversation then between you and Doug and we’ll rejoin after.

Matt: Sounds good Laurie, thanks. Doug, thanks for taking time to meet up with us today.

Doug Basile: Thanks, Matt.

Matt: In your post, one of the first points you make is that small caps are generally not as closely followed by sell-side analysts. Does that relative lack of coverage create opportunity for investors?

Doug: Yes. So because small-cap stocks are less followed by sell-side research analysts, they have some structural advantages. They are less efficient, with less institutional ownership than many large-cap stocks over their counterparts. Many of these companies tend to be younger in their life cycle and have higher growth profiles than some of their larger cap counterparts.

So I did some back-of-the-envelope analysis, and if you look at the S&P 500 in particular, on average, they have 31 sell-side analysts covering them—these are the top five names in the S&P 500. Now, by comparison, if you look at the Russell 2000 Growth Index, which is the small-cap growth benchmark, the top five names only have 11 analysts covering them. So actually if you moved down that list in terms of weights within that index, the analysts coverage list gets even sparser. So teams like ours can take advantage of this dynamic, especially where there’s polarizing views on what’s being underappreciated about that company’s growth profile.

Matt: That’s great Doug, thanks. You discuss one aspect that seems somewhat unique to small caps: investing in transformation. Can you describe what that means to you?

Doug: Really, because of their innovation, their emerging technologies, and their propensity to disrupt existing business models, where they can often times do that by cultivating their own demand. So many of these stocks that we like to invest in are some of the most dynamic companies within the economy. And we’ve put out a few blog posts in the past where we talk about our acronym SCODI, which stands for software as a service, cloud-based technology, online, digital, internet, and, recently, this quarter, we’ve actually added another “I” to that SCODII acronym, which stands for innovation. So, a lot of these companies within software, they’re really generating transformational change through a multitude of areas, whether that be email infrastructure, or call center contact, technologies. And then advancements from medical device companies or medical technology companies that are really having a profound impact on patient outcomes and are really playing a key role within value-based healthcare landscape, and, on the cusp of transformational change.

Matt: You also believe “advancements have a positive effect on our daily lives.” How so?

Doug: Yes. So, often times, I’m surprised when I look at the small-cap growth universe, in particular, really the impact that some of these companies have on our daily lives—both subconsciously and consciously. [For example] a company that offers virtual banking solutions, like auto bill pay. Or a company that plays in the educational space that initially started out being an online bookstore for college textbooks, but has evolved into services like online tutors for studying, test prep, or writing. Or, a company within the healthcare space that offers tele-health technology. Basically a substitute for going to the doctor—where it’s a virtual appointment. And many of these appointments—I think the stat that’s put out is—these virtual appointments have a 90% success rate of issues being resolved on that first appointment. So, again, many of these companies are really positively impacting our daily lives both consciously and subconsciously.

Matt: That’s great Doug, thanks. In your post you make an interesting point “access to growth is limited.” How do small caps offer a point of access for investors?

Doug: There’ve been a lot of studies over the years. If you look at the number of publicly-traded companies that are listed, that they’ve gone down considerably since the late `90s. And if you look at the advent of private equity—and  would include venture capital—which has grown to a three- or four-trillion dollar asset class, and if you go back 25 or 30 years, that was really a rounding error. And so many of those asset classes, like private equity, is very difficult for mom-and-pop investors to get into. And so, when you look at the less amount of publicly traded names, and then you look at some of the innovation and emerging technologies, transformational change that some of these small-cap companies offer, we feel that this is a pretty good field for investors to be able to get into, pretty easily, relative to other areas that have higher barriers to entry, like venture and private equity.

Matt: And one thing that caught my eye in the blog post—and maybe some of the readers saw this too, is you call this space, “the cradle of tomorrow’s giants.”

Doug: Yes. So we were looking at some analysis, going back all the way to the late `90s through the end of the year [2018], and many of the companies that we know and love today, which are now household names, were once constituency of the Russell 2000 Growth. And so some of their market caps have evolved from $2-5 billion in market cap to some of the holdings today that people know are $80- 120 billion market cap companies that have graduated out of the Russell 2000 Growth into larger cap indices. But, many of us aren’t aware they were once smaller companies. So, investors who were able to invest in those companies early on were able to capture capacious growth overtime.

Matt: Doug, before we go, how should we think about duration in the context of equities, particularly small caps?

Doug: Matt, that’s a great question, and we’ve done a lot of work on this over time—and really with our definition of this. So if you think about small-cap equities, small-cap growth companies in particular, they are generally considered long-duration equities—meaning you’re receiving your cash flows further out in the future, relative to large-cap stocks or value companies. So, often times, their cash flows are proportionately larger in the out years compared to their current emerging stages of growth. So because of this, small-cap growth companies often times—or the investors are often times—rewarded with a higher risk premium. So this is where we feel the opportunity lies in that valuation gap that we talk about [on the team], which is really our internal assessment of a company’s growth, relative to what the market is discounting for that company’s growth. And if we can get that part of the equation right, we feel that that’s going to be beneficial for our investors.

Matt: Doug, thanks for your time. We hope you’ll join us again!

Doug: Thanks Matt, thanks for having me; appreciate it.

Laurie: Hey Matt, that was a very interesting interview that you had with Doug.

Matt: Sure!

Laurie: As I was listening, one key takeaway I found intriguing what that idea of these small caps being “the cradle of tomorrow’s giants.” And I think in the blog post you also talked about what that meant for investors who stayed the course and were invested overtime.

Matt: Yeah Laurie, that’s a really good point. You know, these are long-term investments and it takes some time for these to materialize. So not every one of these small caps is going to be a success story, but there certainly are lots of success stories in there that are waiting to be discovered.

Laurie: Well, we’ll wrap this episode up for now. Matt Alexander, thanks for catching up with Doug Basile.

Matt: My pleasure Laurie, thanks for having me.

Laurie: Until next time; I’m Laurie King, take care.

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