Is It Time To Short Small-Cap Stocks?
By DailyAlts Staff Size matters to factor-based investors, as small-cap stocks have historically outperformed their large-cap counterparts. But throughout the equity market’s history, there have been periods of dramatic small-cap underperformance, and David Schulz, president of Convergence Investment Partners, thinks we may be headed into such a period. He and his team at Convergence are rare among small-cap managers in employing an active shortin g strategy as both a source of alpha and a way to reduce risk. The Convergence Opportunities Fund (MUTF: CIPOX ) reflects the views of Mr. Schulz and his team. The fund, which debuted in November 2013 and ranked in the top 9% of funds in its category in its first calendar year, lost 5.4% in the first nine months of 2015, but still ranked in the top quartile of its peers. Going forward, the fund should outperform if small caps underperform, providing a unique way for investors to diversify their portfolio risks. Why are Mr. Schulz and Convergence bearish on small caps? The firm sent out an alert late last month citing a variety of reasons pertaining to valuation: Roughly 27% of stocks in the small-cap Russell 2000 index have negative P/E ratios (i.e., they’re unprofitable), while this is true of only 8% of large- and mid-caps in the Russell 1000; About 9% of Russell 2000 stocks have a P/E ratio of 50 or higher, while less than 6% of Russell 1000 stocks have such high earnings multiples; and In total, 36% of stocks in the Russell 2000 have P/E ratios that are either negative or over 50 – and 10 stocks in the index have P/Es that are over 1000! Furthermore, increased volatility in the equity markets has been bearish for small caps, since conditions have led investors to “sharpen their focus on valuations,” in Convergence’s words. In the brutal month of August, the 25 small-cap stocks with the highest P/E ratios returned -8.83%, while the 25 stocks with the lowest P/Es returned -0.28%. Since there are many more small caps with high P/Es than with low valuations, this trend is bearish for small caps in general, but Convergence’s Opportunities Fund applies a long/short approach to capture the upside exposure to the best-valued small-cap stocks. The firm says so-called “hope stocks” are on its list of shorts – these are companies with “weak balance sheets; low or decelerating cash flow, earnings, and sales; and high expectations.” Convergence believes an active short portfolio can complement an active long portfolio, especially during particularly tumultuous times. The short portfolio can “cushion the fall” when the market is under pressure and “add materially to the overall return of the portfolio over time.” Ultimately, stocks are differentiated by their fundamentals, and with interest rates expected to rise soon, the most fundamentally sound companies should outperform those with weaker balance sheets and decelerating earnings. The Convergence Opportunities Fund seeks to capitalize by applying a flexible long/short approach to U.S. small-caps. Share this article with a colleague