Jeremy Grantham’s Bullish GMO Small Cap Investment Strategy
- Smaller companies emerged in October and investors are increasingly bullish on stocks.
- Jeremy Grantham’s GMO has just launched a fund targeting “quality” small caps.
- Its executives explain how they find companies that are positioned to be long-term winners.
Growing fears of a recession were not enough to prevent small cap stocks from having a strong October.
Markets rebounded strongly last month, with smaller businesses leading the way. The small cap S&P 600 rose 9% in October, while the benchmark S&P 500 rose a respectable 5%.
Conventional investment wisdom holds that small businesses are more vulnerable to an economic downturn and that their balance sheets and business track records are not as strong as those of their larger counterparts. But small caps seem to have some momentum behind them despite rising interest rates and signs of an economic slowdown.
Earl Jeremy Grantham’s business is part of this bandwagon. Grantham, Mayo and van Otterloo, which managed $59 billion at mid-year, launched a new small-cap strategy focused on quality stocks in late September to reflect their optimism about the group.
“We believe a time has come when the long-term and short-term opportunities in quality small-cap stocks are finally aligned, where one can invest in high-quality small-cap stocks at attractive valuations. “, wrote Hassan Chowdhry and James Mendelson, who manage the fund with Thomas Hancock.
In a recent report, Chowdry and Mendelson said that quality stocks — a broad term that generally refers to companies with a history of consistent results, high profitability measured by criteria such as return on equity and a healthy balance sheet — have a long history of beating the market with less volatile returns.
They say quality small caps have outperformed small caps in general by 1.8% per year since 1976, and have beaten a mix of small, mid and large caps by 2.8% per year during that time. . The trick is basically to filter out unprofitable businesses and flashes in the pan that often seem to clutter the space.
“The more predictable, long-term winners are very often undervalued by the market, buried in the buzz of stocks long in narrative but short of fundamental stability,” they wrote. “Investors tend to overpay for stocks of weaker, more volatile companies, perhaps lured by overly optimistic projections or lottery-ticket-like odds for big wins if those companies do well.”
The duo say quality stocks will do well in a downturn because historically, quality small caps perform as well as large caps when the economy slows, but they outperform during recoveries.
Get the right mix
In their fund, Chowdry and Mendelson want to find companies that can deliver attractive long-term results. That’s a challenge for any investor, but they say it’s harder with smaller companies because their competitive advantages fade faster.
“The primary goal of our small cap research is to distinguish which companies have truly sustainable competitive advantages that can sustain long-term outperformance,” they wrote.
In their small cap fund, they hold around 40 names that are attractively priced and have outstanding business models. They also try to avoid relying too much on a specific sector or trend to avoid overexposure. They say many of their holdings fit one of the following descriptions:
- Niche Leaders like Acushnet, which they describe as a leading company in the golf equipment industry.
- Innovators such as medical device maker Globus Medical and chip maker Power Integrations.
- Key Elements of Supply Chains such as the aerospace and industrial company Woodward.
- Companies with a razor and blades business model like packaging manufacturer Kadant.