U.S. Equities

Looking for Attractively Valued and Fundamentally Strong Small Caps

David Corris discusses the BMO Disciplined Small-Cap Value strategy in the current market enviornment, including increased emphasis on quality and the development of a proprietary factor to look at each stock’s COVID exposure.
October 2020

David Corris, CFA®

Head of Disciplined Equity, Portfolio Manager

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This interview was originally published in The Wall Street Transcript’s October 26, 2020 issue. Reprinted with permission.

Highlights

David Corris discusses the BMO Disciplined Small-Cap Value strategy. Mr. Corris thinks small-cap value is best positioned in the current market as it tends to outperform coming out of recessions. Mr. Corris uses bottom-up stock selection to fill the fund with attractively valued and fundamentally strong companies. In response to this year’s unique situation, Mr. Corris says the firm has increased emphasis on quality and developed a proprietary factor to look at each stock’s COVID exposure. Companies discussed: U.S. Concrete (NASDAQ:USCR); MYR Group (NASDAQ:MYRG); Renewable Energy Group (NASDAQ:REGI); Cathay General Bancorp (NASDAQ:CATY); Wintrust Financial Corp. (NASDAQ:WTFC); First Merchants Corporation (NASDAQ:FRME); Zions Bancorporation NA (NASDAQ:ZION) and Tesla (NASDAQ:TSLA).

Sector - General Investing

The Wall Street Transcript: Could you please start with a little bit about your role at BMO and an overview of the funds you manage?

David Corris: I’m the head of the disciplined equity team at BMO. Our team uses a combined quantitative and fundamental approach in managing our equity strategies. We manage the full suite of strategies covering U.S. large cap, midcap and small cap as well as international, Canadian and low-volatility equities. I’m the head of the team and oversee the platform, although my portfolio management responsibilities are focused on U.S. strategies. In particular, today I was planning to speak with you about the BMO Disciplined Small-Cap Value strategy, where my co-manager is Tom Lettenberger.

The Wall Street Transcript: Is your small-cap value strategy the one you see as best positioned in the current market?

David Corris: Yes, we think that for investors with a moderate time frame, small-cap value is best positioned in the current market. Large-cap growth has been leading the market for the last couple of years, and small-cap value has underperformed significantly. Our research shows that typically small-cap and value strategies outperform coming out of recessions. And what’s really interesting this year is that although the market has rebounded fully since the beginning of the year, small-cap value has still continued to lag large growth, not only on the way down but also on the way back up. That suggests the market and the economy have become somewhat dislocated. While the market has had a full recovery, investors are not yet pricing in a full sustainable economic recovery. And our view is that when investors start pricing in sustainable recovery from the recession, we’re going to see small-cap value leading the way. And we’ve started seeing that over the last month or so.

The Wall Street Transcript: Now, as we go into the fourth quarter and the coming election and continued COVID-19 headwinds, how are small-cap value managers meeting these challenges?

David Corris: We’re doing a number of different things with small-cap value. The first is that we always focus first and foremost on bottom-up stock selection. We are using our combined quantitative and fundamental approach to analyze the best stocks that we can find in every part of the market and to construct a portfolio that is filled with attractively valued and fundamentally strong companies with positive sentiment. We invest in a way that mirrors the risk exposures of the benchmark in a style-pure manner, meaning similar market caps, similar sector exposures, etc. Our approach is generally bottom-up and not top-down. With that said, there’s a lot that we’ve been doing to manage through this unique situation. Two things that I would highlight. The first is that in the first quarter this year, we developed a proprietary factor looking at each stock’s COVID exposure. We identified which companies would be outperformers in a COVID environment and which ones would be underperformers so that we could monitor that exposure in our portfolio. And that’s something that our clients have told us they haven’t seen many other managers doing, but it gave us a really powerful lens into how every stock was exposed positively or negatively to COVID. The second thing that we did is put an increased emphasis on quality and, in particular, supplementing our quantitative metrics with fundamental review in the belief that in a rapidly changing environment like this, the fundamental part of our process would be even more important. And we made sure that as we were following our investment process and our model scores. We were paying extra attention to balance sheet strength, default risk and the ability to survive these difficult economic times.

The Wall Street Transcript: What are your thoughts about the outcome of the election, a Republican versus a Democratic win? How might you be positioning for that?

David Corris: First, similar to my comment on COVID, our goal is to model and manage our exposure to the election outcome. We have built a proprietary factor to measure each stock’s exposure to Democratic versus Republican agenda items. So as I mentioned with COVID, that gives us the ability to understand how our portfolio is positioned relative to the election and which stocks are driving that exposure, with the ultimate goal that we are not trying to take a pro-Democrat or pro-Republican tilt in the portfolio, but we are trying to manage the exposure we have in the portfolio to make sure that there’s no unintended exposure in November.

The Wall Street Transcript: Can you share with us your sector allocations as we go into the fourth quarter and a look at a few of your favorite stronger stocks?

David Corris: Sure. I’ll tie this back to your question on the election. While we don’t want to take an intentional view on the outcome of the election, it’s clear that the election is going to drive a lot of the market behavior, and so sector views probably are tied up with the election. In particular, on the Democratic side, we think some of the areas that would benefit would be infrastructure and industrials, with the expectation that a Democratic win would lead to a large infrastructure plan as well as focus on renewable energy and pro-environmental policies. On the Republican side, we think that some of the trends would be lower regulation, lower taxes and lower minimum wage. These themes could benefit banks and consumer discretionary. I can give you a few names that tie into both the Democratic and Republican exposures. Two areas where we are overweight right now are industrials and materials. I mentioned infrastructure would probably benefit on the Democratic side. One name we like there is U.S. Concrete (NASDAQ:USCR), which is a leading producer of concrete, selling into commercial, industrial and residential channels. They should be a beneficiary of infrastructure stimulus, and they are a large national player. Another example is MYR Group (NASDAQ:MYRG). They provide specialized electrical infrastructure to U.S. electric utilities. And so as utility spending increases, as they upgrade or fortify the grid, we would expect MYR Group to benefit from that. I also mentioned renewable energy. An example in that space would be Renewable Energy Group (NASDAQ:REGI). Renewable Energy Group is the leader in producing renewable diesel. They’re very profitable, a company with a strong balance sheet, and they’re looking to expand into additional renewable markets. We would note that you typically don’t find a lot of small-cap value clean energy names, but we think this is a name that not only is attractive on its own merits but also thematically as the market continues to embrace ESG and responsible investing. On the Republican side, I’d mention banks because they tend to be a large weight in the small-cap value benchmark; however, a lot of our peers typically underweight them because they tend to be less liquid. One of the things that we’ve always built into our strategy is tight liquidity control, which allows us to build baskets of stocks to make sure that we get exposures to large parts of the benchmark that may have liquidity challenges, and banks would be a good example of that. We own a number of banks, ranging from Cathay General (NASDAQ:CATY) to Wintrust (NASDAQ:WTFC), First Merchants Corporation (NASDAQ:FRME) and Zions (NASDAQ:ZION), all of which help ensure that we have adequate bank exposure in the event that the banks recover from here.

The Wall Street Transcript: Beyond what we’ve already discussed, if we’re facing a contested election, how do you think the broader market will react?

David Corris: The market never likes uncertainty. Anything that creates a highly uncertain, highly politically charged environment, I would expect would increase market volatility. And in a situation like that, I’d expect there to be short-term choppiness until the outcome of the election is resolved. With that said, it appears that the economic recovery is likely to continue under either a Democratic or a Republican president, so our general view is that small-cap value is a good place to be. And some of these cyclical areas like industrials and materials should perform well over the medium term and wouldn’t be that dependent on who wins the election. While there would be short-term volatility, I think the most important thing for the market would be which party ends up being declared the victor.

The Wall Street Transcript: Can you share with us what you’ve been doing with your own money and any holdings you personally have?

David Corris: Sure, I’m happy to answer that at a high level. Consistent with what I’m talking about with the strategy, I have been putting some of my own money into value strategies. Our research shows that in addition to all the economic discussion we’ve been having today that value strategies have been so out of favor that they’ve become attractively valued relative to growth strategies, and my horizon tends to be a longer-term horizon. So given that horizon and given our views on the relative mispricing of value versus growth right now and the confidence we have that over the medium term the economy continues to recover, I believe that’s going to be priced into value stocks.

The Wall Street Transcript: How do you feel about gold and commodities amid all the uncertainty?

David Corris: We typically don’t hold many gold and precious metal stocks in our strategy. We understand that with all the government spending going on, at some point, that could cause inflationary pressures, in which case we would expect commodities could be a good hedge. But we internally debate why inflation could pick up or why deflation could stay here longer, and so we don’t have a really strong view as to whether we should be investing in gold or commodities right now. And regardless, those areas are typically a small part of our small-cap value strategy in general.

The Wall Street Transcript: You have a Harvard MBA. What are some of the best, most memorable lessons that you take with you and use even in your work currently? And if different, what are some of the personal lessons you’ve learned throughout your career?

David Corris: One of the lessons that I’ve learned that is especially important right now is the importance of diversity of thought. Our team has a fairly unique structure that combines quantitative and fundamental investing. One reason that I believe very strongly in that approach is that I do believe diverse thinking leads to better outcomes. I think in an environment like this, where there is heated debate as to whether the economy is getting better or not, whether interest rates are going to rise or not, whether inflation is going to come or not, it’s really important to have a diversity of opinion so that we can challenge ourselves. In fact, most importantly, I’d say one of the defining debates in the market right now is growth versus value, where growth has been in favor for so long. There are many people who believe like we do that value has been unfairly mispriced relative to growth, and therefore, it’s unusually attractive. But we also recognize that there are others in the market who believe that things have fundamentally changed, and with a low interest rate environment and a technology revolution that these growth multiples are justified. And in a situation like that, where there are such big differences in opinion, having diversity of thought on the team and the ability to challenge each other is really important. The other thing I would add is that it’s really important to have a long-term horizon when you’re making investment decisions. We believe that the proliferation of ETFs is leading to market dislocations happening more frequently and potentially lasting longer. That’s because people are not only trading stocks, but they’re also trading factors right now. One of the challenges that creates is that markets can remain inefficient for longer than we’d like. The flip side is it creates opportunity for long-term investors. And as we see all of the short-term-ism happening across the market, we think that one of the really important perspectives is to retain a long-term orientation. In my personal experience, the way you can really make money in the market is by resisting the short-term fluctuations and the short-term pressures and by looking at the long-term dislocations and opportunities.

The Wall Street Transcript: Are there any other mistakes that you currently see ordinary investors making?

David Corris: There is anecdotal evidence that retail investors were putting a lot of money into speculative stocks in the second quarter. And while in many cases they benefited from that, we still think that balance sheet strength and quality remain very important. The other mistake that we think some investors are making is over-extrapolating the certainty of some growth companies to take over their respective markets. We see lofty valuations in growth companies right now, bordering on speculative, and we believe it’s the combination of investors extrapolating low interest rates out far into the future as well as pricing in the success of many of these growth companies. We would just take a step back and say that investors over time have been known to over-extrapolate positive results and get ahead of themselves with growth investing. Within our team, we take a disciplined approach to growth investing where we combine fundamental strength with valuation. And there are certain companies in the market — for example, Tesla (NASDAQ:TSLA) — that we personally believe investors are pricing to perfection.

The Wall Street Transcript: Can you discuss more about how pandemic-related impacts might have affected your investment choices and what you see going into the future?

David Corris: We believed coming into the year that small-cap value was very well-positioned going forward. When the pandemic hit, it hurt small-cap value companies the hardest. A number of companies in our portfolio were affected. Some of them we believe the market got wrong and were still very strong companies, and others had their futures meaningfully changed by the pandemic for at least the medium term. And so we analyzed the balance sheet strength of all the companies in our portfolio to understand which ones would be able to survive a pandemic of varying lengths of time as well as where the outlook had changed significantly. In the latter case, we were willing to sell those names out of the portfolio. In contrast, where we thought the market had overreacted, we kept those names in the portfolio and even selectively added companies where we thought the market had overreacted to high-quality, small-cap value names.

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Disclosures

Performance data quoted represents past performance and past performance is not a guarantee of future results. This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested. All investments involve risk, including the possible loss of principal. Small-cap stocks are less liquid and more volatile than large-cap stocks.

The investment strategy’s benchmark is the Russell 1000® Index which measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000® represents approximately 92% of the Russell 3000® Index. The Russell 1000® Index is constructed to provide a comprehensive and unbiased barometer for the large-cap segment and is completely reconstituted annually to ensure new and growing equities are reflected. Investments cannot be made in an index.

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