One of the most important qualities of being a value investor is patience. Value stocks often produce “lumpy” returns—doing nothing or even declining for long periods before experiencing prodigious rallies. This has been especially so lately for much-ignored small-cap value stocks.
In the past three years, large-cap growth stocks in the Russell 1000 Growth Index (.RLG) have produced strong 16.9% annualized returns versus a meager 6.5% for small-cap value companies. Yet academics have found that small-value stocks beat more popular growth ones if you can wait out the fallow periods. Jeff John, senior manager of the American Century Small Cap Value fund (ASVIX), employs a quality tilt—favoring companies with strong balance sheets and consistent free cash flow—to improve his portfolio’s results in the meantime.
“Quality has been the hallmark of how we invest,” says John. “We believe that quality over long periods of time will generate excess returns with lower volatility of returns.” The fund has beaten 95% of its peers—and its benchmark—with an 8.4% annualized return in the past five years, but with similar volatility.
Since the 2008 financial crisis, skittish investors have had little desire to own weak, debt-ridden companies. “With small companies, when you have an adverse event, oftentimes that means permanent destruction of capital,” John says. “So strong balance sheets are incredibly important.”
John and his co-manager, Miles Lewis, are part of American Century Investments’ well-established value manager group. John joined American Century as an analyst at the small-cap value fund in 2008. He became co-manager in May 2012, and then took over the leading role when the shop’s 16-year small-cap veteran, Benjamin Giele, retired at the end of 2014. Lewis joined American Century as an analyst in 2010 and stepped up as the small-cap fund’s co-manager with Giele’s retirement.
The managers have three supporting analysts. Lewis is based in New York, with another analyst specializing in technology in California. John and the rest of the team are in American Century’s Kansas City, Mo., home. Being spread out helps the team find more small undiscovered companies.
As of Sept. 30, financial-services stocks were the fund’s largest sector, representing 38% of the portfolio. “Bank stocks are pricing in a recession today,” Lewis says. “If a recession doesn’t happen—or if it happens and it’s not as bad as what’s being priced in, which we would argue is the case—then there’s a significant amount of upside over three to five years.”
Valley National Bancorp (VLY) is a favorite holding. Lewis says it has a good balance sheet and one of the most conservative loan-underwriting policies in the industry. Historically, the company has avoided taking on too much risk, “breezing through the financial crisis in terms of their credit costs,” Lewis notes. CEO Ira Robbins is wringing further operational efficiencies out of Valley by investing in technology, reducing head counts, and shrinking the bank’s branch count significantly.
“These initiatives are going to help Valley grow earnings over the next couple of years irrespective of the interest-rate environment,” Lewis says. Even if the economy stumbles and there’s another financial crisis, Valley’s strong loan underwriting will enable it to be a haven in the bank sector, according to Lewis. The stock trades at just 11 times its 2020 earnings estimates and has a 4% dividend yield, he adds.
The fund also favors insurers such as ProAssurance (PRA), a medical-malpractice specialist. “The payouts from the juries in these medical-malpractice cases are getting bigger, and that’s pressuring the earnings of the malpractice insurance industry,” Lewis says. “So, you might say, ‘Well that’s a really bad thing,’ but we have begun to see insurance pricing increases for several consecutive quarters as a result.” As premiums increase and weaker rivals go out of business, ProAssurance should emerge triumphant when the dust settles, he says, because it has “the strongest balance sheet of any malpractice underwriter in the country.”
Perhaps more surprising is the fund’s 13% allocation to tech stocks. “We’ve found over time some pretty substantial success in buying legacy technology companies that were once viewed as growth darlings but have seen growth decelerate over time,” John says. Such companies can still have strong management teams, balance sheets, and cash flow, but have been “dismissed by growth investors who are going to chase the next great unicorn.” They often end up being acquired by private-equity investors seeking steady investments after the fund purchases them, John says.
One tech pick is Teradata (TDC), a database warehouse and management company. Its stock has declined recently because the company has been transitioning to a subscription-based sales model from an upfront purchase model, John says, temporarily slowing revenue growth. “Customers, instead of buying a big lumpy piece of hardware and software upfront, are now spreading that over a longer-term contract. Investors look at that and say, ‘Boy, that company is really seeing a deceleration in sales.’ ” But John and Lewis are patient enough to realize that investments in such misunderstood companies eventually pay off. And their focus on quality should insulate them until that happens.
|For more news you can use to help guide your financial life, visit our Insights page.|