Fundametrics® Small Cap Equity Q4 2016 Performance Summary and Observations

Stock Chart
Written by J. Cannon Carr, Jr., Jeffrey P. Moeller, CFA on January 11, 2017

Performance Chart

  • The Fundametrics® Small Cap Value strategy returned 14.71% during 4Q16, outperforming the Russell 2000 Value Index by 64 bps and the Russell 2000 by 588 bps.
  • The mainstays of our research process excelled this quarter: 1) Our Alpha Composite generated a convincing 600 bps of outperformance vs. our equal weighted universe, driven by the strength of our traditional value factors, and 2) Our Financial Warnings Risk Overlay effectively removed stocks with higher risk profiles, generating a strong 700 basis point spread between the “pass” and “fails”.
  • While value’s strength played well to our multi-factor model, we didn’t outperform the Value benchmark as much as we would typically expect due to the dominance of a single factor: Price to Book. Diversification across factors and sectors was therefore not as effective as a simple strategy of being aggressively overweight banks at the industry group level or Price to Book at the factor level.
  • Beyond our model, we note a rising expectation that corporate taxes will be lower in the new administration, benefiting earnings. This will likely have minimal impact to our overall analysis and ranking system, as we strive to neutralize tax accounting and speculation by using a static tax rate or pre-tax profitability in our analysis.
  • In December, using our Fundametrics®All-Cap model, we moved from an overweight position in small cap to a neutral one, vs. large cap stocks. 

4Q16 Performance Analysis

CornerCap’s Fundametrics® Small Cap Equity Composite was up a strong 14.71% and outperformed the Russell 2000 Value by 64 basis points this quarter.  For the year it trailed the Russell 2000 Value Index by 147 bps, which is only the 2nd calendar year in the last decade that the strategy has underperformed.  As a result, its 100% rolling 3-year return batting average remains intact since the composite’s inception in 2006.

Stock selection has historically been the strength of the Fundametrics® Small Cap strategy, and it accounted for all the alpha in the 4th quarter.  Attribution compared to the Russell 2000 Value Index shows the strongest selections were in Industrials, Healthcare, and Financials, which were partially offset by underperforming selections in Basic Materials, Energy and Software within Technology. Allocation decisions were neutral if the -52 basis points attributed to holding a 2.28% average cash position is backed out. 

Despite the relative outperformance, we note that it was difficult to materially beat the composite’s benchmark this quarter without making an aggressive bet in banks or on one factor (Price to Book).  Banks in the index were up 29% and the next best performing sector of energy was about a 1/3 lower at 20%.  Although Banks are CornerCap’s largest industry group weighting in the fund at 17.5%, the index weight is 23%.  This underweight caused a drag in relative performance.  Positive allocation decisions came from underweights in Utilities and REITs. 

 Alpha Composite Analysis

To understand the Fundametrics® Small-Cap Value strategy it is best to review the factor exposure of the Alpha Composite. Two-thirds of the attributes in the Alpha Composite consist of fundamental factors in Value and Relative Value, with the balance comprised of a mix of factors across the broad styles of Growth, GARP, and Momentum. “Buy” rated stocks are the top 30% of the investable universe with the best fundamentals, “Holds” are the next 40% and “Sells” are stocks with the weakest fundamentals. Over extended periods of time “Buys” outperform the “Holds” and “Holds” outperform the “Sells”.

Value was the top performing style in the 4th quarter followed closely by high dividend yield.  With such a strong performance from Value the Alpha Composite was effective with “Buys” beating the overall equal weighted universe by 600 bps (Chart 1). 

Chart 1

Other styles like Growth, Quality and Momentum did not experience the same return profile (Chart 2).  The fourth quarter highlighted an environment where using diversifying styles in the alpha composite actually detracted value.  Our investment team is comfortable with this.  Over a market cycle Value will not always lead and the diversification of the Alpha Composite improves the consistency of excess returns, in effect giving the portfolio a better information ratio and batting average.   

Chart 2: Alpha by Style

Financial Warnings Overlay

The Financial Warnings Overlay, or Risk Composite, works in conjunction with the Alpha Composite by helping to identify and avoid stocks that have characteristics of excess risk.

The Fundametrics® Small Cap strategy’s performance benefited this quarter from the effectiveness of the Financial Warnings Overlay. Companies that ranked well in the Alpha Composite and deemed “Safe” to purchase by Financial Warnings outperformed stocks that “Failed” by over 700 bps (Chart 3). 

Chart 3

You’ll note that the “Avoid” group generated the worst returns.  The “Avoid” group contains stocks that are getting close enough to the “fail” score that they are purposely excluded from new portfolio purchases—it is essentially a buffer.  We will not buy a stock with this warning, but we will continue to hold an existing stock at its current weight.  “Avoid” stocks in the portfolio did detract from returns compared to our research.  

Corporate Tax Policy

The United States has the largest corporate tax rate among developed countries and the new administration has expressed a desire to lower it.  We speculate this has helped fuel some of the positive sentiment in small-cap stocks, but will small companies benefit that much more?  To answer the question let’s look at the median income tax rate for companies in CornerCap’s small-cap investable universe compared to those in large-cap universe.

Table 1

Large companies are currently paying a lower rate and stand to lose many of the deductions that allow them to have the lower rate.   It is reasonable to assume Small-cap stock earnings would benefit from any overall tax rate reductions by an average of 13% more than large-cap earnings. Although this looks like a substantial positive to small cap stocks, a lower rate will not likely have a direct impact to the Fundametrics® Small Cap Equity portfolios.  At CornerCap we prefer not to reward companies with lower tax rates and use a static tax rate or pre-tax profitability in our analysis.  As a result, the models capture the ancillary benefits of a lower tax rate with any resulting business re-investment. 

Relative Valuation of Small Caps

With the rally in small caps, investors are often asking, are small cap valuations stretched.

Within US equities, we monitor the relative attractiveness between large cap stocks and small cap stocks through our All Cap Fundametrics® model. In December, we moved to a neutral weighting between the two, from an overweight to small caps (in place since February 2015).

Importantly, we do not use our model for an absolute signal on valuation for small caps or large caps. It is a relative call.

Current Positioning

This quarter offered a good illustration of how the Fundametrics® model performs in environments dominated by top-down sentiment. With expectations that the new administration may bring better growth, less regulation, and higher rates, it’s not a surprise that sectors like banks and energy have surged, after a period of being beaten down.

In such markets, the top-down implication is that a single factor or limited group of factors predominates (e.g., Low or High Beta, “Biggest of the Small Caps”, or Price to Book), which can cause our multi-factor model to lag the Russell 2000 Value Index (which is cap-weighted and defined by price to book).

This quarter, we eked out a “win” relative to the benchmark nonetheless, primarily due to the Risk Overlay. But the larger point is that we are comfortable with our multi-factor approach, which has driven superior returns over longer periods, rather than a heavy emphasis on one particular concept.

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Past performance is no guarantee of future results, and all investments are subject to risk of loss.  

 

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