This overlooked market could be the next big winner

Transcript:

Caroline Woods
Joining me now, Brett Meyer, Head of Capital Formation at Towle & Co. Brett, great to have you on. Thanks so much for joining us.

Brett Meyer
Pleasure to be here. Excited to chat with you.

Caroline Woods
Yes. And we're chatting about small caps. Large caps have been dominating certainly this year but for what, more than a decade? But why is now the time for investors to pay attention to small caps? Fill us in.

Brett Meyer
Yeah, it's a great question. And you're right, it's been, almost basically two plus decades of pretty substantial outperformance by large caps relative to small caps. Listen, I'll give you two kind of scenarios where we really think that small caps and particularly small cap value, where we focus at all and co could really outperform going forward. The first one I'll give you is kind of a bullish scenario just overall for the economy.

Brett Meyer
Look there's incredible positive tailwinds from the adoption of artificial intelligence. That is starting to come through the economy. And we think that particularly for smaller cap companies that tend to have lower profit margins, that could be actually sort of a, a stealthy, tailwind to their margins on a go forward basis. And then a lot of people are not focusing yet on that one big, beautiful bill, but that could be, upwards of a 1 to 1.5% tailwind to GDP next year.

Brett Meyer
And so overall, we see pretty tremendous earnings growth going into next year. Our portfolio if we use capital IQ and look at the weighted average earnings per share growth estimate for next year is actually 30% which is notably above any large cap benchmarks etc.. So, you know, that's that's a scenario that we could really see playing out where small cap and small cap value really starts to outperform going into next year.

Brett Meyer
The other scenario that I'm sure is on everyone's mind is some kind of a rewind of the 2000.com bubble unwinding. The AI trade has been remarkable. And, a lot of these businesses are, you know, quite, quite incredible. Certainly some of the large cap mega-cap names, you know, have tremendous profit margins, etc., but there are many signs that would point to the fact that, on a relative basis, we're more stretched from a valuation perspective between large cap growth and small cap value than we were in 2000.

Brett Meyer
And, look, trying to figure out a catalyst for when that unwind might happen is, you know, that's that's really difficult. With foresight in hindsight, I'm sure it will become very obvious why it happens. But if there is a trade away from the large cap mega cap shoes, as that starts to move, you know, that capital comes out of the market, you know, it's going to look for cheap stocks elsewhere.

Brett Meyer
2000 to 2007 was a golden era for small cap value investing, and Tal had basically its best 5 to 7 year run. And so we see that potential as a possibility as well. So those are kind of the two scenarios where we could really see small caps and small cap value in particular, start to outperform.

Caroline Woods
I'm curious what your outlook for large cap stocks is. Do you see a world where small caps outperform without hurting the big names, or does it come at their expense?

Brett Meyer
Oh yeah, that's a really good question. You know, look, I think in the first scenario that I mentioned kind of more of the bullish one. I do think that actually small caps outperform large caps. But but maybe not by as dramatic an amount. You know, maybe small caps go up. You know, sort of twice as much, as large caps, you know, sort of double double the S&P 500.

Brett Meyer
You know, in comparison to the bubble burst back then. I mean, I guess you can't even calculate a percentage difference because, you know, the S&P was down, I think, from peak to trough, 50 or 60%. And small caps ended up being up, you know, 50 to 70% during that same time period eventually. So, you know, there are kind of two scenarios, one where it's, you know, maybe just a more muted differential in performance and then maybe one if there is truly a move away out of the IE stocks in the large cap stocks, where you could see small caps dramatically outperform, and generate absolute returns where maybe a lot

Brett Meyer
of the large caps, have sort of, you know, negative performance for a period of time.

Caroline Woods
So then my follow up to that is if small caps start to lead the market, what does that mean for the direction of the overall market. Because we know what's really powered the market higher. Are these mega-cap tech names?

Brett Meyer
Yeah. No. Look I think if small caps lead and into next year, that's actually going to be a strong sign for the overall market. I suspect that that means that large caps will come along for some of the ride as well. That's probably the most bullish scenario is it's actually small caps continue their leadership. Although this is an interesting point.

Brett Meyer
If you look at a lot of the, largest weightings in just the broad Russell 2000 benchmark, many of them are AI derivative plays. There's a number of nuclear, small reactor related companies. There's a number of quantum computing stocks. There's a number of drone companies, that make up the top of the Russell 2000. And so there is a little bit of this derivative trade to what's been going on in the large caps.

Brett Meyer
So that's going to be kind of fascinating to see. I think what we're really hoping to witness is a broadening out of small cap leadership. You know, that some of the names that we own that represent more of, as we call it, the move economy, you know, basically moving goods and services, we own a lot of transportation names, a lot of energy related names, etc..

Brett Meyer
If the real economy comes back and you see a broadening out of the Russell 2000 overall, then I think it's actually very bullish just for the overall markets.

Caroline Woods
Okay. So let's dig into that strategy a bit more. You have TCV, the small cap value strategy fund. Where do we find some of these small cap value opportunities.

Brett Meyer
Yeah. So we're excited to have launched an active ETF. TCV, as you mentioned. And it carries the exact same strategy that Toland Co has used for 44 years, of small cap value investing. You know, look, we're we're fairly equally weighted across our portfolio in terms of the names that we have. I mentioned a few of them already, kind of, you know, transportation, energy.

Brett Meyer
I would particularly highlight oil refiners, as a kind of a big part of our portfolio if, our, viewers are familiar with how oil refiners tend to kind of work, there's something called a crack spread that basically, enables the these companies to sell the refined oil product at a higher rate to the end, you know, users, gas stations, etc..

Brett Meyer
And typically when the economy is doing really well, that crack spread widens out and it enables the oil refiners to perform very well with their underlying earnings. And so, you know, that's a theme that is definitely expressed in our portfolio today and one that we're excited about heading into, to next year, especially if we continue to get some of the, the real economy moving again.

Caroline Woods
Okay, so, Brett, as we head into year end and think about 2026, what's your advice for investors thinking about how they should be positioning their portfolios?

Brett Meyer
Yeah, it's an excellent time to to be thinking about that. You know, we I think honestly some of the the recent difficulties in the market that we seem to pass more or more recently, was, you know, due to tax loss selling, which often happens in kind of the November early December timeframe. So now I think the market is trading a bit more on fundamentals, too.

Brett Meyer
And, people can really think about, you know, where where do we go from here? Look, what one thing I would mention is small caps and small cap value in particular is one of the most under owned asset classes in the market today. I think literally, small cap value ETFs, mutual funds make up three, 3 or 4% of the overall investments out there.

Brett Meyer
You know, from our perspective, you know, now is the time to be an independent contrarian thinker and just start moving some money, at least into things that would diversify away from large cap growth. Small cap value is an excellent, excellent diversification agent. And, you know, we really think that it's always difficult to kind of, you know, call these reversion to the mean contrarian moments.

Brett Meyer
So honestly, the best way may be just to think about sort of slowly but surely putting some money to work in some different asset classes and, you know, take away from what has worked for two plus decades.

Caroline Woods
And just finally, I have one quick question, because you were referring to it as an AI bubble, do you actually think that we're in a bubble? And if and when that unwind happens, if it bursts, what do you think that actually looks like?

Caroline Woods
I just want that. Yeah. It's a it's it's I guess it's the million dollar question that everyone is kind of asking themselves, I think as, admittedly a firm who focuses on, this the small cap value space. I don't think we're in a great position to opine for sure on whether we are in a bubble today. What I can tell you with certainty, if we look at financial history and human psychology, is that at some point it will become a bubble and it will go too far.

Brett Meyer
And then there will be some kind of an unwind. I think I suspect it will be in more of the sort of you know, negative earnings companies and sort of the stocks that everybody thinks could be huge in 10 to 15 years, as opposed to maybe some of the mega-cap names to it to a certain extent.

Brett Meyer
But, at some point, I think a day of reckoning will come. How orderly or disorderly that, unwind is, it remains to be seen, and when it occurs. But, you know, I think as value focused investors and mean reversion investors, we do believe that at some point there will be, you know, kind of a time for other asset classes to shine.

Caroline Woods
Okay. We'll leave it there. Brett Meyer, Head of Capital Formation at Towle & Co. Thank you so much for sharing your insights on small caps.

Brett Meyer
Yeah, thanks for having me.