FAM Small Cap Fund Portfolio Manager, Andrew Boord, shares his thoughts on small-cap valuations.
We definitely think small caps are on average trading at much lower valuations than large caps. We also regularly remind ourselves, and others, that historically small and large caps have taken turns leading the market, often for 10 to 15 years at a time, so eventually small caps will outperform large caps. The big difference in valuations doesn’t mean relative performance will change tomorrow, but it does improve the odds of small caps outperforming large caps over the next 5 to 10 years.
That said, we at Fenimore focus 90% of our efforts on about 200 small businesses. We know very little about the other 1,800 lower quality small caps, and probably even less about macro topics, which is why we do not speak to the valuation of the Russell 2000, and instead focus on the valuation of our small cap investible universe. I would rather talk about the industries and businesses we intimately know—Russian fish, new floor offerings, risk of office loans, or the pricing of appliances because it impacts a new idea we’re evaluating—than employment trends. This is why it’s always a challenge to reconcile what we know or are hearing from our companies with the macro questions of the day.
Andrew Boord
Portfolio Manager, FAM Small Cap Fund
Rather than comment about Russell 2000 valuations, we think about the valuations of the 27 companies we own stock in and the other 10 to 20 we might like to invest in eventually. When we think about our positions, valuations feel reasonable overall, maybe even low-ish, but it varies by company. Below is a quick summary of our 10 largest positions (as of 1/31/24), with particular focus on current valuations versus the prior 5 to 10 years.
- CBIZ (CBZ) is trading at a higher-than-normal valuation. Our hope is that EPS growth stays high and they grow into it.
- ExlSerivice Holdings (EXLS) valuation was on the high side of normal about a year ago but has declined considerably. Using FactSet data, the stock is about 19x forward P/E. Relative to the past 10 years, this is in the middle of the range.
- Colliers International Group (CIGI) is very diverse by property type, service type, and geography. That said, soft U.S. office leasing and property sales brokerage is a headwind. So, the multiple is middle of the road versus history, while earnings are a little depressed (probably by 15 to 20%) by the lack of office transactions.
- Pinnacle Financial Partners (PNFP) is trading around 1.7x tangible book. Clearly, investors fear bank stocks today. Outside of now and the COVID pandemic, the stock regularly traded around 2.5x tangible book.
- Trisura Group (TRRSF) is only trading for about 11x earnings, which we view as cheap.
- Chemed Corp. (CHE) is not particularly cheap, although it rarely is, at about 25x forward earnings. Over the past decade, the stock has regularly traded between 20x to30x. I would argue that EPS are a little depressed right now as the hospice business is still rebounding post-COVID, but even if true, the stock isn’t cheap.
- Choice Hotels International (CHH): Investors are concerned that CHH may buy Wyndham, adding debt and integration risk. As a result, CHH is trading around 18x forward P/E, which is on the low side of normal versus history.
- Nomad Foods (NOMD) struggled with supply chain issues especially after Russia invaded Ukraine. Higher interest rates are a headwind too. They are starting to come out of this transition period, as you can see by the recent stock move. However, it still appears to be trading at 9x to 10x forward earnings.
- Brookfield Infrastructure Corp. (BIPC) is a dividend stock, so I would argue the best way to value it is by dividend yield; our thesis is that long-term return will be the yield plus the growth rate of hopefully 5% to 9%. Yield-sensitive stocks sold off as interest rates rose. Today, BIPC yields about 4.4%. History is a bit limited, but in the past the stock usually yielded 3% to 3.7%. I would argue that the stock is cheap.
- Landstar System (LSTR) is a truckload broker—a fabulous, yet volatile business. Demand goes through cycles tied to GDP growth, while supply goes through its own cycles tied to truck builds. In the past few quarters, they have been in a definite down cycle, which is the deceleration phase after the post-COVID boom. While the multiple may not look cheap, EPS are quite depressed. The stock should do quite well when the next upcycle inevitably occurs.
I should add that during the past 13 months, in the FAM Small Cap Fund, we trimmed CBIZ slightly while adding to Colliers, Pinnacle, Trisura, Choice, Nomad, and Brookfield Infrastructure Corp.
Fenimore was founded on and remains true to a value-oriented investment approach focused on individual companies. This value investing philosophy has been applied by the firm in all environments, regardless of market cycle stages, for the last 50 years.
This gives us confidence that applying our traditional focus on valuation to the small-cap equity universe is a worthwhile endeavor. Of course, the concept of “value” does not exist in a vacuum: some stocks are “cheap for a reason.” The quality profile of a company is integral to our assessment of overall valuation.
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