This article by David Abitz considers how dispersions in valuations – as a result of pronounced market volatility and central bank easing – have created opportunities for active money managers covering both the long and short side of the investing equation.

Abitz is president and chief investment officer at Convergence Investment Partners, a boutique equities investment firm that manages over $400 million.

Small cap stocks have undergone a material correction relative to large cap stocks, and now trade at more attractive valuations, presenting a timely entry point for investors.

Over the past 12 months, the Russell 2000 has underperformed the Russell 1000 by more than 1,000 basis points. At the same time, year-over-year growth in earnings between large and small cap stocks have converged, showing a strong relative improvement for small cap stocks. Finally, we have seen the same convergence in the price-to-earnings ratio between small and large cap stocks when we examine companies with positive P/E ratios.

Over the past 12 months the PE of large and small cap have converged.  Small companies have dropped by nearly 10 per cent while big companies remained constant.  As of the end of Q1-2016 the PE (positive) of the Russell 2000 was 19x while the Russell 1000 was 18x.  One year prior, the Russell 2000 was 21x and the R1K was 18x.

In general, our firm is positive about where the US stock market and macroeconomic trends are heading. From higher employment rates and wage growth to increased housing construction, signs point to a positive overall turnaround. With this improvement in economic activity, we believe we are in the beginning stages of an economic upswing.

There is a flipside: we have experienced unprecedented central bank manipulation, which has created some excesses and potential adverse consequences within the equity market. For example, companies in the oil services and capital goods sectors have accumulated a high level of debt. That, from a fundamental perspective, has made these companies risky investments. On the bright side, the market has been distinguishing higher-risk/heavier leveraged companies - the so-called “zombies” – from higher-quality companies, which creates clear opportunities for active managers. The valuation dispersions have increased recently and the valuations of higher-quality enterprises are looking attractive again.

We have also experienced heightened volatility that began last year and has extended into 2016, which has created performance swings and uncertainty in investors’ portfolios. This volatility creates opportunities for fundamental stock pickers that can express their views by going both long and short. 

The high volatility in the market is creating a greater disconnect between stock price and company fundamentals, resulting in a “bumper crop” of good companies with undervalued stock prices and we are excited about this paradigm as greater disparity creates healthier opportunities for us to exploit.

In addition, we have seen a significant shift towards fundamental stock picking. This guides us toward more value-focused stocks along with companies that have the ability to grow their top-line revenue. But stock picking also needs to include overvalued companies whose share price could face downward pressure to varying degrees and because of varying factors.

Investors need to play both the long and short sides of the equation to capture the full opportunity. However, many investors ignore a whole half of the equation. In a game of cards, would you play only half of your hand? Of course not. It would put you at a competitive disadvantage, all but certainly assuring a loss. Similarly, if you believe a company has inferior fundamentals relative to their broader market, why punish yourself? In this scenario, a smart investor takes the short side of the stock, to help generate much-coveted alpha.

Investment managers adept at executing on both fronts should outperform long-only investors. From the short perspective, despite the low weight of our short positions – averaging only 25 basis points as of end of February – four of the top 15 positions contributing to returns during the 12 months through February were shorts. This fact speaks volumes to our strategy of active shorts. Among our bottom 15 laggards, there are no shorts. We reduce the risk by diversifying and tilting the portfolios towards the attractive fundamentals mentioned above. Among the 1600-to-1700 small cap mutual funds in the Morningstar universe, we are the only manager that has an active short strategy and is executing on it in a meaningful way.

The current market environment lends itself to allocations in the small-to-mid cap space. A few years ago, small-cap companies were richly valued when compared to their large cap peers. Over the past two years, those relative valuations have corrected to a place where the less-followed small-cap segment again looks attractive to us. The “under-coveredness” of the Russell 2000 is pretty shocking with an average of only six analysts per stock, compare that to the top 50 stocks in the Russell 1000 who average more than 30 analysts. The additional lever we have – the ability to employ a shorting strategy in this less efficient and under-researched space – gives us even more of an opportunities to add alpha for our investors.

In the Russell 2000, 537 companies had negative earnings as of February, while only 15 such companies exist in the S&P 500 – yet another proof-point of the small-cap investing opportunity.

This is not a market environment for concentrated stock bets, sector bets, or country bets. Small-cap companies source 85 per cent of their revenue from right here in the US, compared to 60 per cent-to-70 per cent for their large-cap counterparts. Do the math, and you find only 15 per cent of the sales from small-cap companies are dependent upon sluggish global growth, a significantly lower number than large caps and funds that employ a US equity strategies have a better chance at obtaining positive returns in today’s market.

The message is clear for investors to allocate to or increase exposure to small-cap equities. That said, no one can time the bottom and portfolios should still be positioned to weather the storm while simultaneously profiting from ongoing market volatility.