Morningstar Magazine - October/November 2017 - 74

Investors

Is determining quality and competitive advantage
within the small-cap area more challenging
than in the large-cap space, given that it's at least
perceived as being an area that's more susceptible
to competition?

Taylor: I've never thought of it as being more
difficult. We have literally thousands of companies
to pick and choose from. You do find a lot
of companies that don't meet the quality bar,
in terms of business model strength or
management quality, but we have more opportunities to sift through. As you get into bigger
caps, companies are well understood. They're
pretty high-quality companies to have
reached that size. There is more differentiation
in the small-cap space.
San Jose: Within small caps, it's actually probably
easier to rule out the lower-quality ones. In our
benchmark, the Russell 2000, there are hundreds
of names that we know won't even come
close to meeting the quality standard that we're
looking for. Within the S&P 500, you might
deem all of those companies as being investable
at some point in the business cycle, whereas
in our universe, there tends to be a cleaner line,
especially among the smallest names.
Adams: As for competitive advantage, the
companies certainly can have scale within the
product categories where they compete.
They don't dominate an entire sector or an entire
industry, but if they dominate the particular
market niches they're in, that can give
them a strong competitive advantage even
relative to a much larger company.

A lot of the quant models end up getting
out of a factor at exactly the wrong time.
Our longer-term perspective provides the opportunity to zig when the market zags.
Don San Jose

Opportunities Ahead
What is the state of valuations in your opportunity set?
And how should investors set their expectations?

San Jose: The market's valuing these small-cap
stocks at pretty high levels, especially compared
to earnings growth that's moderating a bit. People
have to be cognizant that a lot of these stocks
are priced for perfection. Even if you're hitting your
target, that actually may not be enough.
Adams: Relative to large-cap stocks, the valuations
look reasonable. But what we're seeing in

74

Morningstar October/November 2017

particular this quarter is that larger-cap stocks
appear to be benefiting from an improving global
economy. This disproportionately helps larger
companies that have more international exposure.
Whereas for smaller-cap stocks, a lot of the
policy changes that could have benefited them,
like tax reform, infrastructure spending, and
deregulation, haven't played out. We've lost some
confidence that those things will happen,
and it's made for a more difficult environment

for the small-cap stocks. That said, it creates
opportunities for us. Overall, I think 2017
is going to be difficult for the small-cap market,
especially relative to larger caps, but longer
term, we still like smaller-cap stocks.
Taylor: The thing to be worried about is how far
we've come this fast. If you look at the period from,
let's say, the end of 2011, the Russell small-cap
indexes have compounded at about a 14% annual
rate. But the average small-cap company



Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2017

Contents
Morningstar Magazine - October/November 2017 - Cover1
Morningstar Magazine - October/November 2017 - Cover2
Morningstar Magazine - October/November 2017 - 1
Morningstar Magazine - October/November 2017 - 2
Morningstar Magazine - October/November 2017 - Contents
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