Seeking Desert Island Companies in US Small Caps

A historical investigation of the performance of fast-growing companies in the small cap area shows higher returns relative to benchmarks over time. Colin&Cie sees long-term opportunity in this market segment and therefore holds an integral part of its asset allocation in mid and smaller cap companies.

However, the current environment is characterised by geopolitical challenges, rising inflation and interest rates. Investors generally don’t like such high levels of uncertainties and reduce exposure accordingly in areas exhibiting higher risk profiles such as the small cap growth segment.

In light of the current market weakness, Colin&Cie talked with Drew Beja, portfolio manager of the Granahan US Focused Growth Funds, about his strategy in an interview. We discussed the challenging market environment and its effect on the small cap universe, what to expect for the reminder of the year as well as the longer-term implications.

Drew Beja, Portfolio Manager at Granahan, Boston, USA

Question Colin&Cie: 2022 has so far been a challenging year for equities in general. Inflation and interest rates are rising and the war in Ukraine is an additional concern for investors. What were the consequences for the smaller companies, and especially the growth segment?

Reply Drew Beja:
When there is significant fear and interest rates go up, investors typically discount small cap growth equities more than they would in a lower rate environment. In essence, investors are demanding a higher expected return to compensate for higher interest rates and more uncertainty regarding future earnings. Since small caps, in particular those that we own, are growing earnings faster than large caps, the smaller companies' indices have generally underperformed larger cap indices this year.

Question Colin&Cie: What makes the US small cap universe so special and why should one consider an investment in this area?

Reply Drew Beja:
The USA has many small/mid-sized companies that are underfollowed, under-owned, and can grow at high rates. The Granahan Focused Growth strategy focuses on small/mid-sized US companies that we believe are secular growers. That is not to say these companies are immune to economic cycles – they aren't, but their ability to post high growth rates are largely within their control through most intermediate and long-term periods of time.  

During the 15-year life of the US Focused Growth strategy and throughout my career, we’ve repeatedly seen the merits of a sound and consistent actively managed investment process, a well-diversified asset allocation strategy, and not trying to time the market. Market inflection points are difficult to gauge, so it’s important to keep longer-term investment objectives in mind and stick with those allocations in good times and bad. The proof is in the compounding of absolute and relative returns of a strategy over time. Using this lens, I am pleased with the returns we have been able to generate for our US Focused Growth clients since its inception in 2007.

Question Colin&Cie: Is there any reason to be concerned from an investor’s view?

Reply Drew Beja:
Legendary investor Warren Buffett advises to "Be fearful when investors are greedy, and greedy when investors are fearful." While the past ten months have been a rough period for secular growth equities, such downturns are common. I’ve included a long-term chart that shows the periods of sharp downturns and high volatility throughout the life of the strategy, like the financial crisis in 2008 or more recently the COVID-19 pandemic in 2020.

Despite the recent volatility, we believe the companies we are invested in are strong and have excellent long-term prospects. Meanwhile, valuations are also down materially, and the portfolio's forward expected return over the coming years is compelling.

Question Colin&Cie: What is Granahan's "US Focused Growth" strategy? Your investment philosophy obviously focuses on "Desert Island Companies". What exactly does that mean?

Reply Drew Beja:
As noted above, the Granahan Focused Growth strategy invests in small/mid-sized companies that are secular growers. In particular, we seek companies we believe are "Desert Island Worthy" – that is, if one went away to a desert island for 5-10 years, when they returned, these companies would be much, much larger entities. The US Focused Growth strategy owned companies such as Tesla, Shopify, LinkedIn and Concur in their early days as public companies. We seek to give investors ownership in companies we believe will be household names in 5-10 years. We then value companies based on our risk/reward methodology.

Question Colin&Cie: Is the current environment unique or are there any historical precedents? If history serves as a guide, what conclusions/expectations can be drawn for the future?

Reply Drew Beja:
The writer Mark Twain is believed to have said, "History doesn't repeat itself, but it often rhymes.” The same could be said about investor psychology as well, particularly pertaining to growth equities. As noted above, when interest rates rise and investors are fearful, investors tend to shun growth equities. I've been analysing and investing in small/mid-caps since 1985 and managing the Focused Growth strategy since its inception. As seen in the graph below, the Focused Growth strategy has had 7 significant downturns since it began. These have been periods in which investor fears have risen above the fold, similar to the current environment. And while those fears don't exactly repeat themselves, they often rhyme. Secular growth equities are down significantly and are discounting such fears to a large extent. What I do know is that these periods and downturns happen, and this too shall pass. If history serves as a guide, the current environment offers an excellent opportunity to capitalise on promising long-term prospects.

Question Colin&Cie: There is no such thing as “crystal ball” to predict the future, but what is to be expected within the small cap space and how do you manage your strategy through the next month/coming years?

Reply Drew Beja:
You are correct. None of us have the magic crystal ball to predict the future. Thankfully, the Focused Growth philosophy and process don't require us to.  The desert island worthy, secular growth companies will capture a disproportionate share of GDP over the coming years. If we identify such companies and invest in them when risk/reward is attractive, we will be able to generate higher returns in comparison to the broader market over intermediate and long-term time horizons. Our baseline assumption is that the odds of a recession or slowdown have gone up (if we’re not already in one), which we incorporate into our bottom-up scenario and valuation analysis.

Today we have on the one hand higher rates and a cloudier macro view, but on the other hand, a significant contraction in valuations. Where does this net out? All things considered I believe that the expected returns for the Focused Growth portfolio appear quite attractive. That is not to say equities can't go lower. Of course, they can. There is no way to know when sentiment will shift from negative to neutral or positive, but the team at Granahan will continue to stay the course. Finally, as always, I encourage investors to adhere to their strategic asset allocation plans.