The large-cap US stocks, particularly those like the FAANGs, garnered much attention after heavy share price falls in the final three months of 2018. The Russell 1000, a proxy for large-cap USA, declined almost 14% from October to December; the NASDAQ 100, the tech heavy index, ended the period down nearly 17%.
But it was further down the capitalisation chain that really felt the ramifications of the stock market correction. The Russell 2000, a proxy for the small-cap universe, shed over a fifth of its value in the fourth quarter.
“When the big stocks act poorly, ours act really, really poorly,” says William Hench, manager of the Morningstar Bronze-rated Legg Mason Royce US Small-Cap Opportunity fund, which lost almost 23% in the fourth quarter alone in sterling terms.
“Usually, when things look scary, you’re going to hold onto your Google and your Apple and all those wonderful companies and you’re going to get rid of all these little things that may or may not work out.”
While it may be painful at the time, for Hench, it is his fund’s time to shine. During those final three months of the year, he set about taking profits from his hitherto best performers and deploying the cash where he saw opportunities.
As a value manager, Hench says his fund makes its money after difficult market periods. As a result, he made sure his portfolio was “as cheap as we can get it and, just as importantly, make sure we’re positioned to capture maximum upside when the market turns”.
As a result, as well as seeing 21 of his companies taken over through mergers and acquisitions, he spent much of the fourth quarter “selling those things that have done the best”. “That becomes fodder to buy new names.
“We’re good at building positions in very bad markets and it’s always fun to watch people who are new to our group going ‘is he really buying that? Why’s he buying that, shouldn’t he be selling that?’”
On the buying side, there were two main areas of focus for the fund – technology and infrastructure.
Small-Cap Value in Technology
Being a small-cap guy, Hench’s exposure to technology is focused on things like components manufacturers and chip makers.
Before October hit, he had already taken profits from some of the semiconductor names that had “had a great run” but were likely to see a slowdown in their global supply chains and demand. But they were heavily sold off in the fourth quarter, so Hench had a change of heart.
One of the companies that went out before quickly coming back into the portfolio was Kemet (KEM), which makes ceramic connectors used in cars and magnetics and sensors for smartwatches and military vehicles. Hench says it’s “a wonderful little company that has businesses all around the world.”
He initially bought into a management turnaround at a “very distressed situation”. After fully participating in the strong part of the cycle, it had trebled in the 18 months to mid-July to an all-time of high $29, leading to profit-taking.
It recently reported “these terrific numbers”, but the stock price slid around a third. “It was probably the first time I listened to the same conference call twice in a row because I thought I had obviously missed something,” he explains. Hench then took the opportunity to pick up some more shares – “it was an easy add-back”.
Elsewhere, he still likes some of the semi-conductor equipment names, like United Technologies (UCX) and Rudolph Technology (RTEC). “These are companies that we think will participate in what continues to be a really good environment for the type of technology that we invest in.”
Previously – think back to the dotcom boom and subsequent bust – these firms’ list of clients were very much US-focused tech counterparts. Now, they’re selling to car makers in Europe and Japan as well as robotics firms. “Semi-conductors are in everything now. The global market has changed and these companies are much more diversified,” Hench adds.
Infrastructure Plays
One area in the US Hench is very much positive on is infrastructure. He had bought in quite early initially, buying directly after Donald Trump was elected as President. “We thought we’d get it when the new administration came it. It never happened, but it’s just a delay – it’s inevitable.”
The US desperately needs new infrastructure, from new roads and bridges to drainage systems. “There’s been a lack of new spending and, also, a lack of maintenance.” Some reports say as much as 20% of fresh water in the US leaks out before it even gets to its destination, he says.
While some states, like California and Texas, have upped spending on infrastructure already, there’s been little big programmes coming from the Federal Government. That’s something Trump will want to change – and it’s an area he’s likely to find support for from Democrats.
Hench recently bought Insteel (IIIN), which makes structural steel needed to make bridges or underpasses. An indirect play on infrastructure would be Meritor (MTOR), which makes components for trucks and construction vehicles.
In order to add more infrastructure, Hench says he sold down his holdings in both aerospace and defence.
