Small is Beautiful, Especially Now

Playing Defense with Offense

Throughout various market cycles, U.S. small cap growth has been a top performing asset class. The Redwood Team believes that given the current market environment, investment in small cap stocks is timely as this asset class is poised for a period of outperformance.

  • Global economic outlook favors domestically focused companies. Even though our domestic economy is growing slowly, the US markets appear to be better positioned than foreign markets because Europe is on the brink of recession and China is experiencing decelerating growth. Small cap companies tend to focus their business in the U.S. and have far less international exposure than large cap companies. As a result, US small cap stocks afford investors exposure to the currently more attractive US economy while also insulating portfolios from the risk of weakening European demand as well as currency translation risks due to strength in the U.S. Dollar.

  • Faster secular growth outperforms during slow economic growth. Growth stocks have typically outperformed during periods of slower economic growth and given that economies have slowed globally, the Redwood team believes “Growth” portfolios are well-positioned for strong relative outperformance over the intermediate term. In addition, small cap growth companies generally grow earnings faster than most mid and large cap companies. For 2013, the small cap Russell 2000 Growth Index is projected to grow earnings 33.2% compared to 13.4% for the large cap Russell 1000. The same holds true for the five year consensus projected expectations with the Russell 2000 Growth earnings projected to increase 18% annually over the next five years compared to 11% for the Russell 1000. Accordingly, small cap growth companies appear positioned to outperform large cap companies in today’s environment of slower economic growth.

  • Low valuation offers appreciation potential. Small cap growth companies are attractively valued relative to both their historical levels and relative to large cap stocks. The small cap Russell 2000 Growth Index trades at a 23% discount to its 10-year historical median forward P/E and is approaching its decade low levels which occurred during the 2008-09 recession. In addition, small cap growth stocks trade at a discount to large cap stocks on a P/E-to-2013 Growth Rate basis; the Russell 2000 P/E to Growth is 0.61x which compares to the large cap Russell 1000 at 1.00x. This valuation gap should narrow given that the more valuable superior earnings growth is scarcer in a slow macro-economic growth period.

  • Small Cap Rally Has Upside. Small capitalization stocks have appreciated off the March 2009 lows in a similar pattern to typical bear market recoveries. Despite the rally, history indicates that small cap stocks have the potential to rally for multiple more years, as shown below. The current rally is tracking the historical pattern quite closely, and appears poised to continue.

  • Inefficient asset class rewards strong independent fundamental research. Wall Street has focused more research on large cap companies and has devoted less coverage to small cap companies. On average, only 6 Wall Street analysts are covering a Russell 2000 company, while there are 16 analysts covering a Russell 1000 company. Additionally, there are no analysts covering 6% of the companies in the Russell 2000, however, all of the companies in the Russell 1000 are covered by Wall Street analysts. This presents an opportunity for thorough and systematic investors to identify undiscovered, attractively valued, and well positioned companies through in-depth fundamental research.

Capitalizing on the Macro Environment

The Redwood Small Cap strategy is poised for outperformance not only because of the macro-environment and valuation but also because of the firm’s experienced investment team. Over the past three decades, Redwood managers have gained an in-depth understanding of market environments, critical success factors for share price appreciation, and how to create prudently diversified, high quality portfolios. The Redwood Small Cap strategies benefit from the firm’s:

  • Disciplined Investment Process. All Redwood strategies invest in high quality, attractively valued stocks with strong fundamentals. Each investment team member seeks companies demonstrating the same characteristics:

  • Rising earnings estimates and positive earnings surprises

  • Low valuation based on earnings and free cash flow

  • High and rising returns with clean balance sheets run by management teams with a record of success

  • Proprietary Quantitative Model. Based on the size and scope of the small cap growth universe, the Redwood quantitative model improves research efficiency by directing the investment team towards those companies with the characteristics that lead to investment outperformance.

  • Research Leverage. Research analysts are responsible for an entire sector – from the $100 million one product company to the $500 billion diversified global company. Both small and large cap portfolios benefit from the team’s knowledge of companies up and down the market capitalization spectrum. Small capitalization portfolios gain from comprehending the large cap leaders and large capitalization portfolios benefit from understanding the new small cap challengers.

  • Experienced Team. Since the Redwood team brings more than 110 years of combined investment experience to each decision, the portfolio managers are able to navigate bull/bear markets, recessions and bubbles.

  • Redwood Size is an Advantage. Redwood’s nimble asset size enables the portfolio managers to react quickly to opportunities and only own their favorite names in portfolios that consist of 50 – 60 stocks.

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