‘Biden support package to benefit small caps'

US stocks are historically expensive. But this applies in particular to large caps. Small caps are still cheap, despite a strong price rally in the past six months. ‘On average, the companies in our portfolio trade at around 11 times earnings,’ says Blake Harper, one of the managers of the Orchard US Small Cap Value Fund.

Orchard Capital Management is an asset manager specialised in small cap value investing in the US. The Orchard US Small Cap Value Fund has a track record of 19 years. Since May last year, a Ucits version of the fund has also been on the market. The asset manager has been lucky in its timing, as US small caps are doing better than large caps now for the first time in years. Since May, the fund has returned about 75% (measured in USD).

As far as Harper, who is CIO at Orchard as well as a fund manager, is concerned, this is obviously only the beginning of a long-awaited value comeback. However, previous short-lived value rallies in 2016 and 2018, among others, always ended in disappointment. Why should it be different this time?

The Biden administration’s huge $1900bn support package may well ensure that the market rotation towards value continues this time, Harper believes. Small caps benefit most from this because of their relatively greater exposure to the US economy. The deglobalisation trend that started under the Trump presidency could also benefit small caps, he adds.

Perhaps the most obvious impact of the aid package is on banks and other financial institutions, which make up about a third of the fund’s portfolio. ‘The financial support to families and the $1,400 cheques almost certainly will be used to pay off mortgage and credit card debts. So in that way banks benefit directly from the support package,’ says Harper. Of course, much of this support is only temporary, but it is meant to translate into higher growth and more jobs. ‘And should that not be the case, there is plenty to choose from in the small-cap segment. There are many regional banks, but also banks that are relatively independent of the economic cycle.’

Bancorp

Harper mentions Bancorp, with a 6.9% allocation (end of February) the largest position of the fund, as an example of the latter category. Bancorp derives almost half of its revenues from providing infrastructure to payment processing companies. ‘This is a fast-growing market, yet Bancorp is valued at ten times earnings, like an ordinary bank. Last year the P/E ratio was even 5. Many investors overlook these kinds of hidden assets of companies. That’s why they are so cheap.’

Harper emphasises that, despite the recent rally, the valuation gap with growth stocks is still wider than it was roughly a year ago. ‘The difference in relative valuations explains most of the outperformance of growth versus value over the past 10 years. Usually it is a rise in inflation that helps close the valuation gap, and I believe we are only at the beginning of that process.’ The valuations of the companies in Harper’s portfolio have actually fallen in 2020 thanks to average earnings growth of over 20%. At the moment, the average P/E of the portfolio is 11.3.

This strong earnings growth suggests that growth companies can still be quite cheap in 2021. ‘Nothing is black and white, there are also quite cheap companies that also grow fast’, says Harper, referring specifically to the biotech sector. ‘There are plenty of examples of companies that have developed a drug that is potentially very profitable but are still very cheap because the drug has not yet been approved. This kind of companies provides opportunities for us.’

Private equity

The still relatively low valuations are also attracting the attention of more and more private equity firms, who regularly acquire listed companies. ‘US small caps are now attractive takeover targets because the valuations of listed small caps are now lower than those in private markets,’ notes Harper.

In early March, art retailer The Michaels Companies was delisted by private equity house Apollo, one of the top five positions in Harper’s fund. Three other companies in the fund’s portfolio were also acquired in the past year. ‘M&A activity is definitely contributing to our outperformance, and I expect this to continue, if only because of the record amount of dry powder of private equity firms.’

Blake Harper has managed the Orchard US Small Cap Value Fund since its launch in 2001. He is also CIO of Orchard Capital Management. Before joining Orchard, he worked for the Boston Consulting Group, where he advised hedgefunds and Fortune 1000 companies.

Assets under management fund: $300 mln

Assets under management asset manager: $300 mln

ESG has been fully integrated and the fund is classified as article 8 under the SFDR. ISIN: IE00BL0L0092