First Eagle’s Bill Hench on buying tech stocks as a small-cap value investor

‘Can things get worse? You bet. But the cheaper they are, the better your odds’

Bill Hench
Bill Hench

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Manager of the £1bn First Eagle US Small Cap Opportunity fund manager Bill Hench is backing the US smaller companies sector to rebound after a period of underperforming against their large cap counterparts.

Now, the manager is turning his attention to tech stocks, a sector more commonly associated with large-cap growth companies.

“The small-cap market has been pretty crummy for about two years, and a good deal of it has to do with Fed raising rates to get inflation back to target levels, which is ironic because small-cap value has historically done pretty well in inflationary environments,” he told Portfolio Adviser.

“But also, I think a lot of the things that were supposed to happen [over the last year], didn’t happen. Economies were supposed to pick up because China was supposed to open up and drive global demand. Oil prices were not supposed to go up, especially after China didn’t expand at the rate. And the two wars are not helping now.”

According to Hench, one of the major factors that negatively impacted smaller companies this year was the failure of Silicon Valley and Signature banks earlier this year.

“It was not so much because these banks make up a large percentage of the small-cap index, but because most small companies rely on small banks for financing,” Hench says. “That, I think, is what really shook the market, and not so much that they wouldn’t be able to get financing, but more that it would be expensive and much harder to get. Combine those things with the fact that anybody who was asked would tell you that we’re going to have a recession. As a result, the small-cap part of the market has become really, really cheap.”

Market turnaround

Over the last four quarters, small-cap US stocks have trailed large caps. In Q3 this year, small caps were down 5.1% versus a 3.1% fall for the S&P 500. However, Hench is still optimistic about the prospects for the Small Cap Opportunity fund.

“I don’t know when that will improve, but I do know that, historically, anytime you’ve been able to buy small caps that are at very, very cheap levels, you’ve done alright. And I don’t think that this time should be any different.”

He adds: “We’re value players. We don’t try to buy things that are high and hope that they go higher, we buy more when they’re down and hope to get back to normal and that delta has been enough historically for us to make our clients do better than they would have in the index, and that’s all we try to do.

“It’s part of our philosophy. If you’re going to take the risk of investing in small caps, you want to get paid for it, because otherwise, why bother? We’ve found that the best way to do that is to buy assets at really cheap prices. You don’t know when you’ll get a turn, but a healthy amount of bad news has already been priced into a lot of these things. Can things get worse? You bet. But the cheaper they are, the better your odds will be that you’ll have some success.”

The Small Cap Opportunity fund has a sizeable weighting to tech, a sector more commonly known as a hunting ground for growth investors.

“We tend to get more of the nuts-and-bolts stuff,” Hench explains. “We get a fair amount of devices and a large amount of semiconductor capital equipment. So the tools that TSMC and Applied Materials use to produce devices, contract manufacturers, and to a lesser extent, software.

“It’s a healthy part of the portfolio… and for a value fund, that’s very odd. But they are really all value stocks, because they tend to have lots of cash, and in many instances, net cash and no debt. And they sell at incredibly low multiples, because people look and say: ‘Oh, they’re not growing anymore.’ But guess what? When the cycle returns its: ‘oh, my goodness, look at this.’”

Hench added: “Unlike a lot of value players, we have a lot in tech and we don’t have a lot of financials. But that’s only because we take what the market gives, right? We go to those sectors where we think we can make the most money and find the cheapest [stocks].

“But I think financials are definitely, in my opinion, overlooked here. So we’ve been finding more value in things like banks and insurance companies, but they make up a very small part of the portfolio.

“It’s a name-by-name exercise. When we look for things like turnarounds, asset plays, undervalued growth stories, busted growth stories, and no matter what environment you’re in, you’re always going to find things. It’s a big enough market that even in the greatest market, things are going to be cheap. And even in the crummiest markets, things are going to show up with really good value.”

Smaller end of small cap

The strategy’s holdings fall on the smaller end of the small cap spectrum. “Our median market cap is significantly lower than most of our competitors and in the index itself, which has implications for performance,” said Hench. “So in tough periods, we usually do worse than the index and our competitors. But coming out of bad, ugly periods, we tend to do a lot better.

“It’s primarily due to liquidity. When people get nervous in the bad markets, they don’t exactly run to buy the stocks we own. But when they get excited and they think things are going to get better, they understand that increase you get when things start to get better, traditionally has been more than enough to make up for the nasty periods.

“In small cap, it’s very rare for things to be bad for more than a year. So last year, the small-cap index was down about 20%. This year, it’s flat at best, maybe we’re up one or two, but you rarely get two consecutive bad years.”

According to the fund’s latest factsheet, it currently has 260 holdings. At the end of September, the fund’s top 10 holdings accounted for just 7.66% of the overall portfolio, with the largest position being a 0.80% holding in Alpha and Omega Semiconductor Limited.

Meanwhile, the smallest of the top 10 holdings was manufacturing firm Louisiana-Pacific Corportation, which makes up 0.74% of the portfolio.

When asked why the strategy employs a relatively unconcentrated approach, Hench said: “We think that as far as managing risk, the best way to do it is to spread your bets. Also, given we are truly small and sometimes micro-cap, we don’t want to go in and buy a lot of stocks all at once, we like to buy a little bit at a time. And quite frankly, no matter how much work you do, no matter how much research you do, no matter how smart you think you are, you’re going to make mistakes. And in small cap, when you make mistakes, it’s hard to recover if they’re a big percent of your portfolio.

“It’s very difficult to own 6% of something and go to bed feeling good and waking up and finding out that your 6% position is 3% especially with the liquidity. So without great liquidity, the best way to handle that is to really be diverse.”

“All of our ideas start out because they’re cheap. And then the rest of the process is simply trying to figure out whether or not you could get comfortable with some avenue for it to get better. Many times, it’s just time. Other times, it’s more complicated than that. But mostly, we’re buying proven companies that have done well in the past, but for whatever reason, have had a hiccup or an impairment to their value.”

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