Discerning between the climate and the weather for small caps…

The third quarter also marked the end of the first year of investment operations for our portfolios and we are very proud of the results we have achieved, albeit still early days. It bears repeating a statement from our opening letter, that for every decision we make at Langdon – whether it be investment decisions or a business decision – the time scale for measurement is 5-7 years (or more), which we refer to as the long-term.

I wanted to share what we believe is an important distinction that we find we encounter regularly when sitting down with potential and even some existing clients. Why is investing in small cap a timing call for so many allocators? Have they been burned in the past? Does empirical data support the need or importance to make timing a critical component in the decision to get exposure to smaller companies globally? i.e., in order to harvest the alpha in the asset class the timing call must be made correctly?

Now, it certainly isn’t 100% of the time but it does come up a lot and those meeting start like this…

Allocator: We don’t currently have an allocation to smalls, we let our all-cap managers go down cap when they see opportunity. Also, with interest rates higher than in recent memory and so much economic uncertainty, we don’t yet have the conviction to allocate to small caps as an asset class, but we plan to review the category at some point.

Us:  We don’t try to time the stock market or the economy and the reality is there aren’t very many companies in the index that meet our quality criteria. We believe to exploit the alpha that investing in smaller companies can provide, you need to be structured differently than most large cap or all cap managers. Ideally you are comfortable with market volatility and believe that it creates opportunity for meaningful price-value dislocations.

Allocator: But don’t small caps perform well when the economy is doing well?

Us: We own a highly curated collection of roughly two dozen resilient companies that we believe should allow us to meet our long-term risk adjusted return targets. Value creation is fundamental and must be created within the company not in the capital markets. We must be able to say with confidence ‘we’re happy to own this company through a business cycle.’ Our portfolio does tend to underperform when markets perform well because we avoid the riskier companies in our universe. We think it’s important to be invested when things look bad, not when things look good.

This line of conversation led me to reflect on something Charlie Ellis said in his book 'Winning the Loser’s Game,' where he illustrated the difference between weather and climate: “Weather is what’s going to happen today and the climate is what’s going to happen this year, next year and the year after that.”

In the above exchange, we believe the allocator was focused on the weather in the smaller companies’ asset class and was not thinking about the climate.

A lot of investors (ourselves at times I’m sure) feed into talking about the weather when they write white papers about the case for small caps. They primarily focus on timing-based insights, discussing how the asset class performs coming out of recessions when interest rates are coming down, or how the current valuations are below their larger company counterparts.

One of our core philosophies is time > timing when it comes to investing, and we typically politely refrain from timing or relative valuation discussions. Our view is if you buy on timing, you will need to sell on timing, and we are investors not traders. Price discovery is becoming a lost art in investing with close to 90% of capital flows in today’s stock markets no longer fundamentally driven. This means the majority of equity investors today don’t buy or sell stocks based on company fundamentals. This dynamic coupled with the chronic under focus and under-resourcing by the largest global investors in smaller companies, has created what we believe are ‘ideal conditions’ for disciplined business-minded investors, like us, to hunt this vast universe for opportunities.

We very deliberately refer to our approach as ‘All-Weather,’ where we aim to create a portfolio of resilient and high-quality companies that are materially undervalued. It has been our experience, and that of our clients over the last 10+ years, that this time-tested approach helps us avoid the pitfalls of spending too much time focusing on the weather.

We may not pay attention to the weather in global small cap, but we do pay attention to the climate. We like the climate so much that we have now built our ‘forever home,’ Langdon Equity Partners, dedicated to the climate of smaller company investing. In addition to investing our time in the climate, employees have invested over $10 million dollars into our investment strategies which we believe creates proper alignment with our clients.  As a result, we may not be the right people to ask about the weather or the climate! (Hint: we’re biased). However, the evidence supports why we’ve been so pleased all these years.  This approach has garnered approximately 15% net returns over the last ten-plus years (4.5 times the multiple of capital [MOC]), with only two years experiencing negative returns.  Talk about an attractive climate!

The climate for our type of smaller company investing isn’t wholly dependent on where interest rates are or what the economy is doing. Those things can make for better or worse days, but they do not have a significant impact on the long-term outcomes of our portfolios. It is an enormous universe that appeals to our curiosity, as well as our desire to be selective. There is always opportunity, and we believe it is chronically under resourced by many of our peers who can’t justify the ‘business case’ to dedicate resources to such a small market when the world is enamored with the magnificent seven today, and a few years back with the FAANG stocks.

You would never decide where to live based on the 5-day weather forecast, so why do so many clients try to time the asset class investment decision?

We stand behind our belief that the probability of long-term investment success is inversely correlated with one's sentiment towards the investing weather (i.e., short term results). The better you feel about the weather, the worse your forward-looking returns will typically be and vice versa. To us, the climate is just a very long-term weather forecast. We recommend that you should find a few areas of the investing world that offer an attractive climate. These should ideally be areas you understand, where you will find people you trust dedicated to that particular climate, who have a time-tested approach to navigate it. After that, sit back and try to not worry too much about the weather.

A sincere thank you to all our clients, and the exceptionally strong team at Langdon for not just the hard work and dedication every day, but the fun we are having along the way. We continue to believe the climate for our all-weather style of investing in global smaller companies is excellent and as a team we are not overly emotional about the weather. Some days are better than others, but the long-range forecast for global smaller company investing looks excellent.

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