Opus News & Insights

The Night is Always Darkest Before The Don
Thursday, January 12, 2017

"Are the Good Times Really Over [For Good]", a hit by the late Merle Haggard, was a collective theme as we transitioned through 2016. The year was widely seen as a nightmare, where troubles lurked around every corner. Nancy Reagan, Carrie Fisher, Gene Wilder, Prince, Ali, there was no pattern to 2016’s line of destruction. We heard news headlines ranging from “England Just Left Europe” and “The Night is Always Darkest before The Donald” to “They Shot a Gorilla”. The year 2016 has been engraved in the minds by many as a year of devastation, leaving people hoping and praying that 2017 will be different.

Nobody wanted 2016 to end more than active managers, especially small cap managers. They trailed their respective benchmarks across the board, but the damage was especially bad for small cap value managers, who trailed the benchmark by 5.4% this year. A mere 10.2% of value managers outperformed the Russell 2000 Value Index (“R2KV”), a figure that has not been seen since 2006, when only 6.8% of managers outpaced the benchmark. Optimistically, the following year, 86.4% of managers beat the benchmark.

There was a "PerfectStorm" in 2016, which laid waste to active management as factors that favor lower quality drove the market’s return. Active managers tend to skew to higher quality companies, i.e., higher profitability metrics, lower leverage and higher market cap. Numerouslower quality factors helped brew this “Perfect Storm”, which was fueled by increased ETF inflows throughout the year propelling the smallest of the small.

Sector allocation detracted from managers’ performance as we saw heightened valuations throughout the year in defensive areas like Utilities and Consumer Staples, which were the big winners in the first half of the year, and another consistent manager underweight.

Additionally, value managers, who tend to be overweight in Materials & Processing, were not in the “right” Material names from an industry perspective,  as we see in Table One. To add insult to injury, a perennial active manager underweight, banks, contributed over 26% of the R2KV’s 2016 performance. Banks comprise over 23% of the R2KV, with managers, on average, having a 6% active underweight.

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Materials & Processing, as a sector, appreciated almost 63% last year, which was driven by the metal & mining industry, which jumped over 140% last year! At the end of 2015, 55% of metal & miner companies in the R2KV sported a negative P/E, while ending the year with an average P/E (ex. negatives) of only 136x. For value managers, especially those who focus on P/E, like Opus, there is difficulty in buying companies when there is no “E”, let alone holding them when they are trading at triple-digit multiples. Managers tend to be overweight Materials & Processing, due to the lower index weighting, but they did not own the “right” names within the sector in 2016.
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Another reason for manager underperformance was their significant underweight in banks, which contributed to 836 bps of performance in the R2KV. At the end of 2016, the bank weighting within this index exceeded 23%, a weighting which most managers do not feel comfortable holding in a diversified portfolio. On average, managers are 6% below the R2KV bank weighting, their largest underweight against the benchmark. Banks now trade at 2.2X Price/TBV and 20.8X LTM P/E, levels that have not been seen in years.

ETFs now represent about 38% of total assets within small caps after seeing inflows of over $17.5B during the year. The average manager has a higher weighted-average market cap at $2.4B compared to the benchmark’s at $1.7B. Thus, when ETFs see such large inflows, the smallest of the small names outperform, hurting managers. Furthermore, on average, 38% of Value manager’s holdings were not held within the R2KV, creating an additional headwind as non-benchmark names do not see a benefit from increased ETF inflows.

Manager’s had a very difficult 2016, as it seems as every factor was working against them. Between the low quality rally within the R2KV, to increased ETF inflows driving benchmark performance, it felt as if managers were fighting against a storm much like the one the Andrea Gail was unable to survive.

With active managers not seeing net inflows since February 2014, the active versus passive debate will continue, leaving active managers hoping that the pendulum has swung too far. In this relatively high-priced and potentially volatile market, it seems that lower quality names that have dominated the market this year and over the last seven (7) years will not continue to outperform. Higher quality stocks are highly undervalued and are poised to lead the market going forward.

With 2016 now behind us, President-elect Donald J. Trump has created an interesting investment environment with his ambitious plans for taxes, health care and infrastructure, with the market seeming to have already factored in tax reform and fiscal stimulus, given valuations. Coupled with historically high valuations and a potentially farfetched goal of three (3) rates hikes next year by the Fed, there is a higher probability that we see increased volatility, which tends to benefit active management, as we see managers hoping that “the night is always darkest before The Don”.


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Joseph P. Condren, CFA
  Joseph P. Condren, CFA
Principal, COO and CCO

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Kevin P. Whelan, CFA
  Kevin P. Whelan, CFA
and Portfolio Manager

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Nathan M. Bailey, CFA - Associate Portfolio Manager
  Nathan M. Bailey, CFA
Associate Portfolio Manager

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  Nathan A. Bishop, CFA
and Portfolio Manager

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  Jakki L. Haussler, Esq., CPA
Founder and CEO

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  John A. Ferguson, CFA
and Portfolio Manager

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Len A. Haussler, CFA, CPA
  Len A. Haussler, CFA, CPA
and Portfolio Manager

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  Adam T. Eagleston, CFA
and Portfolio Manager

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Associate Portfolio Manager
and Research Analyst

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  Brad J. Rapking
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  David W. Wagner III, CFA
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