HCP Quant’s value decreased -2.99% in May. Comparison index MSCI ACWI SMID Value Total Return increased +2.26% in euros. US S&P 500 Total Return increased +3.24% and S&P Europe 350 Total Return +2.93%. From the beginning of the year HCP Quant has been performing better than its comparison index with -18.60% return compared to -22.35%.
The first quarter of the year has been difficult for small value stocks. Fama French U.S. Small Value Index which measures the development of small value stocks in the United States experienced historic events. The index fell -41.5% in one quarter. This is a record in its 94-year history. Similarly, the drop of the S&P 500 index was left to only -19,6%.
According to The Wall Street Journal’s article there are over 140 funds and ETFs in Morningstar database that are specialised in small value equities. The average loss of these in the first quarter was 37%. From the beginning of the year to the end of April it was -28% and until the end of May -25%. So, compared to US references of control HCP Quant has survived in the corona economic situation better than most.
The same article states that small value stocks can have good prerequisites for the post-COVID-19 recession rebound. One reason is that particularly small businesses experience larger effect on operating income when revenue increases. Small businesses are usually benefitting more from economic recovery.
Another reason is high-yield interest spreads narrowing down. Spreads getting smaller is a sign that investors are willing to take more risk. As history shows similar change has led to small value companies overperforming while larger companies underperform.
High yield interest investments’ spread from the year 1965. Source: Verdad Advisers
High yield interest spread and the following year’s return 1965-2019. Source: Verdad Advisers
The turnaround can be intense. As Verdad Advisers has analysed through 1965-2019, when high yield interest was over 8%, stocks of the cheapest decile and companies in smallest decile by size generated 48% in the following year, S&P 500 index returned 13%. In terms of the cheapest fifth and smallest fifth the return was 42%. In the end of May high yield interest spread had sunk down to 6,5%.
Free cash flow valuation differences and small value firms’ following year’s return 1951-2019. Source: Verdad Advisers
Measured by Free Cash Flow (FCF) the cheapest decile small companies yielded total return of 500% in years from 2000 to 2006. S&P 500 index yielded approximate 8%. The valuation difference between the most expensive and cheapest decile is to date 6 times the free cash flow yield, about as much as in 1999.
HCP Quant country allocation in 29.05.2020. Source: Bloomberg
HCP Quant continent allocation in 29.05.2020. Source: Bloomberg
Above are displayed country and continent allocations of HCP Quant. Any radical changes since the previous update haven’t come up. Emphasis of Australia-based companies has decreased and U.S. stocks can’t be found at all. The only remaining North American companies are from Canada. The big picture stays the same. The biggest emphasis is on Asia and Europe. This is understandable when valuation levels are more affordable than in United States for instance.
You can find the up-to-date valuation levels from HCP Quant’s page where I am updating the fund’s valuation monthly. It is easy to verify from the graphs in the page that the fund has been invested in value equities the entire time, according to its investment strategy.
June’s subscription date is approaching. Don’t let it slip by! As always, you can make an subscription online by clicking the button below. Please remember that the money has to be in the subscription account by June 30th at 4 pm at the latest.
Wishing you a warm summer,
Pasi Havia
HCP Quant portfolio manager
“Even the intelligent investor is likely to need considerable willpower to keep from following the crowd.”
Benjamin Graham
(This text is a translation of the Finnish-language HCP Quant investor letter.)