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Fund manager Thomas Laming invests in small caps with sound fundamentals and a strong story. He details three of those stories, and explains why smaller stocks tend to outperform in eras of rising interest rates or inflation.

Kate Stalter: Today’s guest is Thomas Laming, lead portfolio manager for the Scout Small Cap Fund (UMBHX).

Tom, I wanted to just start out today by putting some of the small-cap volatility in context. The memory of 2011’s third quarter, with that huge market drop, is still very fresh in people’s minds, even though we had a terrific rally in the first quarter of this year.

But a lot of traders and investors are concerned about how 2012 might play out, so can you frame that for us? Where do you see small-cap volatility factoring in?

Thomas Laming: Sure, also thanks for having me. You know, small-cap companies are, from trading vehicles, they are much more risky and much more volatile than large-cap stocks. Over the long run, they have returned more. But partly because you are taking more risks, I think you do need a longer time horizon.

Last fall was an example of how bad things can get very quickly from a return standpoint, with stocks falling in a quarter almost 20% on average. We’ve recovered essentially all of that since then, and then some. So, much of that has been tied to the concerns of last year, about how the economy was going: Were companies going to miss earnings expectations?

And it turned out that things have been OK. The economy is still growing very slowly, and you see that in the job numbers and very weak hiring. But companies, for the most part, have come in, and about 70% of them, the reported earnings have beat expectations. So the market is back up, but it is volatile.

Kate Stalter: Let’s talk a little bit, then, about the cyclical nature of small caps, versus some of the larger names.

Thomas Laming: Sure. You know, one of the things to keep in mind: I mentioned needing maybe a longer time horizon for small-cap stocks as an asset allocation.

But if you look over long periods, if I just think of the decades—small caps outperformed in the 1940s, the 1960s, the 1970s, and the 2000s. Now conversely, you wish you were more in large caps during the 1950s, 1980s, and 1990s. We’ll see how this decade plays out.

One of the driving features, I think, of those longer-term return characteristics has been: Small caps have tended to outperform when interest rates or inflation were rising, and I think there are reasons behind that.

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Small companies are less energy-intensive, so when you have inflation, you have rising commodity prices. They don’t get hurt as badly as large caps. They don’t rely as much on debt financing, so when interest rates are rising, small companies don’t have to go back out and refinance debt at higher rates the way large companies typically do.

And then when rates are rising and inflation is rising, usually it is a sign that the economy is strengthening, and that is usually an environment where investors take a more risk-on approach and want to own riskier assets, and so they buy small caps.

So I think you do need to keep in consideration: Where do you think inflation will be, and where will interest rates be? I think in the same way that gold has been a pretty good investment—it’s basically turned a fair amount in the last several years—and small caps have, as well.

I think they are discounting future inflation that hasn’t hit yet. When we get that, I think that is when you’ll probably see better performance out of small caps versus large.

Kate Stalter: Are there any particular market signals? You mentioned a couple of perhaps macro or economic indicators for people to keep in mind. Anything else, perhaps, when they are looking at an individual stock? Factors to keep in mind on that company’s own price performance?

Thomas Laming: Well, we really take —I mentioned this—a longer time horizon. We like to look out three to five years, and so we try to find companies—and anybody can do this as well—but try to find companies that are taking advantage of some longer dynamics, some longer trend taking place that is unlikely to change.

So we don’t care as much about, say, commodity prices. Some people will own a natural gas company because they think it is going to be a cold winter. We think that is quite unpredictable.

We try to find underlying themes that will take place—whether there is an act of terror somewhere in the world, whether the Federal Reserve raises rates or lowers rates—and I think that can allow you to kind of have a clear mind in terms of why you own a stock and why you ride through the volatility that is going to accompany owning such a stock.

Kate Stalter: With that in mind, I know you have a few of the portfolio holdings that you are able to discuss today. Can you start out by telling us about those? I understand you do have a name from the tech sector.

Thomas Laming: Yeah, we do. We’ve owned for quite some time now a company called Tibco Software (NASDAQ:TIBX). It is a company that sells software to anyone from industrials to retailers to almost any type of company to allow them to manage huge volumes of data, and data that are changing very quickly.

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One of the things that we think is driving demand for that type of product is just the sheer volume of data, and that is being driven by a variety of sources. But certainly anybody that has a Facebook account or uses Google (NASDAQ:GOOG)—we’re well aware of some statistics.

In one second, Google will receive nearly 700,000 queries. People will type strings into Google at about that pace. And in one second, people do about 695,000 updates to their status on Facebook. And companies are trying to mine that data, and so they will buy a product from Tibco that will allow then to, in real time, adjust their marketing efforts, their financing efforts, and really help them manage their business risk in a much more efficient manner.

Kate Stalter: Talk about some of the other sectors—perhaps a couple of names that you like from some other areas right now, Tom.

Thomas Laming: One of the companies that we think is actually demographically favored because of the nature of the people that like to eat there—and I include myself; I think it puts out good food—is a company called Cracker Barrel (NASDAQ:CBRL).

Certainly, people kind of in the south, Midwest, and Southeast will know that name. It is alongside interstates, and we’ve done our own studies, and we’ve actually looked at other people’s studies that have shown that the typical person going into a Cracker Barrel Restaurant is in their 50s, 60s, and 65-plus.

The good thing about that: That’s the fastest-growing part of the population. The birth rate was exploding that many years ago; certainly after World War II through the early 1960s, and so the company is very demographically favored. Its end market is growing very quickly.

The company recently fought off a dissident shareholder, one that we actually did a conference call with to understand their motives, that was trying to change the board and actually get a seat on the board and have more of a direct input to the company on a day-to-day basis. We actually think the management has been re-energized and refocused because of that, and the company is doing very, very well.

Kate Stalter: Now just taking a look, as you’re speaking, at the charts of both of these companies you’re talking about: It looks like Cracker Barrel is near an all-time high; Tibco is pretty close to multi-year highs. So is that something that factors into your asset management at all, or do you really remain fundamentally driven?

Thomas Laming: We’re really fundamentally driven. Like I say, we’ve owned these companies for a number of time measured by years. But again, we are owning them for reasons, we think, that are going to play out over additional many years.

The one thing that I think everyone has to come grips with, although it is an interesting dynamic, from a large-cap standpoint: You know the S&P 500 index is no higher today than it was over ten years ago; small caps have done better than that. And so the average small-cap company—if you look at the Russell 2000 index—is setting record levels today, so you’re going to see that in stocks.

Now, has that pace been exceedingly high over the last ten years? The answer to that is no. The returns over the last ten years have actually been fairly weak. We’re just barely setting these records that were set either in the late 90s or early 2000s.

So we think there is still room, and the small-cap companies don’t look expensive. We’ve just been playing a lot of catch-up for the last several years.

Kate Stalter: Let’s turn to one last sector. I know you have a name to talk about today from the energy sector. Tell us about a stock you have in that area.

Thomas Laming: Sure. One of the things that we’re sensitive to, and the world has become more sensitive to, and that’s why we’re looking at it, is the concern about carbon dioxide in the atmosphere. While I don’t actually believe this, based on my science background—what I did before I got in this business—that renewables aren’t much of a solution; they just don’t have the energy density.

But natural gas is a viable fuel source, and it is incredibly plentiful, even more so in this country, because of new discoveries. And then, it also actually emits less carbon dioxide for each unit of energy that you get out of it, versus say, coal.

So we think there will be longer-term shift toward natural gas away from coal for things like electricity generation and potentially even the case of natural gas as a transportation fuel. So it will be beneficial in everything from the environment to energy dependency in the United States.

We own a company called Chart Industries (NASDAQ:GTLS) that actually allows companies to, among other things, liquify natural gas and so then it can actually become an export. For example, shipping it in tankers too voluminous to ship as a gas, but when turned into a liquid—chilled, of course, to do that—you can then ship it around the world. You can even use it as transportation fuel. So we think there are some good long-term drivers associated with it, as well.

Kate Stalter: This one, too, is right near all-time highs for the moment. Do you just hold these? What would be a sell signal for you, Tom, to indicate that it would be time to take some profits?

Thomas Laming: For us, the typical—I would say nine out of ten reasons, nine out of ten sells that we’ve made, it is due to price. It is in the case of, we simply think the stock is expensive.

We occasionally have a situation where we think the story has changed, with either the management is not executing the way that we thought they were, or maybe a company that has made an acquisition and we now no longer think that company fits with one of our longer driving trends that we are looking for.

But in the case, certainly, of these companies—and our turnover has been running in the last year maybe 40% or so—so we are not selling very quickly. We actually see still quite a bit of headroom.

One thing that is different between small caps and large caps in terms of their earnings growth is: Small companies have not really done it through margin expansion.

Large companies have done it largely because they have laid off a lot of people; tightened their belts. They don’t have a lot of revenue growth, but have achieved a lot of earnings growth because of the headcount reductions. We haven’t had that on the small cap side. We think their earnings are a little bit more sustainable.

Source: 3 Small Caps With Lots Of Headroom