We talk to a US-based investment firm about a small-cap strategy and its aim of trying to beat measures such as the Russell 2000 Index.

Navigating the reefs and shoals of US equities has been a hazardous undertaking as rising interest rates affected markets over the past year or more. For the manager of one small-cap fund, the benefits of doing the work to discover real value is well worth it.

Bill Hench, who manages the First Eagle Small Cap Opportunity Fund, and is head of First Eagle Investments’ $1.332 billion small-cap franchise, is just such a manager. The franchise includes First Eagle’s Small Cap and US Mid Cap Opportunity strategies. The US mutual fund had assets under management of $1.183 billion as of 30 June. First Eagle is headquartered in New York.

“Our goal over the cycle is to make sure you get better than S&P 500 returns and those from the Russell 2000 Index,” Hench told this publication. “We get people paid for the risks of investing in small caps,” he said, noting that liquidity in smaller cap stocks can be an issue.
 
“The biggest risk [in such stocks] is probably management,” Hench continued. This is not so much the quality of existing management – which can be high – but the lack of strength in depth. “There is more reliance in a smaller number of people,” he said. 

There are characteristics that investors need to be aware of. The fund does not do better than the wider market in all conditions; it tends to lag indices in a bear market but is good at building positions in difficult periods.
 
“All my team does is to execute on a strategy that works…I would like to go to cash during the tough times but that’s not possible. We must be in the market,” Hench said. “You have got to take advantage of situations and high convictions in your work. The strategy is about identifying temporal weakness in otherwise solid companies. We distinguish between temporarily cheap stocks and value traps – stocks that are cheap for a reason – and build positions over time.”

According to the 30 September factsheet for the First Eagle US Small Cap Opportunity Fund, the fund, launched in February 2022, has clocked up returns over one year of 16.7 per cent, handily beating the Russell 2000 Value Index, at 7.84 per cent. Year to date, the returns are 4.01 per cent and -0.53 per cent, respectively. (2022 was not a good year for stocks in general.) Hench has been managing First Eagle’s Small Cap team since its formation in April 2021 and previously led the same small cap strategy at Royce Investment Partners.

For those non-US investors seeking a “pure play on the US small cap market,” First Eagle’s US Small Cap strategy has been available since February 2022 through a sub-fund on its Irish UCITS platform. 

Besides Hench, others on the team for the fund are assistant portfolio manager Rob Kosowsky and Suzanne Franks. It’s a small fund so far with net assets of $7 million; the strategy net assets are $1.5 billion, and the portfolio covers 2,560 companies. The average price-earnings ratio of the portfolio was 13.47 times earnings.

Holdings
Among the top 10 holdings, in percentage terms, are Air Lease, Alpha and Omega Seminconductor; MKS Instruments; QuidelOrtho; Stewart Information Services; Goodyear Tire & Rubber Company; Old Republic International; Tenet Healthcare; Louisiana-Pacific; and Herc Holdings.
 
The fund’s team talks to firms’ management to work out whether a company has a credible and coherent plan to a path to recovery. “That is where we have an exit point,” Hench said. 
 
The team looks at metrics such as whether a company has a low price-to-book ratio, price-to-sale ratio, and others.
 
“We believe that businesses with competitive advantages – regardless of size – ultimately should trade at a premium to their lower-quality competitors. But the heightened volatility inherent in small cap stocks means that diversification, along with valuation, is a key element of our portfolio risk management,” Hench said. “From our viewpoint as active, fundamentally driven investors, however, the small cap market’s volatility is not a bug, but a feature. We are looking to get paid to exploit that volatility.”
 
The US tilt of the fund is clearly evident: 80 per cent of the revenues feeding into the fund come from the US, Hench said. 

The First Eagle team believes in eating its own cooking and it has put a “significant” amount of its own capital into the strategy, he continued. 

While some stock-picking fund teams might say they’re indifferent to macroeconomic conditions and sectoral views, Hench says he and his colleagues do look at the macro side to help frame decisions. 
 
On the other hand, the fund doesn’t go in for shareholder activism. “We are not going to run a company,” he said.