Talk Your Book: Finding Small Cap Diamonds in the Rough

Episode Summary

Executive Summary: The episode centers on the long-run case for small caps after years of large-cap growth dominance. Guest Brandon Nelson of Calamos argues small caps remain compelling because of stretched relative valuations, possible Fed easing, and the persistent importance of stock selection in a fragmented, underfollowed universe. He describes Calamos’ fundamental-momentum approach, emphasizing profitable, high-growth names, respect for price action, and disciplined selling.

Main Topics: Cycles and the case for diversification (Priority: 5/5): Michael and Ben discuss how long U.S. large-cap growth has outperformed, but argue that market leadership is cyclical and diversification still matters. Why small caps may be poised for a rebound (Priority: 5/5): Nelson says small caps have historically led for long stretches, now trade at unusually cheap relative valuations, and could benefit if the Fed shifts from tightening to easing. Small growth vs. small value and the role of stock picking (Priority: 4/5): The conversation revisits the academic preference for small value, but Nelson argues both styles can win and that stock selection matters even more in small caps than in large caps. Managing profitability in the small-cap universe (Priority: 4/5): Nelson explains that many Russell 2000 companies are unprofitable, but his portfolios skew toward profitable businesses and away from index-like exposure. Fundamental momentum as an investment process (Priority: 5/5): Calamos’ process focuses on companies with sustained growth and the ability to beat expectations, using both financial analysis and management interactions. Buying strength, avoiding falling knives (Priority: 4/5): Nelson favors names with improving price momentum that confirm fundamentals, and he avoids trying to catch stocks that are still trending lower. Fund-specific positioning and investor access (Priority: 3/5): Nelson highlights the fund’s small asset base, tax-loss carryforwards, and personal commitment to the strategy as differentiators for investors considering small caps.

Key Arguments: Market leadership tends to rotate over decades, so long-term investors should expect cycles rather than assume current dominance will persist. Small caps are historically attractive over very long horizons, but their recent underperformance has made valuations unusually stretched to the downside versus large caps. Valuation alone is not enough; a catalyst such as Fed rate cuts is needed to trigger mean reversion into small caps. In small-cap investing, stock selection is more important than in large caps because the good ideas are rewarded more and the bad ideas are punished more severely. A meaningful share of small-cap indices is unprofitable, but active managers can avoid weak businesses and focus on profitable, higher-quality names. Biotech and other high-upside but unprofitable areas still deserve attention because some companies can become major winners despite near-term losses. The best opportunities often combine fundamental momentum with underestimated growth, where management consistently beats expectations. Price momentum matters because it often confirms fundamental momentum; a falling stock with good fundamentals is not automatically a buy. Selling discipline should be based on fatigue in fundamental momentum and worsening quality of earnings beats, not just price targets. The small-cap opportunity set remains large despite claims that private companies are staying private longer; Nelson says he still sees more buys than sells.

Data Points: Russell 2000 vs. S&P 500 long-term return: Russell 2000: more than 11% per year over 15 years; S&P 500: about 14% per year - Used to show small caps have done well, but not as well as large caps over the last 15 years. Small-cap relative valuation percentile: Around the 15th percentile - Nelson said small caps are very cheap relative to large caps by historical standards. July small-cap valuation rank: 10th percentile to 17th percentile - Jeffries-based valuation ranking moved after a strong July rally in small caps. Current small-cap portfolio profitability: Less than 10% unprofitable or scheduled to be unprofitable - Nelson said Calamos’ portfolios are more profitable than the index composition. Russell 2000 non-profitable companies: About 40% - Referenced as an increase over time in the index’s unprofitable constituents. Small-cap growth fund year-to-date return: 27% - Nelson cited the fund’s strong performance even as small caps overall were only modestly up. Fund assets: Just over $300 million - Used to argue the fund can maneuver more nimbly than larger competitors. Fund history: Started 13 years ago - Calamos Timpani Small Cap Growth Fund operating history. Experience in small and mid caps: 28 years - Nelson’s personal experience managing small and mid-cap stocks. Typical idea funnel: 2000+ stocks narrowed to 150-200, then to an 80-120 stock portfolio - Described the portfolio construction and research process. Sell discipline example: Reduce exposure by a quarter or a third - Nelson described partial trimming when fundamental momentum shows early fatigue.

Pivotal Quotes: "Diversification never dies." — Michael Batnick: Michael’s summary of his belief that cycles eventually rotate despite long stretches of U.S. large-cap dominance. "The market is telling you, yeah, we see it too. And we acknowledge the stock deserves to be rising." — Brandon Nelson: On why price momentum is important confirmation of strong fundamentals. "We don't like to catch falling knives." — Brandon Nelson: Explaining why the team avoids buying stocks that have strong fundamentals but are still trending down.

Implications: Listeners should view small caps as a potentially attractive but selective opportunity: valuations are supportive, but the best results likely come from active managers who emphasize profitability, fundamentals, and disciplined trading rather than passive exposure.