Polarisation across markets is a current focus for the InvestSense team. In this conversation between Greg Dean of Langdon Capital Partners and Jonathan Ramsay, they discuss the current state of small-cap investing and the potential opportunities that exist within this space.

The discussion highlights the stark contrast between the performance of the Russell 2000 index, which represents small-cap companies, and the EFI or xus indices, which represent larger companies. The Russell 2000 has been significantly more volatile and has underperformed the S&P 500 by a wide margin over the past decade.

Greg attributes this underperformance to the presence of "uninvestable companies" within the Russell 2000 - businesses that are highly leveraged, have negative earnings, and consume capital without generating sufficient cash flow. These companies are particularly sensitive to changes in interest rates and risk appetite, leading to the index's volatility.

However, Langdon sees opportunity in selectively investing in high-quality small-cap companies rather than the broader asset class. By focusing on businesses with strong fundamentals, such as higher growth, higher return on assets, and lower leverage, they believe they can outperform the index and generate attractive returns over the long term.

The conversation also delves into the challenges faced by consumer-facing companies in the current inflationary environment. Many of these businesses have seen their margins squeezed by rising input costs and wages, while struggling to pass on price increases to consumers. However, the investor believes that companies with strong brands, pricing power, and cost structures will emerge stronger from this difficult period. By making strategic acquisitions and consolidating distressed competitors, these businesses can position themselves for significant earnings growth as cost pressures ease.

Langdon’s overall philosophy is to invest in "cash flow compounders" with good balance sheets, rather than chasing momentum or investing in highly leveraged companies. They believe that the current environment of higher interest rates and economic uncertainty will reward disciplined companies that can generate excess capital, while penalising those that have been less prudent.

In summary, while the small-cap asset class as a whole may be challenging, the conversation highlights the potential for judicious investors to identify and invest in high-quality small companies that can thrive in the current environment while avoiding some of the excesses that we think excess monetary liquidity has fuelled.

As we navigate what could be a volatile year ahead, discerning investors may find value opportunities by carefully examining these polarised markets.