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Jacob Sonenshine [00:00:00]
All right we're in a somewhat unclear market maybe take a look at small caps. We have Larry Wasserman, head of due diligence and investor opinion at PNC Investments. Larry thanks for being here.

Larry Wasserman [00:00:11]
Thank you.

Jacob Sonenshine [00:00:12]
First question your pitch for small caps. Why now? Why 2019?

Larry Wasserman [00:00:17]
Well we've come off a pretty substantial decline in small caps. If you look at the Russell 2000 index were down well over 20 percent now. So kind of in the bear market territory. So just on the price decline alone 2013 was a rough year for small caps. And you know if you're if you're fishing for bargains just on price alone, small caps are pretty good. If you look at it from a valuation perspective, you know when you look at trailing 12 month price to earnings ratios, small caps actually are trading about 21 percent below their average trailing 12 month PE ratio of eighteen point one. So right now the trailing 12 month PE for small caps is about 14.1. You can pick them up on a relative PE of about 21 percent.

Jacob Sonenshine [00:01:05]
And how much to you is that trailing PE ratio, how much to you is that about small caps got driven down because a lot of US stocks got driven down and it was incidental or it was sentiment based. And how much of that lower valuation now historically to you is really about fundamentals? So which one is it really about to you?

Larry Wasserman [00:01:28]
You know you'd have to look at it you know both ways. Obviously all boats rise and fall with the tide. So you know when you do experience these markets the risk off market experience of the latter half of 2018, you'd expect those small caps in a risk environment to be a little worse than your large cap brethren. So yeah there was definitely a you know a little bit of investor incentive of pushing that down and you know there is some concern that there is going to be a little bit of an economic slowdown coming into 2019. So if fundamentally you know you probably have you know A Tale of Two Cities here. You've got the tail that you know that all markets are being driven down just by sentiment but also the fear of unpredictable earnings quality in the future. You know it certainly weighed on small cap prices you know in the latter half this year.

Jacob Sonenshine [00:02:18]
With that are you more tilted towards value or growth? And it looks like value you know the value small caps have slightly lower earnings multiples so which one are you really more tilted to?

Larry Wasserman [00:02:30]
Right now in our advisory models we've maintained equal exposure to both growth and value. We've seen growth take it on the chin of the most in 2018 and the first week of the new year in January as the markets have come around a little bit, we have seen value outperform a little bit. You know but right now we're we're a little bit neutral in our positioning with regard to growth and value. As we go some of the more recent pops of experience in the economy.

Jacob Sonenshine [00:03:02]
And which sectors, to you which are the most attractive sectors in small caps and and do those sectors and small caps behave similarly to those sectors in large caps the S&P 500 is stuff everyone knows about.

Larry Wasserman [00:03:18]
You're going to see a lot of sympathy particularly in styles in sector across the capitalisation range. But you know this year if you're thinking it's going to be a rough year from an earnings standpoint, if we're looking at some economic slowdown, some of the defensive stocks seem to be areas you may want to look at particularly consumer staples, utilities, healthcare names they tend to hold up a little bit better when there's a little bit of economic uncertainty.

Jacob Sonenshine [00:03:50]
Then moving to the trade issue you know several months ago I spoke to someone who has that if you want it if you want shelter from trade go to small caps because they have less and less international exposure, they're smaller businesses to you. So here's my question, if the tariff situation continues to get better, we've got some decent news today and yesterday, but if the tariff situation continues to get better might we see some capital flight out of small caps. How do you how do you think about that scenario?

Larry Wasserman [00:04:22]
You know it's likely that that you could see the larger cap stocks doing better if the tariff conversations become more productive. Small Cap tends to be a little bit more domestically focused a little less you know dollar exposure a little less international exposure so your smallcaps probably will be a little less impacted by the tariff talk but you know if you think about price impacts you know there's inputs that are coming out of China for example steel as an example that might be used as a as a material input in your your business could actually see some adverse impact whether you're a large cap or small cap company. But you know the small cap stocks tend to be a little bit more insulated from some of the global exposure particularly some of the exposure from what we call currency translation which in fact the fluctuations in the value of the dollar can either hurt or help a stocks earnings. So the small cap stocks tend to be a little bit more insulated the larger more multinational corporation.

Jacob Sonenshine [00:05:22]
And if they are a little bit more insulated from the international conversation do look at gross margins for small caps and say you know we're not seeing the kind of hit that we're seeing for the larger corporations.

Larry Wasserman [00:05:38]
You know it's likely you know there's there's obviously a lot of factors that go into the margins for companies that if tariffs for example are one input and that tariff question remains, it could benefit margins or small stocks. If we see that you know GDP for example here in the United States softens a little bit as as was predicted by Fed Chair Powell just recently, you know that could hurt margins as well. So there's certainly a number of factors even wage inflation could be another factor that could be a negative externalities when you're looking at small cap valuations. But if you're specifically looking at the International question, the small cap stock that's not exposed to China for example might hold up a little bit better on a relative earnings basis.

Jacob Sonenshine [00:06:33]
Now when you go to the small cap markets and say OK here's here's how we're going to get exposed to small caps, there are so many out there, there's so many tiny companies out there, do you just decide it's more worth our time to put money into a broad Small cap ETF and accept broad exposure or what are some ways to efficiently find really good mutual funds and active management?

Larry Wasserman [00:07:06]
So I think that it's a two sided question again. There are some investors out there that you know they want to get diversification and they want value of professional money management. They may want to look at a variety of different managed mutual funds. A lot of times those actively managed mutual funds come with a little bit of a higher expense ratio or management. If you're just looking for broad based diversification and small caps and you want to keep these down, ETFs are certainly great way to do that. They're pretty much invested across the index in all the constituents. And the fees on the ETFs tend to be significantly lower than they're actively managed counterparts.

Jacob Sonenshine [00:07:46]
Pardon me if I don't know, what does the taxation situation with with ETFs? Is that also less of a burden to investors?

Larry Wasserman [00:07:53]
Potentially. Potentially. You know taxes with mutual funds are, it's a tricky science if you will. When you have more active managements, you know more portfolio turnover, you know those types of portfolios actively managed portfolios tend to throw off what we call capital gains transactions. ETFs tend to be a little lower turnover and manage more toward maintaining their exposure to a particular index rather than outperforming it so that tax consequences can be a little bit smaller. Also with the ETFs a lot of times you can buy float you know trade on the float rather than create impacts directly in the fund. So the ETF for example can be a much more tax efficient vehicle than actively managed mutual funds.

Jacob Sonenshine [00:08:43]
All right. Larry thanks so much for joining us.

Larry Wasserman [00:08:46]
My pleasure.

Jacob Sonenshine [00:08:47]
All right.

Small caps stocks may be rebounding from their rough down spell at the end of 2018, but there's plenty of time to hop back into the often overlooked class of stocks.

"If you're fishing for bargains just on price alone, small caps look pretty good," said Larry Wasserman, Head of Due Diligence and Investor Opinion and PNC Investments. 

The Russell 2000 was 27% off of its all-time high on Christmas Eve, and is now 18% off of that high, still close to bear market territory. But it's the average valuation on the index that matters most. The average trailing one-year price-to-earnings multiple on the Russell 2000 is just above 14, far below the historical average PE ratio of 18. 

The argument for small caps became clearer at the end of December, but as investors continue to look for good bargains in a broader U.S. market that has seen considerable valuation compression, small caps still offer value on a relative basis. 

Also, defensive sectors are good places in the stock market for investors to park their money if the economy turns down considerably, and small cap companies don't behave any differently than the large companies in that regard. Wasserman recommends consumer staples and utilities in a scenario where an investors wants to be defensive. 

See the rest of TheStreet's coverage on investment strategy for 2019, as the economy slows. 

Follow Jacob Sonenshine on TheStreet  or on Twitter @SonenshineJ