Disruptive change drives small-company growth

While it is well-established that the COVID-19 pandemic is a global health crisis, we are just beginning to see evidence of the economic toll it is taking on businesses. For many small-cap U.S. companies, the near-term outlook remains highly uncertain. However, I am optimistic about prospects for the asset class over the longer term. Indeed, we have already seen signs of resilience, and in some cases recovery, since the market bottom and the height of the business shutdowns.

As investors, we believe the negative shock of the COVID-19 pandemic will reveal the strengths and weaknesses of many business models. At the same time, it should also accelerate the pace of disruptive change that many small companies help to promote.

Our three-step approach to managing through volatility

As the virus evolved from an emerging threat to a global crisis, we implemented a three-step approach to managing our small-cap growth portfolio. Steps one and two sought to mitigate downside risk for the portfolio, while the third step was aimed at finding growth opportunities. First, we analyzed the liquidity and debt levels of our holdings to determine which companies could weather this severe shock. Our investment approach going into the crisis was beneficial, as we were already focused on businesses with strong margins, strong returns, and cash-generating ability. We did not find many companies in our portfolio with debt levels that were high enough to hamper future growth prospects, in our view.

Detecting longer-term structural weakness

Our second step was to conduct deeper analysis to determine which companies might be structurally weaker in a year or two as a result of the pandemic. It is worth noting that far fewer companies declare bankruptcy than is commonly believed. However, future returns on capital and growth prospects can be diminished if liquidity and debt levels force a company to cut costs too deeply. For example, if an airline cannot fly its planes, which were acquired through loans, the business faces serious challenges. Many stocks in the travel and leisure industries have been punished severely. However, in many cases, the long-term impact is not obvious. Will a regional casino operator, for example, be able to successfully conduct business with fewer patrons? If "yes," then this presents a compelling opportunity. Our top priority is determining the answers to questions such as this as we manage our portfolio.

Seeking growth drivers

Step three in our process is finding companies that will be structurally stronger as a result of the pandemic. While the nature of every crisis is different, they do have one thing in common. Crises tend to accelerate the pace of change, often out of necessity. In our fundamental research, we always consider disruptive change, as it is often the force that enables small companies to compete against their larger peers. We are already finding that the Covid-19 pandemic has enhanced the growth potential of many small companies, and we are seeking to add them to our portfolio.

Small companies that may benefit from disruptive change

1Life Healthcare, Livongo Health, and Teledoc. These companies specialize in remotely connecting patients and health-care professionals. We believe the adoption rate of telemedicine has advanced by several years as a result of the sudden COVID-19 lockdown and the need for social distancing.

Q2 Holdings and Chegg. Changes brought on by the pandemic should also benefit businesses with cloud-based software offerings. One example is Q2 Holdings, which enables small and mid-sized financial institutions to offer mobile banking services. Chegg, a name most college students may recognize, provides online learning services. Previously offered as a supplement to in-person college learning, Chegg's services have become more valuable as a result of pandemic quarantines.