‘Small cap value is historically cheap compared to large cap’: Expert

Charles Bobrinskoy, Vice Chairman, Head of Investment Group, Ariel Investments, joins Yahoo Finance Live to discuss the market sentiment and Fed tapering expectations.

Video Transcript

ALEXIS CHRISTOFOROUS: I want to continue our conversation with the markets now and bring in Charles Bobrinskoy, he is Vice Chairman and Head of Investment Group at Ariel Investments. Charles, it is good to have you here and I know you sort of bring a new or a different perspective I should say to the markets because you take a look at something called behavioral finance, how investors are thinking about the market. And what are some of your big takeaways as you see market sentiment right now as the Delta variant continues to spread, yet the market continues to reach these record highs?

CHARLES BOBRINSKOY: Yeah, a lot of the work that people like Daniel Kahneman and Tversky did and people at the University of Chicago have done in behavioral finance has been very applicable we think to the markets this year. One of the things that they've all found is that people tend to anchor. Which means that they're slow to bring new data into their estimates. And if there's positive news they tend to not be quick enough to bring that news into their new estimate. So we're seeing that right now, where you've heard for a long time people say this market is too expensive relative to earnings.

And one of the mistakes they're making is their estimates of earnings are too low. We've seen almost 88% of companies beat their estimates this quarter. And I'm now using $200 a share for what the S&P is going to earn this year, that's up from $160. So that's one example of anchoring which is a behavioral finance tendency.

There are a couple of others that are very important just quickly, there's an endowment effect, where people tend to over like what they own compared to what they don't own. And that's why you're having some of the big tech stocks are so popular right now is everybody owns Amazon and so everybody loves Amazon. That's called the endowment effect and it's a very powerful driver of the market.

ALEXIS CHRISTOFOROUS: Well, speaking of which, I guess people do that at the expense of some of the mid and smaller cap stocks. So the Russell 2000 has been sort of holding its own here in this market. What's your take on those smaller cap stocks right now?

CHARLES BOBRINSKOY: That they're very cheap compared to the big tech companies that dominate the S&P 500. For 100 years small caps have beaten large-cap and this is one of the reasons why is every newspaper article talks about how wonderful Amazon and Facebook and Apple and the FAANG stocks are. They don't tend to talk about how good the smaller companies are.

And that's why we believe at Ariel in small and mid-cap value investing where first of all, the markets just aren't nearly as efficient. And second of all, there isn't this endowment effect where everybody falls in love with what they have. So we think right now, particularly small-cap value is historically cheap compared to large-cap and particularly large-cap growth.

ALEXIS CHRISTOFOROUS: I'm curious, Charles, what you like right now in terms of if you can share specific names, that's always great for our viewers but also sectors. What moves are you making right now in the portfolio?

CHARLES BOBRINSKOY: Yeah, just, generally speaking, we do think another behavioral tendency is people tend to focus too much on the short term. And right now we do have a Delta virus variant problem but we think we're going to get to the other side of that. And so names that are sometimes called the reopening names, some of them are very cheap.

One of the names that we love is Madison Square Garden Entertainment which owns The Garden in New York, the number one venue, some would argue most prestigious venue in the world, and then is building the Sphere in Las Vegas, it owns-- it's got the Radio City Rockettes. And it's just extremely cheap. The stock has gone down from $120 down to about $70 today because people are worried about another round of lockdowns which may happen in the short term but long term, Madison Square Garden is going to be fine.

They're frankly sold out for concerts. If you're a large band and want to do a concert in New York, you can't even get Madison Square Garden for the next 12 months. So that's an example of a name we love.

ALEXIS CHRISTOFOROUS: OK, another name I know you love is Northern Trust. Why does that fit the bill for you right now?

CHARLES BOBRINSKOY: Because there's going to be more inflation than people think and interest rates are going to go up. Right now interest rates are at historically low levels, the 10-year's at the lowest level since Alexander Hamilton created the 10-year back in the 1780s. And we're going to see interest rates go back up in the face of these massive deficits.

When that happens, Northern Trust holds a lot of the cash for its customers and they reinvest at their own income level. Right now they earn nothing on that reinvestment because interest rates are basically zero. When interest rates return to normal levels, Northern Trust is going to make a lot of money.

ALEXIS CHRISTOFOROUS: Speaking of higher interest rates, Charles, we know the Federal Reserve has been somewhat transparent, letting us know they think they're going to be raising interest rates at least twice by the end of 2023. Of course, the big question is, when are they going to start tapering those bond purchases. We've got the Jackson Hole Symposium kicking off on Thursday. You know, Fed Chair Powell is going to speak virtually on Friday. What do you expect to come out of that virtual meeting and when do you expect we're going to start to see those bond purchases be tapered?

CHARLES BOBRINSKOY: You know, I don't think I'm any better than anybody else is in predicting the exact date that. But I can tell you two years from now, they're not going to be buying at the rate that they're buying now. So sometime over the next year, they're going to stop these purchases, they're going to have to fund massive federal deficits and we're going to have a stronger economy, all of which are going to be pointing to a return to normal interest rates.

And 10-year interest rates have averaged, frankly, close to 4% over the last 200 years. I think they're going to go relatively quickly over 2%, 2.5%, 3%. And so in that higher interest rate environment, which I really do believe we're going to have sooner rather than later, you want to own things that benefit from a higher interest rate environment and not own things that are hurt by a higher interest rate environment. Growth stocks tend to be hurt when interest rates go up because you're discounting their future earnings back at a higher discount rate.

ALEXIS CHRISTOFOROUS: All right, we're going to have to leave it there but to be continued for sure. Charles Bobrinskoy, Vice-Chair and Head of Investment at Ariel Investments. Thank you.