For understandable reasons, we have seen periods of outright risk aversion since the New Year – but periods of outright risk aversion tend to be brief. Over the last six months, valuation multiples of small-cap stocks in the US have fallen by significantly more than those of large caps.
Once risk aversion abates, we would expect small caps to outperform: fundamentals and growth will eventually prevail over sentiment.
Their bias towards the domestic US economy means smaller companies are somewhat sheltered from international disruption and volatility.
The below chart illustrates that on a forward-looking basis, multiples of small-cap stocks are now below their long-term average. They have been this low on just two occasions in the past 20 years: the financial crisis and during the early stages of the pandemic.
And the long-term arguments in favour of an allocation to US smaller companies remain
- The US is unusually rich in innovative, rapidly growing smaller and medium-sized business.
- Small caps are a way of gaining more targeted exposure to the vitality of the US economy (mega caps tend to be ‘global’ businesses).
- The smaller companies market is less efficient and less analysed than the market for large caps, giving active managers greater opportunity to generate alpha.
- Relative to smaller companies in other geographic regions, US small caps are not particularly small; by European standards these are large companies and in market capitalisation terms the opportunity set here is huge.
At a time of turbulence in the global economy, the US economy appears to be in a good position, helping stocks with a domestic focus
OECD forecasts suggest that the US economy will grow by a very strong 7.8% in nominal terms in 2022. That should directly translate into rapid top-line growth for corporate America. Companies’ sales will rise merely by standing still. Driving that growth:
Consumers are still in a strong position. Savings rates may not be as high as they were a year ago, but excess savings are still high by historic standards. Companies are significantly increasing their planned capex. Employment growth continues and wages are rising, which should support top-line demand. We appear to be in the end-stages of the pandemic (barring the emergence of another variant). So, consumer demand should begin to normalize from here.
Once inflation worries abate, smaller companies should prosper.
Understandably, risk aversion has increased as geopolitical tensions have intensified and as inflationary pressures have mounted. At some point, however, that inflationary panic will start to ease, it should allow investors to regain their appetite for riskier stocks – including smaller companies.
Look away from the jobs market and at least some of the factors that fuelled headline inflation are already starting to ease. Rising used car prices have attracted an unusual amount of attention through the pandemic (prices rose by an incredible 30% in two years ). But their contribution to headline inflation should start to fade from here – or even go into reverse as global auto production resumes.
Finally, the massive investment in technology undertaken by corporate America over the past five years – and which they accelerated during the pandemic – should have a disinflationary effect.
These extremely polarised market conditions won’t persist indefinitely
The correlation in returns between growth and value has fallen to all-time lows. The market is currently extremely polarised, rotating between the extremes of these two styles as the debate over inflation and interest rates evolves. If cyclicality is doing well one day, then growth is, by definition, doing terribly.
We don’t expect this to continue – over time, stock specifics should reassert themselves over style factors and we are confident that our style agnostic approach, with a portfolio that has some cyclicality and some growth, should do well. We expect to deliver alpha in both types of stock.
Positioning: we have a number ‘growth’ names but avoid lossmaking companies.
The Russell 2000 is littered with loss making, high-beta companies which trade cheaply – but many of which we suspect will prove to be value traps. And there are some rapidly growing companies that may deliver profits somewhere down the road. We avoid both extremes – and it’s an approach that has stood us in good stead since the fund’s launch.
We are wary of lossmaking companies and so have a quality bias relative to the benchmark. Instead we’re overweight in growth and quality. Bio-Techne, for example, is already highly profitable but is growing its sales at around 20% per annum. The story with Syneos Health is similar. At the same time, however, we also have cyclicality/financial names such as Signature Bank. More stock examples below.
Our portfolio is underweight in software but overweight in financials
Banks came into the pandemic with extremely strong balance sheets, having rebuilt them since the financial crisis. They over-provisioned for loan losses during the early part of the pandemic. That capital is now being returned to shareholders. We expect a recovery in consumer borrowing as the pandemic is consigned to the past. The yield curve has yet to steepen: yields are rising across the curve. But we do expect yield curve to steepen this year, which will boost lending margins.
Stock example one: Maravai
Maravai’s products critical to the development of drug therapies, vaccines and diagnostics. It recently received – and rejected – an offer from a German company. Its products address the key phases of biopharmaceutical development:
Complex nucleic acid for diagnostics and therapeutic applications. Antibody-based products to detect impurities in the production of biopharmaceutical drugs. Products to detect expression of proteins in tissues. It is well-positioned to take advantage of the massive influx of interest and investment flowing into the mRNA area as well as growth in the cell and gene therapy space more broadly.
Stock example two: Planet Fitness
This will be a familiar name to longstanding clients; we have owned this low-cost gym chain for some time. It makes gym-going more affordable and less intimidating to newcomers. We reduced our weighting to it significantly during the pandemic but have added to our holding again as disruption caused by Covid begins to be consigned to the rear-view mirror.
To date, its shares have lagged those of other ‘reopening’ stocks.
By removing excess capacity, gym industry became more attractive during the pandemic. Industry data suggests one fifth of gyms won’t reopen.
Planet Fitness ticks an ESG box by helping broaden access to health and fitness (it gives free membership to students during the summer, for instance).
Stock example three: Pool Corporation
Through a combination of organic growth and acquisitions Pool Corp has established a dominant position in the market for swimming pool supplies and consumables: lights, filters, pumps. This gives it an enviable degree of pricing power in its niche.
Moreover, during the crisis people used their savings – and filled their time – by installing swimming pools. This dynamic came in addition to a southward migration in the US: people are moving to more southerly and warmer states where pools are more attractive.