26May 2016

Ralph Bassett

Head Of North American Equities

Big opportunities, US smaller companies

Smooth sailing does not accurately describe most of today’s global markets, particularly small cap performance.

While the swings in small-cap returns may be discouraging to investors, such correction is typical in a recessionary environment and not when monetary policy is on a tightening course as a reaction to economic strength. This is not a typical business cycle. Central banks are not aligned on monetary policy, creating issues for exporters and foreign economies alike from the strengthened US dollar.

At the same time, sustained low energy and commodities prices are suggesting financial catastrophe for many smaller companies, particularly those that carried leverage. None of these are new issues, but time is testing patience.

The question is whether the markets are now oversold or if there are indeed more potholes ahead. Many investors focus on valuation(s) as a reason to become more constructive. On this measure alone, small-cap stocks now trade largely at parity with larger companies and below their historic forward price/earnings multiple. But we look at the world from the opposite perspective and would suggest that to have confidence in valuations you must first have conviction in forward profits and cash generation.

Over the past several quarters, we have seen some businesses deliver unexceptional results, but they are far from disastrous. Currency swings have tended to be the main spanner. The focus of investors has hinged on the outlooks of management teams, which now have increasingly incorporated a dose of conservatism.

The biggest risk to US smaller companies is US Federal Reserve (Fed) policy. This includes, first, if future policy does not take into account the peripheral risks of a stronger US dollar on trade and international economies. And second, if the current macro contagion causes domestic businesses and consumer to pause. Absent this, the domestic US economy will remain reasonably healthy with near full employment and low inflation.

What does this all mean for small-cap stocks?

While we are prepared for volatility ahead, we remember that times which test our patience can provide investment opportunities. In fact, we see more now than in a long while. Some businesses are trading at discounts to their intrinsic value under less fear-driven market environments.

On a relative basis, we also see a favourable overall backdrop for small caps – over the medium to long-term. This stems from our conviction in a healthy set of small-cap companies’ business models, current valuations and a stable domestic economy. Such conditions are generally supportive of smaller companies, which usually source less revenue from overseas. In particular, this type of environment leans well toward active management strategies that focus on the fundamentals: searching for quality businesses with supportive balance sheets and pragmatic management teams.

© John Holcroft/Ikon Images/Corbis

Ralph Bassett, Head of North American Equities

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