Where Does the Value Lie?

Small and mid-cap equities continue to be among the least efficiently priced segments of global equity markets. This situation has fostered a favourable investment landscape for active investors looking for companies that can generate long-term shareholder value.

The view that markets are less than completely efficient and that the actual value of a business is not always reflected in the price of its shares is well established and widely held.

There are various metrics for identifying such undervalued companies. These include analysing revenue streams, focusing on businesses that have the potential to generate significant revenues from changes in their industry, and looking for firms that are well placed to take advantage of an upward earnings cycle.

If we take Fidelity International’s Global Future Leaders strategy as an example, from a list of approximately 1,000 global small- to mid-cap companies, those with poor ESG ratings are immediately screened out.

It then conducts more detailed analysis on the 150 to 200 investable stocks that are found to have the most promising prospects during the initial screening, based on viability of returns (pricing power, strong opportunities and rising return on equity), sustainability of returns (a strong industry position and the ability to generate cash flow to fund growth and withstand competitive pressures), and credibility (strong conviction in the quality of the business and management).

At an individual stock level, the highest-conviction positions are in the range of 200–300 basis points (bps) overweight, medium-conviction holdings are 100–200 bps overweight, and reasonable-conviction positions have a 50–100 bps exposure at any given stage.

How to Defend Your Position

Risk management is a key element of investment strategy regardless of market conditions. But when there is so much uncertainty surrounding global macroeconomics and geopolitics, it is vital to have some sort of allocation to defensive assets.

There are many options here – some investors will hang their hats on consumer brands that seem oblivious to inflationary turmoil, while others will look at the tech giants with their soaring valuations and seemingly limitless potential. The startling rise in the value of gold, which peaked in the early weeks of this year, will have encouraged many to look to precious metals.

According to Artemis analyst Harry Eastwood, an allocation to some of the world’s modestly valued, growing but under-owned smaller companies has something to offer the defensively minded.

This thesis is based on three interrelated factors:

• The world looks different from how it did when many managers formed their ideas of what constitutes a ‘defensive’ asset.

• The fundamentals of some smaller companies are compelling, particularly when compared with the large US companies that dominate market-cap-weighted indices.

• Diversification remains the only free lunch on offer in financial markets.

Eastwood notes that attributes that were once helpful for mega-cap multinationals, such as their globally diversified revenues and international just-in-time supply chains, now appear to be liabilities. Smaller companies, by contrast, tend to focus on their domestic markets, which offer shelter at a time when trade tariffs can change overnight.

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“Diversification may be the only ‘free lunch’ in investing, but it has slipped down the menu in recent years,” he says. “The comfort zone for many investors has been to be long in the US, long in mega-caps and long in growth. Funds that track capitalisation-weighted indices are exposed to the same themes and, until relatively recently, that was a winning formula.”

But now a handful of mega-cap technology stocks exercise outsized influence over the success (or otherwise) of market-cap-weighted indices. Given the level of political and economic uncertainty, it is reasonable to ask whether having close to two-thirds of your equity portfolio exposed to the US – as anyone tracking the MSCI AC World Index does – makes sense.

Don’t Rush to Judgement

Small-cap stocks have been viewed as persistent buy-and-hold winners since the 1990s because their higher risk premium led to historical outperformance. However, this return anomaly has faded.

When the small-cap anomaly started to gain notoriety, large firms had relatively more debt and made more acquisitions that were not always accretive to earnings. These bloated conglomerates often made small and nimble firms appear attractive.

However, we are now in a different era. Small-cap stocks have lost much of their edge over the past decade, with persistent underperformance against large-caps driven by structurally less supportive long-term market dynamics rather than just short-term cyclical factors.

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That is the view of Michael Gates, Head of Model Portfolio Solutions for the Americas and Lead Portfolio Manager for Target Allocation Models and Mutual Funds at BlackRock.

But just because small-caps have lost some of their edge does not mean that they should be discounted. For example, Gates sees reasons to own small-caps selectively with a more dynamic approach, trading on tailwind indicators rather than owning them long term.

“If the IPO market re-emerges from its current winter, we believe that smaller firms could go public sooner and potentially allow the stock market to capture more early growth,” he says. “In our view, small-caps could also see tailwinds from rate cuts, which could lower the cost of their relatively high debt burden.”

The Fed moving faster than markets anticipate on the way back down could provide an upside for debt-laden firms, while temporary supply disruptions have also benefited smaller stocks in the past.

Gates notes that because large-caps tend to rely disproportionately on global supply chains, supply shocks and trade disruptions have served as a boon for firms that source domestically. These forces could create tradable events and sector trends.

“It is not that small-caps have lost all their potential,” he concludes. “Our analysis indicates that they can be great investments when bought at the right time.”

This article was written by Paul Golden at www.financemagnates.com.Retail FXRead More

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