As earnings season uncovers the creaks at U.S. large cap stocks, investors are now spending more time researching U.S. small cap investment managers. Given a back drop of rising rates and recessionary pressures, it seems like a contrarian view. But the investment managers they are looking at are doing things differently. Here are 4 examples of the types of U.S. Small Cap companies these managers like:
1. Small Cap companies that have managed to keep their balance sheets strong. In doing so, they have protected themselves from rising rates.
2. Small Caps that are not affected by a strong dollar that could hurt non-domestic demand for their goods and services.
3. Small Cap companies that are not affected by supply chain dislocations, or reliant upon maintaining large inventories.
4. And if you can find them, small cap companies which have pricing power with their customers. Which is what the fundamental based research asset managers are doing.
The attraction to U.S. Small Caps today is supported by valuation. Comparing Small to Large Caps, various multiples suggest the market is trading at lows not seen in almost 50 years.
U.S. Growth Stocks have fallen back to earth this year, and even more so then the broader index. The combination of accelerating inflation and interest rate hikes has switched investors risk-on trade firmly off.
Investing in companies run by new, unproven, or inexperienced leadership teams, building businesses built on disruption and the promise of abnormally high future earnings streams has lost followers. The question today is who are they now following?
Whether Bond Yields have peaked was a common search query that had nothing to do with bond allocations. The insights that were viewed were from asset managers running long duration equity portfolios i.e. growth strategies.
Given the underperformance of this segment of the market in the first half of the year, and the poor 18 month outlook for growth, institutional investors seem to be assessing whether the market is now at fair value.
Expect an Increased Focus on Capital Allocation, Quality and Sustainable Free Cash Flow
Until recently, we had been in a disinflationary environment since the 1980s, when Volcker helmed the Fed. This secular trend reflected three forces: (1) Correcting the policy mistakes made in the ’60s and ’70s that stoked stagflation, (2) the increasingly globalized nature of trade, investment, and finance from the mid-1980s, and (3) the deflationary impact of tech, which has been especially impactful during the last two decades. While the latter factor remains in place, we believe it is being overwhelmed by the 3Ds — Deglobalization, Demographics and Decarbonization — meaning we have entered a secular reflationary environment.
The remainder of this note briefly explains each of the three Ds and then concludes with a discussion of what all this means for investors.
With the Russell 2000 trading at it's most attractive discount to the Russell 1000 in more than 20 years, professional investors are considering looking beyond the cyclical characteristics of U.S. smalls caps. Even as rates are on the rise and a recession may lie ahead.
This contrarian tactical view revolves around the contention that fear is preventing most investors adding to Small Caps (as supported by the current extreme levels of the VIX index) and the belief that the spread between large and small caps will follow the historical mean reversion path.
Mid Cap Stocks occupy a unique place in the market capitalisation continuum around the $2bn to $10bn space. At this stage in the economic cycle professional investors are turning to Mid Cap stocks to solve two main issues.