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This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
Our small-cap event was back by popular demand this week. Here, we recap the thoughts of the three managers presenting, covering UK, US and Asian markets.
Invesco Perpetual UK Smaller Companies
Robin West, manager of Invesco Perpetual UK Smaller Companies (IPU), kicked the presentations off by giving a positive view on the domestic outlook for smaller companies.
The UK has been an orphan asset class since the Brexit vote, Robin said, and the myriad Prime Ministers and chancellors (four and six respectively since the start of 2020) we’ve had in recent years has meant that both domestic and overseas investors have avoided the UK.
That seems to be changing, though. The current Labour government is painting itself as a centrist party with a growth agenda, making the UK look like a beacon of relative stability on the global stage, Robin added.
Global fund managers are more positive on the UK, interest rate cuts to come will demonstrate the attractiveness of equities over cash, and the marked pick-up in takeover activity seen this year is proof that UK plc is once again attractive.
To give you a sense of the potential in UK smaller companies right now, when the FTSE Small Cap Index has traded on a similar trailing price-to-earnings ratio to today (11.4 times), the return has been 22.1% over the next 12 months and 42.3% over the next 24 months.
IPU briefly traded on a premium to net asset value at the end of 2019, so there’s clear scope for its current 15% discount to narrow should sentiment continue to improve.
One of IPU’s points of differentiation is its enhanced dividend policy, which was established in 2015. The policy is to pay four quarterly dividends that pay a yield equal to 4%, based on the share price at the end of the prior financial year (31st January). This amount comes from a blend of the underlying income generated by the portfolio and a contribution from capital.
abrdn Asia Focus
Asian small-caps tend to be a more niche part of the market, but they have an enviable record of outperformance, according to Gabriel Sacks, manager of abrdn Asia Focus (AAS). In the past 20 years, smaller Asian companies have outperformed large caps in every single year except for 2021.
Not only that, but the asset class offers higher long-term returns than the MSCI World Index for less volatility.
Gabriel highlighted the structural tailwinds that exist within Asia, which includes the growth of the middle class: 80% of the global consumer class is in Asia and that’s only going to grow quickly.
China is the biggest consumer market globally and while AAS has just 8% of its portfolio in the country, it is invested in local cosmetics businesses, where consumers are downtrading from expensive Western brands such as L’Oreal and Estee Lauder in favour of strong, local brands.
In addition, capital expenditure from businesses in Asia has started to rise once more, which is a positive for companies in information technology.
Soaring stock markets in India, where AAS has just under quarter of its portfolio invested, are convincing more ordinary people to invest through mutual funds. Gabriel was positive on Kfintech, which provides capital markets infrastructure for domestic mutual funds in India, where it operates as a duopoly with one other company.
Gabriel runs a concentrated portfolio of 61 stocks, giving AAS an active share of 97%. In the past three years, the trust has captured 80.6% of returns in rising markets, but only 51% in falling markets.
Despite Asian small-caps having done well both recently and over the long term, valuations remain attractive, trading at around their 10-year average, while investors’ allocation to the region is at decade lows.
AAS has a high-quality (with an average 18% return on equity and 25% earnings per share growth) concentrated portfolio on attractive valuations (the average PE ratio is 17 times and the trust’s discount is 16%). Downside capture over the past three years is low at 51%, but AAS has participated in 80.6% of the upside in rising markets.
Brown Advisory US Smaller Companies
For Chris Berrier, manager of Brown Advisory US Smaller Companies (BASC), there are a couple of potential catalysts that point to a potentially long period of outperformance for American small caps.
First, small caps, which are currently largely ignored and underowned, stand to benefit when capital finally flows out of the small number of mega-caps that have driven the US stock market in recent months with astronomical share price gains. This will happen at some point in the future, though it’s hard to know what the trigger is.
Second, smaller companies have seen good performance in both absolute terms and relative to large caps when inflation has been high (above 3%) and falling.
While Chris can’t say for certain that valuations are absurdly cheap across the board in small-cap land, he certainly thinks that the quality component of the small-cap market (which is where BASC fishes) have good fundamentals and look very cheap versus large companies.
One fundamental change in the small-cap space that we’ve seen recently is that there’s been a big rise in the amount of money that is managed passively by funds that care about the market trends and momentum rather than the fundamentals of companies.
For Chris, this creates a long-term opportunity in the asset class because there are more mispriced equities, be that stocks that are too cheap or those that are too expensive. This has already come through in the rise of the proportion of small companies that do not make profits.
The job that bottom-up, fundamental, active managers such as Chris and the BASC team have is to uncover those opportunities and invest in them on behalf of their clients.
One area the team has found opportunity in is the continued move from evermore globalization to nearshoring and onshoring: the fact that American companies are bringing the production of their goods closer to home, meaning that they must build out or improve the infrastructure that is needed to support this.
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