Why have investors become allergic to small-cap growth stocks?

Nick Ford

Premier Miton US Smaller Companies

After a great run in 2020, the Russell 2000 Growth Index has fallen into bear market territory. This key index is home to many of the fastest growing smaller companies in America. It has fallen more than 20% from its November high and the magnitude of the decline from a peak in February 2021 is now close to that that occurred during the recession in 2020. The sector performed spectacularly while the pandemic was raging as it is well populated with online business and other stay at home plays. Since the demise of the pandemic, however, investors seem to have preferred companies set to benefit from recovering global economies.

Newly public companies (also known as recent IPOs) have suffered even sharper falls as evidenced by the decline in the price of Renaissance IPO ETF which is a good proxy for this asset class. We’re very enthusiastic about the prospects for this area of the market as it tends to have the potential to be home to the undiscovered gems of the future. Companies like Starbucks and Salesforce.com were recent IPOs a few decades back, as was Amazon.

We’d point to a number of reasons why the sector has done poorly since the end of last year. They all centre on a market environment that has moved from “risk on” to “risk off” as investors worry about the impact of inflation and higher interest rates:

1) Newly public companies are at the far end of the risk spectrum. Their shares often have lower trading liquidity and large amounts of stock are typically closely held by early backers. This is a high beta sector and just a few large sellers can hurt stock prices.

2) Business models are relatively unproven: the sector features many companies which are not yet profitable. This makes them an ideal target for short sellers when market conditions are less favourable.

3) Companies that have recently listed have limited financial reporting histories for analysts to scrutinise. Some of the most severe share price markdowns we have seen have been for stocks listing within the last 12 months.

4) Valuations are often high as these new companies attract investors with forecasts of strong top line growth. We have seen sharp falls in richly valued stocks in the aftermath of higher long term treasury bond yields.

5) The high level of new issuance over the last two years has caused some “indigestion” as investors struggle to work out which ideas are the most exciting.

Key growth sectors including healthcare and technology have been under tremendous pressure. The S&P Biotechnology ETF has entered bear market territory having fallen more than 40% from its peak in February 2021. The trigger for the change in the prices investors are prepared to pay for companies in these sectors has been the back up in 10-Year Government Bond yields. This is an important component in how investors value growth companies as it provides the rate of interest used in models to establish the worth of earnings streams which are anticipated in the future. The low interest rate tailwind for growth stocks in the years prior to 2021 has become a headwind as yields have risen from 1.2% last summer to over 2% now.

The back up in bond yields has encouraged investors to buy cyclical stocks and the Russell 2000 Value Index of smaller companies has begun to significantly outperform the Russell 2000 Growth Index. The former features many companies set to benefit from the reopening of global economies. Growth stock underperformance has been exacerbated by sector rotation – investors selling pandemic winners/buying lower priced cyclicals. Stocks in the energy, basic materials, industrials, and banking sectors have been the big winners.

Somewhat encouragingly for small-cap growth investors, we may now be reaching a point where the severity of the drawdown has begun to make valuations look appealing again. The relative PE ratios of some of the key smaller cap indices compared to the large cap S&P 500 Index appear close to the record lows of the last twenty five years. In particular, the high growth software sector within technology has seen quite a de-rating to a point that is near the trough of valuations seen over the last several years. The sector was a major pandemic beneficiary as many constituents help businesses transact online.

What would really get the small-cap growth asset class motoring again, however, would be if investors begin to anticipate that inflationary pressures are peaking (suggesting less need for the Federal Reserve to raise interest rates aggressively) and that the yield on the US 10-Year Treasury Bond has already made most of its move higher. High growth stocks are currently considerably out of favour, and any change in investor sentiment has the potential to result in a sharp rally. Our enthusiasm for the sector remains undiminished despite the recent drawdown.

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Risks

Reference to any particular stock does not constitute a recommendation to buy or sell the stock. The value of investments may fluctuate which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.

The performance information presented in this fund manager insight relates to the past. Past performance is not a reliable indicator of future returns.

Where investments in a fund are denominated in currencies other than sterling (for example, if a fund holds assets priced in euros), its value will be affected by changes in the relevant exchange rate. Certain other investments, such as the shares in companies with profits from other countries, will also be effected.

Government and corporate bonds generally offer a fixed level of interest to investors, so their value can be affected by changes in interest rates. When central bank interest rates fall, investors may be prepared to pay more for bonds and bond prices tend to rise. If interest rates rise, bonds may be less valuable to investors and their prices can fall.

Changes in central bank interest rates can affect all types of assets, in particular, securities such as government bonds and corporate bonds that generally offer a fixed level of interest. If interest rates go up, the value of a bond may fall, and vice versa.

Investment in smaller companies is typically higher risk than investment in larger companies. Shares in smaller companies can experience greater levels of volatility.

Forecasts are not reliable indicators of future returns.

IMPORTANT INFORMATION:

Whilst every effort has been made to ensure the accuracy of the information contained within this document, we regret that we cannot accept responsibility for any omissions or errors. The information given and opinions expressed are subject to change and should not be interpreted as investment advice. Reference to any particular stock or investment does not constitute a recommendation to buy or sell the stock / investment.

All data is sourced to Premier Miton unless otherwise stated. Persons who do not have professional experience in matters relating to investments should not rely on the content of this document.

For your protection, calls may be monitored and recorded for training and quality assurance purposes.

Issued by Premier Miton Investors. Premier Portfolio Managers Limited is registered in England no. 01235867. Premier Fund Managers Limited is registered in England no. 02274227.  Both companies are authorised and regulated by the Financial Conduct Authority and are members of the ‘Premier Miton Investors’ marketing group and subsidiaries of Premier Miton Group plc (registered in England no. 06306664). Registered office: Eastgate Court, High Street, Guildford, Surrey GU1 3DE.

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This section of the website and the content it contains is for retail clients only and by persons who are resident in the United Kingdom [who are not US persons]. Professional advisers should refer to the Professional Advisers site.

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The information contained on this website does not constitute an offer or solicitation to sell or purchase shares in the funds or portfolios or to provide you with other products or services. Any application or investment must only be made on the basis of the relevant documentation of the investment, such as, for example, terms and conditions. The information on this website does not constitute any investment, tax, legal or other advice. Persons who do not have professional experience in matters relating to investments should always consult with an independent financial adviser before making an investment decision. Any opinion expressed on individual funds, services or products represent the views of the individual at the time of preparation and should not be interpreted as a personal recommendation to buy or sell or otherwise trade all or any of the investments that may be referred to.

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