Imogen Harris, fund manager of the Premier Miton Global Smaller Companies Fund, highlights how a recovery in global economic conditions and a mean reversion back to more normalised valuation levels could see a risk-reward balance that swings back in favour of smaller companies.
In a recent pub quiz, I was faced with the question “What is Ernest Hemingway referring to when he states it happens ‘Gradually, then suddenly’?” I insisted the answer was Risk; rather embarrassingly as that is incorrect (the correct answer is bankruptcy). I blame the lost point on the numerous conversations we have had on the Global smaller companies desk about how risk can manifest in markets. We have been overusing the distorted phrase ‘risk comes slowly then all at once’.
In general, smaller companies have been seen as the riskier investment space versus their large cap counterparts. I would place a caveat here – I am using the term ‘risk’ as a generalised catch-all term for both upside and downside risk. While small-caps have outperformed over the long term, it is true they do tend to underperform in periods of economic crisis and bubbles. Investors have been able to take their pick of global economic shocks - choose from the Covid-19 pandemic, the cost inflation shock from 2021 onwards, or an uptick in geopolitical conflict. This is also in the context of an elongated period of ultra-low interest rates, followed by the Federal Reserve implementing an aggressive tightening cycle in 2021.
Despite this assortment of economic speedbumps, the global market has still followed the ‘standard’ small-cap playbook. Simplistically, this is underperforming going into a recession, inflecting when the economic picture bottoms out, and then outperforming through the end of a recession. While growth in Europe and the UK, reflected in indicators like the Purchasing Manufacturers Index, may still be weak, we are seeing a stabilisation in the data. The sluggish prospect of China’s property sector has been weighing on global markets, but fiscal stimulus may at least encourage more activity than we have seen of late. The US economy has held up much better than expected, despite some weaker macroeconomic data points emerging over the summer, and we have seen stronger markets in the post-election aftermath of a more certain policy framework. Indeed, Global small-caps have delivered double-digit returns over the last year with many regional small-cap indices sitting at or close to all-time highs.
The outperformance of the large cap space, while somewhat driven by earnings, has been also accompanied by a significant re-rating. The Russell 2000 Index, our proxy for US small-caps, is trading on a price to book ratio of 2.2x, having not rerated at all from its September 2014 valuation of 2.1x. Conversely, the Russell Top 50 index now trades on a price to book ratio of 6.8x, having re-rated significantly from its own September 2014 valuation of 2.9x. While the re-rating of mega caps has been justified to an extent by earnings, this valuation dynamic does imply that the mega-caps need to keep growing over the next decade at a similarly rapid rate as they have over the past decade.
Valuation gap between large and small-cap is extreme
Source Bloomberg: 30.09.2004 - 30.09.2024. Past performance is not a reliable indicator of future returns.
If we see the combination of the two catalysts above – a recovery in global economic conditions and a mean reversion back to more normalised valuation levels, then we could see a risk-reward balance that swings back in favour of small-caps. At this stage in the investment cycle, global small-caps are providing an earnings generation stream at cheaper valuations, both versus their own recent history and large cap peers. Moreover, this earnings stream could inflect higher if we do see continued economic recovery. If I could also talk up the global book - added to this are the benefits of being able to be diversified geographically, broadening your market risk out. In an investment landscape that is dominated by concentrated indices and the prevalence of mega caps, small-caps offer an alternative form of risk with upside optionality.
Risks:
The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.
Past performance is not a reliable indicator of future returns.
Forecasts are not reliable indicators of future returns.
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