Investment fundamentals have taken a back seat to factor rotation, and this has created attractive bottom-up opportunities where share prices for select companies with solid growth prospects have been unfairly punished.
January saw the sharpest monthly outperformance of value to growth in over 10 years, with this volatility only continuing throughout February as the Russia-Ukraine crisis weighed heavily on investor sentiment.
The situation remains tense and Russia’s risk premium remains elevated with the likelihood of further sanctions. In the short-term, the market may see a continued risk-off environment, a temporary setback in European consumer confidence and growth, a further rise in energy and select commodity prices, and a more cautious stance from the European Central Bank and Bank of England.
In the medium to long-term, the market could see a return to previous trends of rebounding economic growth post-Omicron, faster diversification away from Russian oil and gas, more spending on renewables and nuclear power, more military spending and a progressive weakening of the Russian economy.
However, as with all global market shocks, there are multiple moving pieces, and the ramifications of these scenarios are anything but certain.
From a pure earnings growth perspective, 2022 strongly supports the global small cap market. Economic recovery, cost reductions achieved during the market downturn, and significant potential for merger and acquisitions activity will likely deliver tailwinds for the sector.
Small cap stocks are projected to deliver faster earnings growth in 2022 – relative to their large cap peers – and the asset class continues to provide many attractive stock selection opportunities.
While consensus earnings-per-share growth numbers may come down and the market sees a challenging earnings environment early in 2022, there remains an attractive backdrop for small cap earnings growth in the second half of the year.
Perhaps counter-intuitively, lingering volatility will continue to create stock-picking opportunities for small cap investors. Given the high level of uncertainty in the market, maintaining a diversified portfolio of companies that represent compelling process fits, businesses with accelerating and sustainable earnings growth, is critical.
It is wise to take a measured approach to both risks and opportunities at the stock and portfolio level. Maintaining a balance between reopening and secular growth trends will also be key.
Other thematics driving the performance of global small caps for the remainder of the year may include:
- Consumers’ preferences shifting to face-to-face experiences: As the global economy recovers, stay-at-home trends are fading in favour of a return to more normalised, in-person interaction. This benefits many bricks-and-mortar businesses and experiential companies, including travel and leisure. The wildcard in this equation is the ultimate impact of Omicron and any subsequent variants. A return to lockdowns could delay the return to normality for consumers.
- Information technology spending remains robust: In addition to ongoing secular trends, companies are increasingly realising the importance of a hybrid business model. Investment in online commerce, security, employee identification and payment processing are helping IT investment surpass that of physical plant and equipment.
- Inflationary pressures may persist: Recruitment companies may continue to benefit from tight labour conditions and wage inflation. Distribution companies who can pass on price increases may also offer inflation protection. Inflation can also be a positive driver of earnings growth for companies with pricing power like residential and commercial warehousing property REITS, such as Tricon Residential REIT in Canada and Tritax Big Box REIT in the UK.
- Easing supply chain bottlenecks in 2022 may create opportunities: Select small cap companies that were negatively impacted by supply chain pressures in 2021 may see renewed opportunities after a sustained period of supply pressures. However, the current situation in Ukraine may delay those improvements.
- While Russia does not represent a large portion of the small cap universe, it is important to understand how the crisis may impact companies more broadly. This include companies that may be affected by high and rising energy and select commodity prices, sanctions, and/or elevated risk premiums. We have been reducing exposure to high multiple, low free-cash flow, long duration names. We are also reviewing our exposure to European companies that may be impacted directly by the current situation and have become more positive towards several commodities including fertilisers and nickel because Russian sanctions are likely to disrupt supplies in the near term and lead to a strong pricing backdrop.
It has been a remarkable couple of years for global share markets, and uncertainty is likely to remain in the short to medium term, at least. But for global small cap investors, such volatility has the capacity to create opportunities that would otherwise not exist.
Jim Shore, client portfolio manager at American Century Investments.
