Four small caps for the 2023 contrarian

Last year was one the worst on record for global stock markets. Yet the MSCI World Index has returned to levels that can hardly be described as cheap, trading at approximately 16 times earnings.

However, the discrepancies are extreme. Small-cap land has been most heavily hit, which is where the opportunities may lie in 2023.

Sheltering in quality

As is usual in bear markets, there is currently a strong desire to own “quality” - resilient stocks that won't outgrow significantly in good years but will remain steady during the bad. Many big broker houses are recommending a quality tilt in their research reports and 2023 equity predictions. However, you don't have to look far to see that the resilience of these companies is already being priced in for most, with many now trading at significant valuation premiums relative to the broader market.

There is a place for quality companies within a portfolio. A number of them provided a bright spot in what was a rough year for the Forager International Shares Fund, including Keysight (NASDAQ: KEYS) and CDW (NASDAQ: CDW). But we believe the real opportunity for the contrarian investor lies within the sectors that have been punished most harshly during 2022.

Opportunities in distressed spaces

Many of the darling sectors that performed well in 2020 and 2021 have experienced a vast unwind. They are now faced with a tougher outlook due to rising interest rates and a weak housing and consumer market.

Finding the exceptions within these punished sectors - companies that end up being more resilient than expected - is where some great returns could come from.

Pockets of opportunity

Starting with the sports betting sector, Flutter (LON: FLTR) was a huge favourite in 2020 and 2021. It was then hammered in the first half of 2022.

The share price tumbled in solidarity with Draftkings (NASDAQ: DKNG), Flutter’s main competitor in the US. Investors were throwing these two companies in the same bucket, despite their differences. Flutter posted better-than-expected results for several quarters, while in the same period Draftkings posted several profit warnings.

It looked to us like Flutter was winning in a huge and important market, yet the share price was suggesting the opposite.

Businesses experiencing Covid unwind is the next area of focus. In Australia, companies like JB Hi-Fi (ASX: JBH) and Nick Scali (ASX: NCK) have sold off due to investor concerns surrounding the profits and sales these companies were making during the pandemic. Therein lies an opportunity for any business that can buck the trend.

A recent International Fund portfolio addition, Yeti (NASDAQ: YETI), a lifestyle brand that produces premium coolers and drinkware, is a company that could do exactly that. Yeti has grown more than 25% year on year for the better part of a decade and, with its significant international expansion potential, could keep doing so. The strong secular component of the Yeti story should offset cyclical headwinds.

Fears about a rising interest rate environment, largely because the impacts have not yet hit, is another area where pockets of opportunity can be found.

Techtronic (HKG: 0669), a stock previously owned by the International Fund in 2020, was recently added again during the 2022 weakness. The company has shown strong resilience and continues to take market share from competitors in the tools space (it owns Milwaukee drills). Techtronic invests heavily in R&D relative to competitors and even if there is continued pressure, the company should emerge from the recession much stronger than it came in.

The last area of focus is where smaller companies have been hit by rising interest rates alone. Where the underlying business is still performing well, but investors are applying higher discount rates to compensate.

Janus International (NYSE: JBI) is exposed to the consumer storage space. This is an industry that is booming and at all-time high utilisation rates in the US. The company itself has been outperforming expectations throughout the year, but the share price has lagged to reflect this.

Janus, alongside companies like eGain (NASDAQ: EGAN) and InMode (NASDAQ: INMD), are all showing signs of resilience and are coming into next year at near-rock bottom valuations relative to their history. And ultimately, lower prices present an opportunity for better returns.

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