Is now the right time to buy smaller companies?

Smaller companies often outperform the broader market in the early stages of an economic recovery. This is because they can be nimbler in managing costs and seizing growth opportunities in a changing macro environment. Australian retail investors currently have an opportunity to access fast growing global smaller companies at unusually attractive valuation levels.

“Great things are done by a series of small things brought together.”
– Vincent Van Gogh

What has happened to smaller companies?

Our previous article explained how an allocation to smaller companies adds to portfolio diversification and enhances long-term risk-adjusted return potential. We now consider if this is a good time to increase small cap exposure.

Rising interest rates led to weaker global share markets during 2022, when small caps underperformed because of:

• A perception of greater earnings risk due to more concentrated revenue streams
• Concerns around ability to raise further financing on reasonable terms
• Fewer liquid markets experiencing greater volatility
• Higher country/currency risk reflecting smaller companies’ domestic orientation

Nonetheless, many smaller companies – especially those at the smaller end of the size spectrum – have been quite resilient. Some are nimble enough to adjust their cost base to the evolving economic environment and exploit new opportunities to grow earnings. Others have performed poorly. So it is important for investors to differentiate between companies when investing in small caps. However, small cap stocks overall now appear attractively valued compared to larger caps:

Smaller companies look cheap on an historic basis

The current discount in small caps relative to larger companies is one of the largest since 2008, after which time small caps experienced a sustained period of outperformance.

While share markets are expected to remain volatile for some time, markets have started 2023 positively. Many investors now believe the bottom of the current equity market cycle has passed, inflation has peaked and interest rate rises will soon end. Smaller company stocks tend to outperform at this stage of the market cycle as investors return to the sector.

Which smaller companies can perform well in 2023?

Small cap stocks can be expected to deliver a wide dispersion of returns. Stocks able to perform strongly at this stage of the market cycle are those which manage inventories, control costs, and grow earnings despite the economy uncertainty.

Technology company valuation levels were hit hard in 2022. However, those able to deliver increasing profits despite fluctuating consumer spending are expected to perform strongly. These include business models with largely fixed costs that serve less cyclical markets, such as IntegraFin, the UK investment platform for financial advisers. Similarly, software companies such as Finland’s Tietoevry, which provide difficult to replace services can pass through rising costs as contracts are renewed.

Certain consumer businesses grow earnings in the early stages of the recovery. Polish retail chain Dino Polska which sells essentials is well positioned to capture the ‘first zloty out of the wallet’. Moreover, it is opening new stores in towns and suburbs with growing populations of aspirational shoppers.

The Inflation Reduction Act is driving decarbonisation and manufacturing onshoring in the US – with comparable measures now under consideration in Europe. Industrial groups exposed to these trends stand to gain. Orion Engineered Carbons manufacturers components for lithium batteries and conductive carbons used in high-voltage cables that connect wind and solar farms to the grid.

Global travel is booming following its post-COVID re-opening, helping smaller companies grow earnings. UK online holiday business On The Beach has an agile scalable platform, is experiencing strong demand growth, and can pass through costs.

Opportunities will broaden as the economic recovery gathers pace and a wider range of sectors grow earnings.

The US dollar is now normalising following an extended period of strength. This process will support earnings of companies with US dollar costs but revenue in appreciating currencies. It will also enhance the relative valuations of non-US stocks. European companies are attractively priced following earlier fears that high energy prices would drive a steep recession in the region.

US dollar weakness is expected to favour smaller companies located in Europe, Emerging Markets, and Japan. Tax changes in Japan are facilitating takeovers of subsidiaries, such as Relia, the IT group acquired at a premium by its affiliate Mitsui in a JPY60 billion takeover.

What does this mean for investors?

Small-cap investing may bring elevated volatility but has shown it may also deliver superior long-term outperformance. The current economic environment presents opportunities for long-term investors to enhance potential returns through adding global smaller company diversification.

An actively managed strategy is best placed to identify attractively valued smaller companies that offer attractive long-term risk-adjusted return potential across region, sector and size.