Good things come in small caps

Global small caps typically outperform during economic recoveries – and the past several months have been no exception, with the sector delivering strong returns as earnings recovered sharply. For investors, the question is whether this momentum is likely to continue now the global vaccine rollout and economic recovery are well underway? 

It is no secret that small caps behave differently to their large-cap peers at different stages of the market cycle. While small caps tend to sell off more heading into a recession, they historically, have led the market during recovery periods supported by faster earnings growth.

As well, small caps generally have greater exposure to cyclical recovery than large caps although it is worth noting they also tend to be more impacted by stock-specific factors compared to large caps.

Recently, we have seen strong performance from the small-cap sector. Measured by the MSCI ACWI Small Cap Index, it delivered strong absolute returns over the past 12 months and solidly outperformed its mid and large-cap peers – outperforming both by approximately 15%. A mixture of Government stimulus measures and investor optimism saw Q2 2020 become one of the strongest quarters for small caps on record, despite a continued uncertainty related to COVID-19.

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While all small-cap sectors have delivered strong performance over the past year, the markets were led by the more cyclically-exposed areas of the market, including the energy, consumer discretionary, industrials, and materials sectors. Value began to significantly outperform growth at the end of 2020 as investors’ risk appetite increased with the release of positive vaccine news.

RISE AND… FALL? NOT NECESSARILY

While small caps are unlikely to deliver the same level of returns over the next 12 months, there is nevertheless a favourable backdrop for small-cap equities going forward, for a number of reasons.

Expectations for small-cap earnings growth is healthy and small caps continue to trade at a valuation discount to their large-cap peers.  

A healthy outlook for mergers and acquisitions (M&A) is also supportive of small caps, as the asset class is historically a beneficiary of M&A activity. 

Certain geographies are also just starting to see the economic benefits of vaccine rollouts, including Japan and select emerging markets. This should support both improving economic growth and small-cap earnings growth.

While the outperformance of certain cyclically-exposed industries in the past 12 months is not surprising given the improved global economic outlook, the magnitude of performance exceeded many investors’ expectations. 

For example, energy companies, led by oil and gas exploration and production companies, outperformed the broader small-cap index by close to 35%.

As investors, it can be difficult to identify suitable oil and gas exploration and production companies due to ESG and climate-related risks. Nonetheless, there have been attractive investment opportunities in the metals and mining industry that delivered robust returns in the past 12 months and also met key environmental, social and governance (ESG) criteria.

One example is Capstone Mining, a Canadian copper miner listed on the Toronto Stock Exchange. Capstone capitalised on a combination of robust production, healthy pricing and reduced costs. 

Additionally, following a period of company engagement on ESG issues, the company is working to improve energy and water efficiencies in its operations, acquiring innovative technology and equipment, and working to improve transparency, which could collectively improve the company’s fundamental outlook. Executive compensation is also linked to ESG metrics, including health and safety and talent management.

THE FUTURE IS GREEN

Responsible investing remains a key theme in small caps as investors and other stakeholders pay increasing attention to ESG issues. However, investors often overlook bottom-up investment opportunities within the small-cap space and the positive environmental impact certain small companies are having.

Indeed, by the very nature of their more manageable size, small caps can be well-positioned to benefit from environmental and social trends. They often are more nimble than larger companies and adjust to changing market conditions more efficiently. 

Corbion is one such firm in the small-cap universe. Its innovation in biotechnology is translating to more sustainable products used in degradable food packaging, touch screen computers and durable automotive components. Corbion’s bioplastic partnership with France-based Total also highlights the differing impact product innovation can have on small versus large companies.

While bioplastics may meaningfully affect Corbion’s earnings growth prospects, it will not move the dial for its much larger partner, Total.

Investors are also increasingly attuned to the fact that what is good for the long-term viability of our economic system and society may also lead to positive investment outcomes. Companies focused on managing risks associated with ESG and capitalising on opportunities tied to ESG may be better positioned to deliver sustainable growth. 

Engagement around ESG issues is a key part of the investment process, and is especially important in the small cap space as disclosure and transparency around ESG is often less robust compared to their large-cap peers.

Ultimately, integrating ESG into the investment process is a critical aspect of understanding risks and opportunities at the company level. In addition to implementing a disciplined integrated ESG approach to our investment process, this excludes any and all names that violate the UN Global Compact (UNGC) and that are on the Norges Bank exclusion list.

SEEKING ACCELERATING AND SUSTAINABLE GROWTH

For asset managers like American Century, the remainder of the calendar year and into 2022 should see a continued focus on companies that have accelerating and sustainable earnings growth. 

We believe in having an increased exposure to ‘door-openers’, companies that are likely beneficiaries of economies reopening and recovering. An example of this is meal delivery company, HelloFresh. We believe the company benefitted from lock-down and stay at home measures.

The stock was a strong performer at the height of the pandemic and lockdown period of last year but, at the time of sale, no longer offered a compelling risk reward trade-off. We also think limiting exposure in some IT stocks should be considered. 

Conversely, we believe there are opportunities in consumer discretionary companies benefitting from a pickup in mobility and consumer spending including travel-related companies, retailers, and auto components makers. Interestingly, we are finding bottom-up opportunities in travel and leisure companies that are benefitting from pent-up demand from consumers, and earnings are recovering strongly off a low base. 

The world’s largest hotel franchisor, Wyndham Hotels and Resorts, is one such example, and is reporting high occupancy rates and revenues per room. The company has also reinvested in the business, which we think may support a sustainable improvement in earnings growth. 

Another consumer discretionary name that we believe may continue to deliver sustainable and accelerating earnings growth is footwear retailer, Crocs. The company spent years cleaning up its sales channels and excess costs in its business and has successfully reinvested in its brand, including strengthening its digital presence.

The company’s growth outlook is also supported by new products, and it recently reported better than expected revenues and profits and significantly raised its guidance for the full year as its Americas business delivered robust results.

While we believe we are unlikely to see a repeat of 2020 performance for the global small-cap market, there nevertheless remains real opportunities for investors to capitalise on the reopening of economies globally, as well as to invest in stocks that offer sustainable and accelerating earnings potential. 

Trevor Gurwich is senior portfolio manager at American Century Investments.