Small caps are out of favour and valuations are low. Recession is ahead but business remains reasonably solid for the moment.
Small caps are out of favour but their low valuations offer opportunities
Smaller companies have been hit harder than large caps in 2022 for three main reasons:
- They are ‘perceived’ to be more risky than large caps,
- They are seen to have more exposure to the domestic European economies which might be suffering more from the energy crisis and
- There have been a number of IPOs of small cap ‘concept’ stocks whose valuations were out of proportion with their fundamentals over the last years and then came back down to earth in 2022.
The valuations of smaller companies have come down substantially, revealing a number of opportunities.
Lower share prices and the resilience of our portfolio company profits mean that median multiples of the Argonaut Fund have now come down to well below the historical average: the price to book value multiple is now below 1.0x at 0.98x, the PE ratio has fallen to 10.7x last year’s net profit and the dividend yield is 3.3%
The gravitational pull of fundamentals
2022 was the year of inflation, but also of the return to fundamentals as the exorbitantly over-valued shares and concept stocks, which had driven markets higher over recent years, started to come back down to earth. “Concept” stocks that did not have a medium-term path to value creation through net profits were dumped and led markets lower. This means that “value” shares (or simply companies creating value and trading at sensible multiples) fell less than indices.
The rise in interest rates has also accelerated this trend towards shorter duration assets which produce profits now rather than further away in the future. Rather than a classic “growth” to “value” rotation that investors can play tactically for the short term, we have observed the beginnings of a more structural shift from “growth at any price” to “valuation counts” or what we call “fundamentals Investing”.
Outlook for 2023
Inflation – Despite complications in the supply chain and component cost inflation, we expect our portfolio companies to have grown profits by 5 to 10% last year. For this year we expect wage inflation to put pressure on costs, but most of our companies have shown good pricing power and have raised prices further on 1 January. We therefor expect the self-help measures to drive to earnings growth this year.
Recession – We have had many meetings with company management in 2022 and they are all expecting a recession which will be concentrated on the first half of 2023. However, when asked about their own business trends we hear of relatively good resilience so far. We expect that the messages will deteriorate as we get deeper into the recession in March and April, but some will start to look for light at the end of the tunnel.
The received wisdom is that investors anticipating a recession should be invested in defensives and avoid cyclicals. However, this recession has been anticipated so long in advance that these shares have already moved. If the recession is not too deep and the recovery begins in the autumn (a reasonable scenario), then good quality industrials, with solid balance sheets and attractive valuations that have already over-anticipated the recession, may actually prove to be the best risk-reward balance.
China – At a conference with Swiss small caps in January, we started getting messages on the positive impact of the reopening of China on business in 2023. Companies that exported to China or had operations over there (relevant for many of our investments) reminded us that the continued lockdowns negatively impacted 2022 profits in a substantial way so the reopening in China should provide a tailwind for 2023.
To sum it up – If the global outlook is complicated – to say the least – , we can be sure of one thing which is that buying “good” companies at “great” prices is a long-term strategy that delivers outperformance.