With small-cap stocks staging a strong bull-market rally in 2013 and outpacing larger-cap stocks for more than a decade, investors may be worried about a correction.
But despite stretched valuations, small cap is one of the few places investors can still find growth in today’s market. While economic prospects are improving, growth remains scarce so small caps still have room to run, says Andrew Neville, portfolio manager of the AllianzGI Global Small Cap Fund.
However, jumping in and out of small-cap stocks tactically can be a recipe for failure. Historically, it’s been difficult for investors to get the timing right, prompting them to sell smaller companies on the way down. Yet, in every rolling 10-year period from Jan. 1, 1999 to Dec. 31, 2013, smaller companies have outperformed larger companies. Given small caps’ inherent volatility—20%-plus swings up or down are not uncommon—it makes sense for investors to have a strategic long-term allocation to small-cap stocks, he says. That way, investors can tap the long-term growth potential of smaller companies, diversify more broadly and look to reduce the overall risk of their portfolios.
In the following interview, Neville discusses current small-cap valuations, his outlook for 2014, the pace of M&A activity and where he’s finding attractive growth opportunities around the world.
Small-cap stocks had a strong run in 2013, capping 13 years of outperforming their large-cap counterparts. Are small caps too richly valued?
From a global point of view, not only have smaller companies outperformed larger ones for the past 13 years, but also their earnings have grown faster. Intuitively, when the economy is growing, smaller companies will outperform and grow their revenue, earnings and dividends faster than larger companies. So there’s good reason for that outperformance. But it’s fair to say that small-cap valuations, relative to their long-term average, are at a premium right now. That’s primarily because smaller US and Asian companies are trading above their long-term average.
The other side of it is that growth around the world is in short supply. Western governments—and the financial system in which they operate—have too much debt and they need to shore up their balance sheets. Those are two strong headwinds. If you can find an asset class that’s growing—and if it can finance its own growth—then that asset class will go to a premium. And we’re starting to see that trend take hold. But smaller companies still have a ways to go before they reach historic valuation levels. They’re not overvalued because people are valuing their growth. They’re overvalued because growth is so scarce and small cap is one of the few places you can find it.
Cheaper Earnings Growth
On a growth-adjusted basis, small caps
are cheaper than their larger-cap counterparts.
Source: Allianz Global Investors. Data as of 12/31/2013.
||MSCI World Small Cap Index
||MSCI World Index
|Price-to-Earnings Ratio 2014 (weighted harmonic average)
|Earnings Growth 2014 (weighted median)
What’s your outlook for small caps in 2014?
Smaller companies start to underperform when an economic downturn is on the horizon—typically at least six to nine months in advance. I don’t see that happening in the United States and Europe, where we’re seeing a recovery—albeit different stages of a recovery. Meanwhile, Japan has powerful tailwinds at its back including monetary and fiscal stimulus. North Asia is recovering. Aside from Southeast Asia and Latin America, I don’t see an economic downturn in the rest of the world for at least three years. And that should benefit smaller companies.
As long as the recovery, in terms of GDP growth, is between 1% and 3.5%, small companies are poised to do very well. They’re exposed to niche markets that are growing and they don’t rely heavily on the financial system, whereas large companies struggle in a slow-growth environment. That 1%-3.5% growth range is the sweet spot for small caps because you don’t have interest-rate pressure. When you have modest economic growth like we’re seeing today, that’s when the “niche-iness” of smaller companies comes into play.
Big Edge for Small Caps
Since 1999, small-cap stocks have outperformed
large-cap stocks in every rolling 10-year period.
Past performance is no guarantee of future results.
Source: FactSet. MSCI. Rolling 10-year returns from 1/1/1999 to 12/31/2013.
Where are you finding attractive small-cap opportunities?
We’re finding companies in North Asia attractive, particularly exporters that are already benefiting from the US recovery, and may stand to benefit from a nascent recovery in Europe. We’re also well-positioned in China, investing in companies that should benefit from its latest economic and political reform agenda—environmental waste companies, for example.
In Japan, we favor exporters and industrials that are not only benefiting from the improvement of fiscal and monetary stimulus in Japan, such as homebuilding and reconstruction companies, but also companies that are benefiting from an improving global recovery. In the United States, we’re currently focusing on health-care companies that are benefiting from regulatory changes and hospitals looking to cut costs. In Europe, we’re finding the domestic consumer arena attractive particularly in North European countries where economic conditions are improving.
Can you cite specific stocks that best reflect the investment process?
We own Tadano, a Japanese crane manufacturer, which has strong market share—23% globally and 50% in Japan—and strong products. And the end markets it serves are improving. The company stands to benefit from Japan’s reconstruction efforts and an improving construction market in the United States and the Middle East. It’s a sector where a lot of the competitors dropped out a long time ago because they didn’t have the financing to maintain their fleets. This has created significant pricing power. It suits our philosophy too. It’s based in Japan. Management speaks Japanese. So having that local expertise is crucial.
Elsewhere, we own China Everbright International, a waste-water treatment company that benefits from China’s efforts to tackle its environmental issues. In China, the skill set to do this is pretty thin on the ground. So there are significant barriers to entry. This market is driven by both consumption and legislation. Another company that we hold in the portfolio is Yoox, an online retailer in Italy. On Yoox, consumers can buy branded goods from all over the world. While we trimmed our position in the stock in September after a strong run, the company is still exhibiting rapid growth.
Small caps tend to benefit from accelerated merger and acquisition activity. What’s your outlook for M&A?
Looking ahead, US M&A activity will continue to improve along with the economy. Europe is starting to turn a corner. In 2014, we expect cautious finance directors and management at European companies to become more confident in the outlook and start to deploy their cash. Today, they’re still in capital preservation mode. They’re not spending ahead of growth. They’re waiting for growth to come. As the political situation quiets down, you can expect some pressure from shareholders to put that cash to work either through M&A or returning it to shareholders. Management will likely go down the M&A route if given that choice.