Small caps are usually among the sectors hardest hit in any market downturn, and this year has been no different – IA UK Smaller Companies is the third-worst performing sector out of 58 in 2022 so far, with losses of 22.8%. Only IA European Smaller Companies and IA UK Index Linked Gilts have done worse.
Yet while small caps tend to fall furthest when markets take a dive, they also tend to bounce the highest when they recover.
Performance of index in 2022
Source: FE Analytics
IA UK Smaller Companies was the second-worst performing sector in 2008 when the financial crisis hit, but was the seventh-best performing sector in 2009 and the second best in 2010, generating returns of 50.2% and 31.6% respectively.
Richard Bullas and Dan Green, managers of the FTF Franklin UK Mid Cap and FTF Franklin UK Smaller Companies funds, acknowledge that profit growth, margins and earnings momentum will be challenged as we head into the second half of 2022 and beyond.
However, they said that while there are undoubtedly huge inflationary cost pressures for many businesses, every one will be affected differently and the recent declines in small- and mid-cap stocks have pushed valuations down to bargain levels.
“With market movements being more top-down and macro-data driven, we’re starting to see many interesting opportunities emerge where we believe the risk/reward is being tilted in our favour,” they explained.
“The FTSE 250’s 12-month forward price/earnings (P/E) ratio is currently estimated at 13 times, which is below its long-term average of around 14.4.”
The managers warned that lower valuations don’t automatically make good investments and at times like this, you need to beware of buying into businesses that might not survive the recession.
To protect against this, they are avoiding overleveraged and cash-hungry businesses as well as high-risk or speculative areas of the market.
Instead, they are looking for companies that can take advantage of the current environment and use their balance sheet strength to improve their competitive position, either by acquiring rivals or boosting returns for shareholders.
“Recently, we have seen a large increase in the number of companies using their strong balance sheets to buy back stock,” the managers said.
“Additionally, many companies have emerged from a challenging two-year pandemic period much stronger, with improved market positions and more efficient operations. Many will use their financial and competitive strength to make the most of any volatile periods and we believe they will emerge in an even better position once the economic cycle starts to improve.”
While a strong balance sheet will help a company make it through the current difficult environment, this alone will not drive returns when conditions start to soften. Looking further out, Bullas and Green have identified four themes they believe will help their holdings outperform when the market eventually turns.
The first of these is the digital economy, with the managers pointing out the pandemic acted as a catalyst for technology adoption, accelerating underlying trends.
“We’re seeing growth in the digital economy in different end markets, such as electronic tagging for offenders, cyber security, online auction platforms, language translation and digital marketing, as well as companies in the e-commerce logistics supply chain,” they said.
The second theme is decarbonisation, with Bullas and Green pointing to beneficiaries such as businesses that manufacture more energy-efficient ventilation products for residential homes, and electronic components for customers in renewable energy. They said alternative asset managers that invest in sustainably led companies would also receive a boost.
Next up is consumer brands.
“Although businesses within consumer brands will likely experience short-term pressure on earnings due to a decline in discretionary spending, we believe brands with stronger market and competitive positions will come through tougher economic conditions with enhanced market share,” said the managers.
Last up is content and IP creation, with Bullas and Green noting that audiences are demanding more and more new content through digital channels such as video games, television subscription services and social media.
“We believe the structural growth here will endure for the long term, particularly benefiting businesses that either produce and own content or manufacture equipment used for creating content.”
Yet they pointed out some investment themes remain constant, one of which is using volatility to their advantage by focusing on individual company fundamentals when volatility surges.
“In times of challenging economic forecasts, we heed the advice of Sir John Templeton: ‘The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell’,” they finished.