Investors planning to capitalise on the ongoing recovery from the coronavirus crisis with global small-caps should ensure they are looking for firms with clear growth strategies and strong competitive advantages, according to Aberdeen Standard Investments investment director Kirsty Desson. 
Desson – who co-manages the £1.6bn ASI Global Smaller Companies fund with FE fundinfo Alpha Manager Harry Nimmo – argued that small-cap stocks are often a good way to play the recovery from an economic shock but warned investors to be selective.
As the chart below shows, global small-caps have a strong long-term track record. Since the start of 2000, the MSCI World Small Cap index has made a total return of close to 650 per cent while the MSCI World (which is mainly large-caps) is up just over 290 per cent.
“Whilst small-cap outperformance has been largely consistent, the periods of greatest performance divergence over the last 20 years have been post the tech bubble, from 2001 to 2005, and post-global financial crisis from 2009 to 2011,” Desson said.
“These were periods of market recovery when more economically sensitive, nimble stocks were able to react quickly to the changing environment. We are experiencing similar conditions today.”
Performance of global small-caps vs MSCI World since 2000
Source: FE Analytics
Global small-caps have outperformed the broader index over 2021 so far, as the world economy re-opens from the lockdowns of 2020 and investors anticipate a period of much stronger growth.
The ASI Global Smaller Companies co-manager added that relative valuations are still favourable for small-cap stocks, following their heavier sell-off at the start of the coronavirus pandemic.
But she cautioned that “changes are afoot once again” as we enter the second half of 2021, which could influence how investors should take exposure to the asset class.
“In deciding upon where to place their money, investors need to be aware of two key factors: firstly, a company’s ability to sustain growth and, secondly, its ability to withstand higher input costs and tightening liquidity,” she explained.
“Since the start of the year, (almost) all boats have been lifted by the tide of stimulus-induced growth. The economic recovery from the lows of 2020 has been faster and sharper than expected. Pent-up demand post the US-China trade war in 2019 coupled with unprecedented government support packages during the pandemic have sparked a wave of corporate and consumer spending.”
On the first point of companies’ ability to sustain growth, Desson pointed out that some forward-looking indicators – such as the OECD Leading Indicators – suggest that this broad market activity is starting to peak out.
China is a case in point. As the first country to emerge from the pandemic, it has already started to tighten policy and is reviewing measures it could use to curb excessive growth. Likewise, the Federal Reserve has started the conversation about when it would start to taper its stimulus in the US.
“Hence, we would recommend staying focused on companies with a clear growth strategy, independent of external drivers, which will continue to deliver over the next one-, two- or three-year time horizon,” the manager said.
When it comes to companies’ ability to pass on higher costs and invest in their business, Desson noted that firms’ input costs have been rising since the end of last year and inflation started to tick up.
“In our view, companies with a strong competitive advantage, such as a market leading product, a trusted brand or a unique technology and entrenched relationship with their customers are best placed to ride out higher input costs and maintain margins,” she said.
“Tightening liquidity will also place strains on corporate spending, except for those with healthy balance sheets. Sticking to quality companies will become increasingly important as we go through the rest of the year.”
So which companies does the manager of ASI Global Smaller Companies think are good examples of small-caps that tick all these boxes?
Desson highlighted Generac Power Systems, which is a US manufacturer of standby generators. It makes gasoline-fuelled, diesel-fuelled and bi-fuel engine generators for the residential, light commercial and industrial markets.
“Thanks to its best-in-class product offering, Generac is the market leader in the US,” the manager said.
“Not only that, whilst competitors are grappling to secure supplies and facing production disruption, Generac’s superior inventory management system and well thought out capacity expansion mean that, in contrast to the rest of the sector, the company continues to grow.”
Performance of Dunelm vs wider market over 10yrs
Source: FE Analytics
Dunelm, a leading UK home furnishing retailer, was also singled out as a company that is “rewards of investing in its own business”.
The firm has made significant market share gains in recent years thanks to a successful roll-out of its online operation and a revamped product line-up of homeware goods.
As can be seen in the chart above, Dunelm shares have been strongly outpacing the wider UK equity market (represented by the FTSE All Share index) in recent years, turning this around from some more challenging times.
The third global small-cap highlighted by Desson was Taiwan’s Voltronic Power Technology, which she called “a small-cap gem”. The firm designs and manufactures UPS (uninterruptible power supply) units, inverters and solar power products, supplying them to Tier 1 electrical giants such as Schneider and Eaton.
The manager added: “Management flagged rising raw material prices to us back in November.
“Because of its longstanding relationship with clients, who trust Voltronic’s product reliability, durability and delivery capability, the company has been able to raise prices three times in the last six months to maintain margins.”
Finally, she pointed to Italian IT services provider and systems integrator Reply. The manager said the firm has a “robust financial position”, which it has been putting to use by carrying out acquisitions and enhancing its product offering.
Performance of fund vs sector since launch
Source: FE Analytics
Since launch in January 2012, ASI Global Smaller Companies has made a total return of 316.96 per cent. This puts it in the top decile of the IA Global sector, where the average fund has made 186.39 per cent.
It has an ongoing charges figure (OCF) of 1.05 per cent.