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Small Caps so far in 2022 – is this a longer-term opportunity?

Small caps have sold off, underperforming the wider equity market in the opening months of 2022. Lucy Morris discusses the top-down economic and market factors driving this underperformance and looks at how individual companies are reacting as well as looking at the factors that may trigger a recovery in performance.
March 2022
Lucy Morris

Lucy Morris

Director, Portfolio Manager, Global Smaller Companies Equities

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Inflation had disrupted equity markets even before war hit

Equity markets had been under pressure right from the start of the year from disrupted supply chains, rising prices and higher interest rates. The war in Ukraine is a tragic event that is hugely destructive and poses far-reaching risks. In terms of markets and economies, the war has brought geopolitical risks while compounding the existing inflationary pressures.

Growth shares have been hit hardest, while ‘bond proxy’ investments are at risk from rising interest rates. Broadly, small-cap equities fit into the ‘growth’ section of the market while being more sensitive to investor risk appetite. Underperformance of small caps at the beginning of 2022, however, should be set in context of superior returns over the last 20 years.

A period of higher inflation may also be supportive for the asset class as data from the 1970s demonstrated how smaller companies can outperform in a period of inflation. It is worth remembering however, that the composition of equity markets was very different from now and developed economies haven’t had to deal with sustained inflation for a considerable period.

We focus on talking to the individual companies to find opportunities

While it is important to understand the top-down economic and market forces it can be dangerous to think purely in general terms. Small companies can successfully operate in niche markets, be less subject to broader trends and be more nimble than larger operations. As a result, it makes sense to focus on understanding an individual company’s ability to deliver in the current environment. Talking to management to really grasp the opportunities and challenges they face is key. In recent weeks we’ve checked in with many of our investee companies, exploring how the conflict has impacted their business and seeking reassurance over the safety of staff. These conversations showed that that the experience of Covid-19 had encouraged many companies to actively manage their supply chains to mitigate the knock-on effects from unpredictable events.

Portfolio activity has been limited

In terms of portfolio activity, we’ve not had to make the fundamental shifts in the same way we did when Covid-19 emerged – something that suggests events in 2022 haven’t derailed the broader trend of global economic recovery. We have made some smaller adjustments, however. For example, we sold glass-bottle maker Vidrala at the beginning of the year from the European Assets Trust. This energy-intensive manufacturer had not hedged its energy costs, so a 10% price increase was insufficient to protect profitability and industry-leading margins left little scope elsewhere. By contrast, we added to the holding of Fluidra after the shares sold off with the market fall, as this swimming-pool-equipment manufacturer has end-markets that have been resilient and price-insensitive.

Small caps are positioned for a recovery.

So, will small caps continue to lag in relative terms or are they set to regain ground? On balance, we see several reasons to be cautiously optimistic.

Risk appetite rebound

The course of the war is currently unknowable but, equally, any de-escalation allows scope for a recovery in markets and economies.

Investment-driven growth recovery

There is an opportunity for increased investment to drive growth, as governments seek to build back better in areas such as energy independence and the shift to a more sustainable economic model. With company balance sheets strong, we should expect increased investment in strengthening capacity and reinforcing supply chains.

M&A returns

Strong corporate balance sheets should also encourage a resumption of merger and acquisition activity, which has been suspended in face of the uncertainties of war.

Active management

Broad market moves will leave opportunities for selective investment in under-researched smaller companies.

Risk Disclaimer

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.

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