Smaller companies are like a barometer of stock market sentiment. When investors become nervous about the future, they tend to underperform larger stocks, which are perceived to be less sensitive to macroeconomic news. Conversely, when optimism about the market outlook picks up, smaller company shares often rise the most. The movements of past 12 months reflect this pattern, with the initial fears about the impact of the pandemic quickly superseded by hopes of revival, not least after the positive news around the successful development of Covid vaccines.
Reflections on our portfolio
We have seen a similar impact to the BMO Global smaller Companies Trust portfolio over the last year, but as in any period for a smaller company fund, there have been some large-scale winners and losers. The initial gainers from the lockdowns – the “stay at home” beneficiaries – have tended to lag more recently as markets moved to look forward to a return to normal(ish). Unsurprisingly, companies such as those involved in the hospitality sector have now outperformed. The Restaurant Group in the UK, which operates the Wagamama chain, and Dine Brands Global in the US, which operates grill and pancake franchises, and Dutch-based Sligro Food Group, a distributor into the restaurant and bar market in Benelux, have all seen their share prices pick up strongly. This reminds us that we must be prepared to look to buy into quality stocks when the market is taking too negative a view about them due to short-term trading conditions.
Where to from here?
There are clearly uncertainties around the outlook for the pandemic; will new virus variants set us back? Maybe more concerning is whether the recent increase in inflation will become a problem for the markets and force higher interest rates. And over the longer term, how will governments finance their much larger debt piles?
We are optimistic about the outlook for company profits. A lot of the companies in our portfolio are upgrading their expectations, and we expect this to continue as global industrial production rebounds given still-low inventory levels in many sectors, and as consumers regain the confidence to spend some of the savings they have accrued over the pandemic.
The other good thing for small cap performance at the moment is the increased level of takeover activity. In our UK portfolio, we have already seen recommended offers for a number of our holdings in 2021 (AFH Financial Group and Arrow Global), and rebuffed takeover approaches for others (Elementis and Sanne Group). There is a lot of cash held by private equity funds seeking to invest in businesses, and some of this will be spent on listed smaller companies, while post the Brexit uncertainties, there appears to be more interest from overseas predators.
We are also seeing a lot of IPOs in the market. This is historically a bit of a warning sign that we could be nearing the top of the stock market cycle, so we are taking a cautious stance around taking part in new issues. However, it’s good to see new, interesting companies joining the markets. Even if they are coming to the market at too high a price for our liking today, they may be potential investments for us in the future.
We are pleased at how our portfolio of holdings has navigated the crisis, and we are optimistic for the near-term profits outlook. But we need to be mindful that, as ever, smaller company shares can move sharply based on macroeconomic developments. The outlook for inflation is something that will be important for markets and smaller companies too in the rest of the year.