- Smaller company valuations are priced for a recession
- Economic reality is more positive – peak rates and falling inflation should ease small cap pressures
- Discount prices and improving outlook are driving M&A and flows into small cap funds
In the US, where the Magnificent Seven have driven the market rally, small caps currently trade 30% below their historic average discount to large caps; a 22-year low and a level that previously kick-started a decade of strong relative returns when the dot-com bubble burst.
The picture globally is similarly stark, particularly for small cap value companies that SKAGEN typically owns. These now trade 20% below historic average valuations and at a 45% discount to large caps –prices that would normally signal that a deep and long recession is around the corner.
Improving macro fundamentals
In reality, economic conditions look more positive for small caps than they have done for some time. The aggressive interest rate rises that began last year appear to be over, most importantly, with more central banks globally now cutting rather than hiking rates for the first time since 2021. The Russell 2000 index of US small cap stocks rose a huge 5.4% earlier this month on better-than-expected inflation data as investors bet that the Fed is finished tightening and could even start cutting rates early next year.
US small caps have tended to outperform the broader market following the end of previous tightening cycle, often significantly. Smaller companies generally have more financial leverage, bank loans and floating rate debt than larger ones, meaning debt burdens should ease as interest rates stabilise. With labour costs also disproportionately higher for small caps, falling wage inflation should provide a further boost to cash flows and earnings. If we experience a soft economy landing – increasingly the consensus view among investors[1] – small caps could soon take-off again.
Merger mania
Small cap outperformance over the long-term is reward for the increased risks attached to smaller companies but also due to the premium prices usually paid to take them over. With valuations at rock-bottom and greater clarity over the future path of interest rates, I believe we could be on the verge of small cap ‘merger mania’ as large caps, strategic buyers and private equity snap up good companies at discount prices.
We have already benefited from this in our portfolios. In September, SKAGEN m2 was boosted by Norwegian Self Storage Group, a top ten holding in the fund, receiving bid at a 67% premium from a US pension fund. The listed real estate sector looks ripe for further deals as private equity, family offices, sovereign wealth funds and other investors take advantage of undervalued property assets, distress situations and the lucrative themes driving real estate and infrastructure such as data storage and the energy transition.
In October, our small and mid cap fund SKAGEN Focus received even better news. First, German automotive supplier Vitesco, a 1.6% position in the portfolio, attracted a bid representing a 20% premium from compatriot Schaeffler AG. This was soon followed by private equity firm Stonepeak acquiring Textainer, a US-based container company which represented 2.4% of the portfolio, at a 46% premium. Both positions were exited at the portfolio managers’ target prices, allowing the cash to be recycled into exciting new ideas.
SKAGEN Focus completed a hat-trick of positive M&A action this month when Pasona, a 2% holding, agreed to sell its stake in subsidiary Benefit One to M3 at a 40% premium, allowing the Japanese staffing solutions provider to buy back shares.
Each of these cases are in the top ten contributors of the respective funds year-to-date, highlighting the positive contribution M&A makes to returns. Equally satisfying is that several of these companies were identified as potential takeover targets as part of the portfolio managers’ company analysis and were held despite being unpopular with the broader market, illustrating the benefits of our active, value-based and often contrarian approach.
Growing popularity
Alongside increased corporate activity, we are also starting to see more capital flowing into small caps as investors recognise their attractive risk-reward. US small cap funds have attracted $1.7 billion so far in November, according to EPFR Global data, the first inflow in four months. This is positive for both sentiment and shareholder returns. With several of our funds owning a healthy number of attractive but undervalued smaller companies, I am hopeful we will see further positive developments in the months ahead, especially if merger mania takes hold.
NB: Information as at 31 October 2023 unless stated.
[1] 74% of respondents expect a soft or no landing according to the November Bank of America Global Fund Manager Survey