Despite Headwinds, We See Global Small-Cap Opportunities

Macroeconomic Headwinds Have Dominated the Landscape

Last year, global small-cap equities faced rising inflation and interest rates, war, COVID-19 and China lockdowns. And now to investors’ dismay, the collapse of Silicon Valley Bank and the ensuing banking crisis complicates the macroeconomic environment.

Markets dominated by macroeconomic conditions or sharp factor rotations can be challenging for investors taking a bottom-up, fundamental approach. While earnings growth isn’t always immediately rewarded, as in 2022, we believe companies with improving earnings can outperform over the long term. Sticking to your process when your approach is out of favor can help support long-term performance.

Encouraging Signs in 2023 Improve Our Global Small-Cap Outlook

We expect macroeconomic uncertainty to continue in the near term. Markets remain challenged by inflation and recession concerns, the ongoing war in Ukraine and COVID. But inflationary pressures are easing, mobility in China is improving and supply chain pressures are subsiding.

Importantly, small-cap valuations have compressed significantly and appear attractive relative to large caps and on an absolute basis. While the near-term outlook for the markets is hard to predict, the team has a positive medium- to longer-term view supported by bottom-up opportunities and valuations.

Macroeconomic risks also vary by region. The outlook for U.S. and European growth remains uncertain as the economies of both regions digest interest rate increases and recent financials sector risks. Japan and select emerging markets should benefit from the reopening and recovery of China.

Looking for Small-Cap Companies That Can Thrive Amid Global Uncertainty

One potential advantage of an active investment approach is identifying businesses that may prosper in various environments.

For example, we favor companies bolstered by Europe’s efforts to reduce dependence on Russian energy. These companies should benefit from increased capital spending on renewables, which we believe will be a long-term structural tailwind. We believe these firms include:

• Aker Solutions, a Norway-based energy solutions provider with an expanding renewables business.

• Nexans, a France-based maker of high-voltage cables connecting offshore wind farms to the grid.

• Acciona, a Spain-based conglomerate focused on infrastructure and renewable energy).

Our team is also identifying businesses benefiting from reopening economies and weak currencies. Examples of these companies include:

• Matsukiyo Cocokara, a drug store operator in Japan that is seeing more foot traffic.

• Samsonite, a global luggage company whose revenues are inflecting positively alongside improving travel data in Asia.

• Tongcheng Travel, an online portal in China that is benefiting from increased travel.

In information technology, we favor businesses with a strong outlook for spending on logistics software. We believe these firms include:

• Manhattan Associates, an innovative Atlanta-based company focused on omnichannel supply chain solutions.

• Kinaxis, an Ontario, Canada-based provider of cloud-based software-as-a-service solutions for supply chain management.

• Tenable, a cybersecurity firm based in Maryland dedicated to helping companies reduce their cyber risk exposures.

We’re Not Throwing Out the Baby With the Bathwater

We also see opportunities in companies whose shares have sold off sharply despite strong fundamentals. We favor those we believe have attractive earnings acceleration prospects.

For example, InMode, an Israel-based provider of equipment for minimally invasive surgeries, sold off sharply despite having delivered strong results. We believe the company is poised to benefit from the resumption of elective procedures and its expansion into new product areas.

Small-Cap Valuations Appear Attractive

Small-cap valuations have compressed significantly since the beginning of 2022. In this uncertain environment, we think it’s important to own a diverse group of holdings with varied drivers for improving earnings growth.

Most small-cap markets are trading at or near their 10-year lows based on the following 12-month P/E estimates. See Figure 1. As a result, we believe they are trading at attractive valuations compared to large caps. While we’ve seen earnings growth decelerate, multiple compression, not earnings, has driven the recent correction in small caps.

Earnings growth is likely to remain challenged in the short term. But the size and diversity of the small-cap universe continue to offer investment opportunities. We look for companies we believe can deliver accelerating and sustainable earnings growth.

In many cases, these companies are now at much more attractive valuations. This “barbell” approach, including positions benefiting from high interest rates and growth companies whose shares may be oversold, could help mitigate risk amid uncertainty.

Figure 1 | Small-Cap Markets Are Trading Near Their 10-Year Lows

MSCI ACWI ex-U.S. Small Cap vs. MSCI ACWI ex U.S. – Valuation Comparison

^{Data from 1/31/2013 – 2/28/2023. Source: FactSet.}

While each market downturn and recovery has its own specific dynamics, small-cap stocks have historically led during recovery periods. See Figure 2. Timing the markets is hard, but we believe the combination of attractive valuations and bottom-up fundamentals is attractive for small-cap investors.

Figure 2 | Small Caps Have Historically Led During Recoveries

MSCI ACWI Small Cap vs. MSCI ACWI – During Market Corrections and Recovery Periods

^{Data from 3/10/2000 – 12/31/2022. Cumulative returns in USD. Dot-com crisis: 3/10/2000 – 10/9/2002; 2008 financial crisis: 10/31/2007 – 3/9/2009; Ebola 7/3/2014 – 10/13/2014; COVID-19: 1/15/2020 – 3/23/2021; COVID/inflation/Ukraine: 11/17/2021 – 10/12/2022. Source: FactSet. Past performance is no guarantee of future results.}

Easing Headwinds Reveal Global Small-Cap Opportunities

The macroeconomic challenges facing global small caps have been formidable. But we think these headwinds may be easing, brightening the outlook for the latter half of 2023. We think global small caps are attractive in terms of growth potential and valuation relative to larger-cap stocks.

In this environment, our bottom-up investment approach is helping us identify opportunities in many sectors across multiple regions.