As we sit here in February, it is apparent that global markets and investors have become discouraged. The Band-Aid came off around the turn of the year, and the hemorrhaging began. From its summer high, the Russell 2000 Index is down nearly 25% this month.
Such correction is typically witnessed in a recessionary environment, not when monetary policy is on a tightening course as a reaction to economic strength. But this is not a typical business cycle. Central banks are not aligned on monetary policy, creating issues for exporters and foreign economies alike from the strengthened U.S. dollar.
At the same time, sustained low energy and commodities prices are suggesting financial catastrophe for many smaller companies, particularly those that carried leverage. These are all not new issues, but time is testing patience.
The question now is whether the markets are now oversold or if there are indeed more potholes ahead. Many investors focus on valuation(s) as a reason to become more constructive. On this measure alone, small-cap stocks now trade largely at parity with larger companies and below their historic forward price/earnings multiple. But we look at the world from the opposite perspective and would suggest that to have confidence in valuation we must first have conviction in forward profits and cash generation.
The question now is whether the markets are now oversold or if there are indeed more potholes ahead.
Over the past several quarters, we have frankly seen some businesses deliver unexceptional results, but they are far from disastrous. Currency swings tended to be the main culprit. The focus of investors has hinged on the outlooks of management teams, which now have increasingly incorporated a dose of conservatism.
The biggest risks to U.S. smaller companies we see ahead are U.S. Federal Reserve (Fed) policy. This includes, first, if future policy does not take into account the peripheral risks of a stronger U.S. dollar on trade and international economies. And second, if the current macro contagion causes domestic businesses and consumer to pause. Absent this, we are still of the conviction that the domestic economy is reasonably healthy with near full employment and low inflation.
What does this all mean for small-cap stocks? While we are prepared for volatility ahead, we remember that times which test our patience can provide opportunities for us as investors. In fact, we see more potential opportunity now than we have in a long while. Some businesses that we know are trading at discounts to their intrinsic value under less fear-driven market environments.
On a relative basis, we also see the investment environment as favoring small caps for investors with a medium to long-term horizon. This stems from our conviction in a healthy set of small-cap companies’ business models, current valuations and what we see as a more stable domestic economy. Such an economy is generally supportive of smaller companies, which usually source less revenue from overseas. In particular, this type of environment leans well toward active management strategies that focus on the fundamentals: searching for quality businesses with supportive balance sheets and pragmatic management teams.
Ralph Bassett is head of North American equities at Aberdeen Asset Management.