US small caps: it is a very different world, so having a good pulse matters

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Selecting and investing in small-cap stocks requires a skill set that is in tune with the segment’s very diverse and idiosyncratic characteristics, so that a solid understanding entails portfolio choices that can do well in both the near term as well as on a medium-term horizon, argue Geoff Dailey, portfolio manager of US small-cap equities, and Chris Fay, portfolio manager US equities.

Comparing small-cap and large-cap investing, the difference in attributes are striking. Small-cap companies are typically managed in an entrepreneurial way and are more like start-up companies in that sense. They have the ability to take targeted risks, which can help boost the level of innovation at such companies. Small caps are usually well-funded, reducing their need to turn to the market or to banks.

We would argue that such features translate into opportunities across multiple industries. The healthcare sector, for example, which has been leading the market and has outperformed the broad market index, is very diverse. The biotech and med-tech services industries are highly innovative, producing defensible products earning steady revenues and marked by stable management. In a market pullback, shares in these industries would classify as defensive and, we believe, should be part of a basket that can do well in the near term, but also further ahead in 2019.

Small-cap healthcare: filling the gap

The small-cap healthcare segment differs notably from the wider pharma sector which has been typified by “me-too products”, and has suffered from doing business in crowded spaces or being exposed to easy-to-copy or easy-to-genericise drugs. That is making the innovative biotech segment more interesting, giving it the space to fill a void in which demand and drug prices are not affected by the shape of the economy. The field is open for small-cap biotechs to operate in high-end niche markets targeting rare diseases. These areas are marked by a sustainable competitive advantage, opportunities for growth and pricing power.

From an investment perspective, that opens up interesting prospects. However, to be able to pick stocks successfully in this field, a good medical understanding is essential. So, at BNP Paribas Asset Management, we hone our skills by attending medical conferences and using doctors and pharmaceutical consultants. Our aim is to become mini-experts and be able to take the pulse of the industry to good effect.

Small caps: a resilient asset class

Of course, share performance plays a part in our stock-picking. After the recent pullback, we are taking a second look at this and other sectors. For example, in tech and software, we believe valuations are now more attractive. That would argue in favour of the segment as well as the absence of signs of a pullback in IT spending. Elsewhere, in energy, US exploration & production and services companies look particularly attractive. Their intermediate outlook is quite robust.

The small-cap segment as a whole has not been able to escape investor concerns regarding trade wars, the later stages of the current economic up-cycle and increased market volatility, but we believe the background for small caps is skewed towards the positive. Small caps are more exposed to the US economy itself than to international trade: they stand to benefit more from the administration’s tax reform and from US consumer spending.

Attractively valued: small caps

Admittedly, market corrections have also affected small-cap stock valuations, but we regard current levels [1] as neither stretched nor cheap. A forward price/earnings (p/e) ratio for the small-cap Russell 2000 index of about 17 times is in line with the long-term average, but still some 15% below the October 2017 high.

Relative to large caps, we regard small caps as attractively valued: the Russell 2000 is trading at a discount to the main market S&P500 index on metrics including p/e, price-to-book and price-to-cash flow.

Where do we go from here? We are upbeat on the outlook for the longer term. The US economy is strong, unemployment is low and corporate confidence high. There are many positive elements and little evidence of a recession on the horizon. We regard market corrections as healthy – these have been a regular occurrence in the past – and we seek to use such dislocations to take advantage of potentially rewarding opportunities.

To read more on small and mid caps, click here >

[1] This article is based on comments made in a 23 October BrightTalk webcast covering developments in US small caps so far in 2018, the outlook and the performance of the healthcare sector (+38% through 30 September 2018), bottom-up views and the opportunities.

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Eric McLaughlin

Senior Investment Specialist, US equities, CFA Charterholder

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