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Small caps return to re-opening plays

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MEDIA RELEASE: As the global economy continues to recover from the impacts of COVID, the stay-at-home thematic within small cap stocks is becoming less prevalent as people seek a return to re-opening plays and returning to normality of a brick and mortar environment, according to Trevor Gurwich, senior portfolio manager, American Century Investments.

The stay-at-home trend seems to be fading and there is now more of a preference by consumers to go out and shop; they don’t want to be isolated at home on their computer. Accordingly, investment portfolios managers are starting to reflect this shift, Mr Gurwich says.

“Stay at home-related stocks, such as videoconferencing platform, Zoom, and home fitness names like Peloton, have had their growth momentum reduced as their growth rates slow and active fund managers reallocate their portfolios to other companies that are seeing re-acceleration in fundamentals   Quintessential stay-at-home plays, like Zoom or Peloton, will be impacted as jurisdictions open up their economies and relax lockdowns and movement restrictions. If you look at the recent results and stock prices of companies like Peloton, one can see that  the company is having more challenges growing its subscriber base to meet analyst expectations,” he says.

“Conversely, there are other global small caps companies poised to benefit from the return to normality and a face-to-face way of life.  Travel and Leisure are two such sectors that are experiencing a resurgence in growth given people are once again looking to travel and satisfy their experiential needs.

“US-headquartered Wyndham Hotels is one such example. Hotel occupancy rates are trending upwards and edging closer to pre-pandemic occupancy levels, although it should be noted, it does depend on the country. China, for example, is not following this trend as it continues to experience periods of lockdown.  Seaworld is another example of a company that is up 100 per cent this year as people start to visit their parks in North America.

“Another  powerful trend we are witnessing within global small caps include continued demand for robust IT spending.  Companies realise that IT investment is extremely important to conduct business in a hybrid world.  Whether it is online commerce, security, employee identification or transaction processing or payments, investing in software and technology is surpassing investment in physical plant and equipment. Investing in logistics and engineering new ways to access and communicate with a company’s supply chain is vital for modern day business.

“Companies like Australia’s Wisetech, Canada’s Descartes and Kinaxis and the United States’ Manhattan Associates  and SPS Commerce are all notable examples of companies benefitting from this type of investment. There is also a strong demand among global small cap companies for cloud-based security solutions and other IT-related services where we are seeing companies like Tenable Holdings and Endava benefit.

“The impact of inflation presents some interesting opportunities for the global small cap universe.  The surge price inflation we are witnessing is being driven high levels of short term demand trying to buy goods that are constrained due to Covid related manufacturing challenges. “Bottlenecks in production facilities in factories, especially in Asia, and congestion in ports mean there continues to be major delays in receiving shipments in the European and North American markets. The key to identifying attractive investment opportunities in this market is to focus on companies that can project pricing power and avoid companies with high raw material input costs, complicated logistics and high shipping costs.

“Inflation is indeed positive for companies with pricing power like Residential and Commercial Warehousing Property REITS with the ability to pass on the effects of rising rents like Tricon Residential REIT in Canada and Tritax Big Box REIT in the UK.

“Labour inflation can also be good for recruitment stocks like Hays and Michael Page in the UK or even SEEK in Australia as they get to benefit from the commission share of a higher salaried placement.   Restaurants are to be scrutinized more closely as they are more challenged with adjusting their menu prices to  keep up with higher food costs and labour costs.

“Small cap stocks are projected to see good growth in 2022 and the asset class continues to provide many attractive stock selection opportunities.  There will certainly be obstacles on the way to economic recovery, but they will more likely be speed bumps, not roadblocks,” Mr Gurwich says.

Jim Shore, client portfolio manager, American Century Investments notes there continues to be a divergence between large and small caps on levels of ESG disclosure, however the trend is encouraging for small caps.

He says the divergence is seen in a variety of environmental and social reporting categories, including greenhouse gas emissions.

“There are positive signs, however, that many global small cap companies are increasingly aware of their importance of appropriate ESG disclosure.  A growing body of academic evidence is highlighting increased ESG disclosure may eventually result in a lower cost of capital over time,” Mr Shore says.

“Active small cap investment managers are in a unique position help mitigate some of these data challenges and influence this positive trend, and can do so by implementing two important steps; developing a proprietary ESG research framework and company engagement. The latter is critical to offsetting data challenges, and will lead to a better understanding of how ESG data can be used and interpreted. It can be difficult to quantify, but a well-structured, targeted engagement program may ultimately drive positive and tangible changes in small cap companies.

“ESG can represent challenges for the small cap sector of the market however there are no shortage of opportunities of companies with robust and/or improving ESG disclosure. One of the attractions of investing in global small caps is the sheer size and scale of the market, and the ability for asset managers to identify focused and innovative businesses benefiting from secular growth trends, including those related to the environment.

“Kornit Digital is an Israeli manufacturing company, producing high-speed digital printers and consumables for the textile and apparel industry.  Digital printing is gaining share from traditional analog printing, but still only represents approximately 5 per cent of textile output. There is a large addressable market to go after and it is still in the early stages of the transition from analog to digital printing. The company has had strong sales growth and profitability, and unlike many of its small cap peers published a detailed Impact Report.  Kornit’s printing systems are designed to be 100 per cent waterless and its NeoPigment inks are non-hazardous, non-toxic, and 100 per cent biodegradable.

“By allowing its customers to print on demand, it translates to lower levels of required inventory and less waste.   Its technology has the potential to help the fashion industry dramatically improve its  environmental footprint by significantly reducing water usage, pollution and waste in the industry.  It’s a very well-run business with an environmental-focused strategic plan, and is a prime example of a global small cap stock whose earnings growth is supported by its approach to  ESG,” Mr Shore says.

 

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