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ARTICLE

FINDING ALPHA: VALUATION AND QUALITY WITHIN THE SMALL-CAPS UNIVERSE

By Humberto Nardiello, Equity Analyst DPAM, and Nathalie Debruyne & Bart Geukens,
Fundamental Equity Fund Managers DPAM

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Last year was a challenging period for equities. However, the savvy investor could still generate alpha in a consistent way by remaining focused on both valuation discipline and quality (of operations, management, positioning, balance sheet, and ESG factors). As the decade-long dormant inflation woke up, central banks across the world responded by raising interest rates. The higher cost of capital meant that equity valuations had to be reassessed downwards, and they did so rapidly and fiercely. Of late, with the speed of inflation appearing to slow down, the narrative of “peak inflation” has gained traction. Investors have begun anticipating a reverse of 2022, with interest rates ceasing to go up and eventually declining, making equity prices attractive again. This has helped keep the equity market more stable in recent months.

It is still unclear whether the rise in inflation was a conjectural distortion fuelled by government stimulus and constrained by sanitary lockdowns and the Russian invasion, or if it is something more enduring, especially on the supply side, with a permanent loss of labour participation, underinvestment in commodities exploration, and diminishing global cooperation as the US-China worldview bifurcates. When and where inflation and interest rates will stabilise depends on which scenario plays out. This is a complex situation, and while inflation is indeed slowing down, the service component (skewed to wages) is still holding up or in some cases even accelerating. It is hard to temper wage inflation without a significant employment reduction or economic recession, which could be bad news for companies’ sales growth and profit margins going forward.

It seems to us that the short- to medium-term risk on equity prices is shifting from multiples (P/E, a function of cost of capital and growth) to the “E” (i.e., profit warnings). On average, if interest rates go up by 1%, the stock price should fall by approximately 14%, all else constant. For reference, in 2022, interest rates went up more than 2%. On the other hand, the average operating margin of a listed company is 15%. If their costs go up by 5% and management is not able to pass that on to consumers or find sources of cost-cutting, that means their profit would decline by 28%. The stock price would likely fall by a similar amount.

Figure 1: [left] Impact of 1% higher interest rate on the value of a company. [right:] profit impact of 5% cost inflation ( no pricing power).

Source: DPAM – February, 2023

In 2022, companies’ main focus was trying to cope with/mitigate inflationary pressures. We believe the effort in 2023 will be even more important as last year’s high inflation caught everyone off guard. As a result, passing prices along customers/clients was deemed ‘acceptable’, as every company had a good excuse to do so for the time being. However, just like those higher input costs, there were suddenly many ‘Plan B’ options (or even Plan C, Plan D…) as well to substitute suppliers, products, go-to-market options, etc. for 2023 and onwards. We believe that the next few years will be a good test of the real strength of companies’ business models and management teams.

Broadly speaking, there are two ways a company can generate superior profits: 1) product differentiation, which will grant them the opportunity to increase prices without losing too much (if any) demand, as these products are highly desirable; or 2) cost leadership, by having a greater scale versus competitors, the company can raise prices less and absorb more customers, further diluting costs. Management must be aware of this and act accordingly.

As long-term investors, we are constantly reassigning such traits and following how management teams are nurturing and improving these. We also debate short-term trends when engaging in shareholder meetings. However, the focus should not be on predicting quarterly (or even intra-quarterly) trends, but rather on looking for narrative changes or inflection points to validate both the quality of the business and the people operating it. It is also important to ensure that decisions are contributing to maximising the value of the company and not just chasing short-term gains, while assessing whether there are structural changes within the industry.

There are two key reasons that explain the attractiveness of small cap stocks: 1) their higher flexibility and hence their increased ability to navigate through economic cycles and adapt accordingly to the macro environment. It is indeed easier to move a small cruise boat than a tanker stuck in the Suez Canal; 2) These companies are significantly less covered/analysed by institutional investors and the general media, resulting in more accessible management teams who prioritise regular discussions with investors. This fosters a better understanding between small cap investors and the companies, which is crucial.

Indeed, in order to outperform in this universe, one needs to correctly assess the quality of a company, thereby avoiding the pitfalls of value traps without overpaying for short-term performance or fleeting trends. Quality is assessed based on the company’s market positioning, the attractiveness of the market segment it is active in, the quality of the management team in place (track record and strategy), their capital allocation priorities, their focus on long term sustainable value creation, their balance sheet and cash flow profile and -last but not least- their ESG profile. Ultimately, making sure that one pays the right price at the right time is important to avoid negative surprises, mainly in times of turbulent market conditions. This is what we call ‘quality growth at reasonable price’.

This year might be another difficult year for companies. Even so, we believe that by not overpaying for sustainable growing profits, investors can protect and compound their portfolios in the year ahead.

DISCLAIMER

Degroof Petercam Asset Management SA/NV l rue Guimard 18, 1040 Brussels, Belgium l RPM/RPR Brussels l TVA BE 0886 223 276 l

Marketing communication. This is not investment research. Investing incurs risks. Past performances do not guarantee future results.

© Degroof Petercam Asset Management SA/NV, 2022, all rights reserved. This document may not be distributed to retail investors and its use is exclusively restricted to professional investors. This document may not be reproduced, duplicated, disseminated, stored in an automated data file, disclosed, in whole or in part or distributed to other persons, in any form or by any means whatsoever, without the prior written consent of Degroof Petercam Asset Management (“DPAM”). Having access to this document does not transfer the proprietary rights whatsoever nor does it transfer title and ownership rights. The information in this document, the rights therein and legal protections with respect thereto remain exclusively with DPAM.

DPAM is the author of the present document. Although this document and its content were prepared with due care and are based on sources and/or third party data providers which DPAM deems reliable, they are provided ‘as is’ without any warranty of any kind, either express or implied. Neither DPAM nor it sources and third party data providers guarantee the correctness, the completeness, reliability, timeliness, availability, merchantability, or fitness for a particular purpose.

The provided information herein must be considered as having a general nature and does not, under any circumstances, intend to be tailored to your personal situation. Its content does not represent investment advice, nor does it constitute an offer, solicitation, recommendation or invitation to buy, sell, subscribe to or execute any other transaction with financial instruments including but not limited to shares, bonds and units in collective investment undertakings. This document is not aimed to investors from a jurisdiction where such an offer, solicitation, recommendation or invitation would be illegal.

Neither does this document constitute independent or objective investment research or financial analysis or other form of general recommendation on transaction in financial instruments as referred to under Article 2, 2°, 5 of the law of 25 October 2016 relating to the access to the provision of investment services and the status and supervision of portfolio management companies and investment advisors. The information herein should thus not be considered as independent or objective investment research.

Investing incurs risks. Past performances do not guarantee future results. All opinions and financial estimates in this document are a reflection of the situation at issuance and are subject to amendments without notice. Changed market circumstance may render the opinions and statements in this document incorrect.

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