The recent background for small cap investors in the UK has been a testing one. At the same time th...
The recent background for small cap investors in the UK has been a testing one. At the same time that the tech-induced euphoria at the start of the year was shifting to short-term concerns based around sustainability of valuations, so the general macro environment for small companies was deteriorating.
In the past few months, domestic growth forecasts have been reduced for next year and the legacy of a strong currency and continued downward pricing pressure in both retail and manufacturing have led to a decline in earnings expectations. Across a wide range of companies profit downgrades are now beginning to outnumber upgrades. Technology stocks have been some of the worst affected as in a number of cases, project delays by major corporates have impacted negatively on short-term earnings projections.
Looking forward, as well as relatively low valuations compared to the market as a whole, small companies are currently benefiting from the positive liquidity position of smaller company investors. As long as corporate fund raisings do not undermine this position then despite some caution with respect to shorter-term earnings forecasts the belief that we are nearing the peak in the interest cycle is supportive of a relative pick-up in small company performance.
One significant feature of the past month or so has been the breakdown in disparity in performance between the old and new economy stocks. In the first part of the year the best or worst performing stocks were either exclusively old economy or new economy, depending on which time period was being reviewed. A much more even spread of performance returns is now evident. With no clear market leadership a balanced approach to portfolio construction should be the most appropriate as we move through the rest of this year and into next.
We continue to invest in areas of the economy with secular growth characteristics where we believe that substantial growth is still achievable despite a macro background of rising interest rates and forecasts of slower domestic growth.
In this context the support service sector, with the continuing trend towards outsourcing and with service sector inflation running at just over 4% continues to provide a wide range of investment opportunities.
We also remain heavily invested in media particularly after the recent sell-off and in small financials. Technology is one of our largest overweightings compared to our benchmark index, although not relative to our peer group.
Exposure to technology stocks remain the most significant portfolio differentiator amongst smaller company investors so far this year, and this looks set to be the case for some time to come.
The IPO market continues to provide a steady stream of new technology issues. Valuations have reduced as the supply of equity has increased and management and venture capitalists have become more realistic in their expectations.
For their part, investors have become much more selective in their investment approach. The companies themselves are seeking to float at much earlier stages of their development than before.
For investors, it is important to build in a risk premium for a management's ability to manage the transition from, in many cases just a concept to a high growth company. Some companies will fail to make this transition even though they have a good technological niche as they are inadequately financed or have insufficient marketing clout. Some managements' forecasts for the price customers will ultimately pay for their product, also seem overly optimistic. Reassuringly for investors we are also now beginning to see some attractive businesses coming to the market that are not technology based.
Arguably one positive benefit for the economy as a whole of the increased focus on the potential of technology stocks, is small company investors' willingness to incorporate a higher degree of shorter-term volatility in their portfolios. At the same time, an increasing ability to discriminate between the ultimate winners and losers should mean prices more fully reflecting prospects. Stock selection will remain critical.
To complement the core growth stocks in the portfolio we seek to invest around half of the fund in companies where shorter term re-ratings; for instance up to 18 months are driven by changes in economic and business cycles. This is driven by the HSBC business cycle philosophy and seeks to provide a balance and degree of momentum to the growth component of the portfolio.
It is important to note that at the same time that the potential of the technology and biotechnology sectors keep being talked up, a substantial part of our investment universe is trading at cyclically low valuations. Substantial returns will continue to be made by investing in some unfashionable sectors of the economy where cash flows are strong and stocks have become oversold. This is highlighted by the increased number of public to private transactions.
By combining a longer-term growth portfolio invested in secular growth sectors of the economy with shorter-term investments driven by changes in the business cycle we are aiming to provide consistently above average returns over the medium term.
David Taylor is the head of UK smaller companies at HSBC Asset Management (Europe)
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