Falling interest rates will trigger a small-cap recovery

abrdn Global Smaller Companies manager Kirsty Desson sits down with ii's Sam Benstead to discuss her fund, which has delivered disappointing performance since interest rates began to rise two years ago.

Desson explains why this has affected returns, but gives reasons to be optimistic, such as a change in the economic outlook and the strong business performance of portfolio companies. 

She says that small-cap shares tend to outperform as interest rates peak and economies go into a downturn. 

abrdn Global Smaller Companies is a member of ii’s Super 60 list of recommended funds.

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Kirsty Desson, manager of the abrdn Global Small Companies fund. Kirsty, thank you very much for coming into the studio.

Kirsty Desson, manager of abrdn Global Small Companies fund: Thank you for having me.

Sam Benstead: Performance has disappointed since the end of 2021 linked to rising interest rates. Can you explain the connection between interest rate movements and the share price performance of your fund?

Kirsty Desson: So, you're right. Markets peaked in November 2021. The fund actually outperformed in that month, but then the performance starts to crack from December around that year. And that was very strongly linked to what we saw in terms of inflation and higher interest rates coming through

In particular, in January 2022, you'll recall that we saw a very sharp spike in inflation and that was followed by a statement from the Federal Reserve whereby they indicated that they would be increasing the pace of interest rate increases. So, the market moved from pricing in around three interest rate hikes to five interest rate hikes. So, for highly rated growth stocks, we started to see those selling off quite sharply.

I think the other point to remember about going into January 2022 was there was a high degree of concentration in the market. And so that unwinds coupled with concerns over inflation and the shift into value-related stocks led to this precipitous fall we saw in growth small-cap names.

Sam Benstead: You are a bottom-up stock picker. So, how have the companies been performing in terms of their businesses during this period where we've seen share prices fall so much?

Kirsty Desson: There's been an interesting dichotomy between the actual underlying company performance and what we've seen in terms of shares. So, the types of companies that we hold, which have very strong market share, strong competitive positioning, solid pricing power, have tended to continue to deliver reasonable results.

We've seen a change in management forecasts and management guidance from being concerned around supply chain pressures to now being more concerned about what the revenue outlook is, particularly in those companies that benefited from higher inflation and being able to pass on higher prices.

As inflation is starting to roll over, a lot of those companies are now worried about what's going to happen, particularly to the pricing side. And I think that's where we're going to see a bigger split between quality companies and value-related companies, where quality companies are still able to hold on to those price increases.

What's encouraging for us from a market point of view is that the market is now starting to look at bottom-up fundamentals as a driver for stock performance as opposed to just macro factors.

• Still time to buy, or too late to profit from the best market since Covid?
• Six experts name their top five funds that should be in every portfolio

Sam Benstead: Interest rates now look like they've peaked. Could this be a catalyst for better returns?

Kirsty Desson: That's certainly what we're hoping for. If we look back historically, typically you see quality stocks outperforming in periods of falling yields, falling inflation and falling interest rates. And we are starting to see each of those factors beginning to materialise.

In fact, if you look at the fund performance over the last few months, we are beginning to see stabilisation in performance. And also looking at the factors that drive our quant tool, we're starting to see that quality factors are beginning to come to the fore in that.

So, all these indicators point to the fact that we are seeing a shift in dynamic as we're seeing this expectation around interest rates starting to normalise.

Sam Benstead: And what about if low interest rates, which are potentially good for share prices, are actually a result of a weak economy? Are your companies going to be resilient in the case of a recession in the US or the UK?

Kirsty Desson: Two points there. First, what we tend to see is that small-caps start to outperform at the start of a recession, and we tend to see that inflection between large-caps and small-caps come through in the first couple of months of recession. And small-caps tend to outperform most in those recovery periods for about one to three years after the market bottom.

So, from a market point of view, we're quite optimistic about the asset class if we do go into a recessionary period. I think for us as stock pickers, the kinds of companies that we're picking tend to have better balance-sheet management. They tend to have a high degree of recurring revenue, which means there's a lot of predictability about earnings. And so all this makes for the fact that these stocks tend to outperform well going into periods of a downturn.

Sam Benstead: Have there been some companies that you've really taken advantage of a weak share price and increased your position over the past couple of years?

Kirsty Desson: We have maintained our quality-growth momentum approach. And while we always understand what the drivers are behind our stocks, we tend to wait to see a stabilisation in share price performance before we add back into those names. So, we would tend to wait to see those share prices bottoming out, and perhaps even ticking up again before we add back into them.

Sam Benstead: We’re near the end of the year. So, as we head into 2024, what companies and sectors are you really excited about?

Kirsty Desson: So again, looking at the themes that we see in the portfolio, we continue to see very strong structural growth drivers around certain key areas. And to give you a few examples, this is not exhaustive, but areas where we continue to see investment include things like EV, automation and digitisation, energy transition and continued spending on areas such as well-being.

So, we continue to see very strong performance out of the likes of Asics, the running shoes. and also Deckers Outdoor Corp (NYSE:DECK), which owns things like HOKA trainers and UGG boots. They continue to report very strong performance numbers, so we expect those areas to continue to see very healthy levels of investment.

• Concentrated portfolios: 11 funds and trusts favoured by the pros
• What should you do when a star manager leaves a fund?

Sam Benstead: There's a lot happening in the world right now. Can you give me a reason to be cheerful and a reason to be fearful from an investment perspective?

Kirsty Desson: Well, I'm pleased to say that there's more reasons to be cheerful than there are to be fearful. I think the reasons that there are to be cheerful include valuation discount on small-cap relative to large-cap. The fact that macro factors are now moving in favour of quality-growth companies. And from a bottom-up perspective, we're really seeing a number of the companies that we hold starting to surprise and beat analyst expectations.

So, for all those reasons, I'm more optimistic as we look into 2024. The reasons to be fearful would be if we continue to see upwards pressure on oil prices from geopolitics, and we will very much hope that the situation in the Middle East continues to be contained, although it would be a surprise to the market if we were to see another change in interest rate stance.

But given that the way macro data is moving, given what we're seeing in terms of inflation and consumer spending, I think that the chances of that happening are less likely. So, on balance, I think now is a really interesting time for investors to maybe start to put some of their savings back into equity markets.

Sam Benstead: And on valuations, just how cheap are smaller companies at the moment relative to their history?

Kirsty Desson: So if you look relative to, well, first of all, relative to large-caps, the discount is as wide as it's been since before the global financial crisis. And if you look in detail at where we are in terms of small-cap growth stocks in a number of areas, particularly the US, the UK and Europe, those names are actually trading well below their 10-year P/E averages.

Sam Benstead: And finally, the question we ask all our guests, do you personally invest in your fund?

Kirsty Desson: Yes, I do. And my children and my husband all have shares in the fund as well.

Sam Benstead: Kirsty, thanks so much for coming into the studio.

Kirsty Desson: Thank you.

Sam Benstead: And that's all we've got time for. You can check out more Insider Interviews on our YouTube channel where you can like, comment, and subscribe. See you next time.