Top investors tap ‘very rare’ opportunity to buy cheap small stocks

The market sell-off this year punished small-caps, but fund managers tell Sam Benstead that cheap valuations are a golden buying opportunity.

Leading professional investors are upping their bets on small stocks, a part of the market that has sold off steeply this year due to rising interest rates and inflation.

Smaller companies tend to be less mature than large companies but faster growing, meaning investors buy them when they are feeling optimistic about the economy, but sell them when they are more pessimistic.

This year, the FTSE 250 index has fallen 16% ,while the blue-chip index, the FTSE 100, is flat. In the US, the S&P 500 is down 13%, while the Russell 2000 small-cap index is down 16%.

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James Lowen, co-manager of the JOHCM UK Equity Income fund, said this drop was due to a “rush to safety” from investors at the expense of small-caps, caused by the war in Ukraine, monetary policy tightening, inflation, the cost-of-living crisis and slowing economic growth.

Lowen said: “Whenever there is such a market mentality, small-caps tend to underperform. We have seen this at other risk points such as Covid and the financial crisis.”

He also put blame on Neil Woodford, the former star fund manager whose foray into unlisted companies played a big part in the downfall of his fund and his firm, Woodford Investment Management.

“The Woodford situation has also impaired the UK small-cap market over the last few years,” said Lowen.

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This weakness in the smaller end of the market means that valuations have fallen and become more attractive. As a result, Lowen has been moving to take advantage.  

He said: “We believe the valuations that we now face on many of our small-caps are now very appealing – typical price-to-earnings ratios are between four and eight times, with significant potential to increase.

“Catalysts for a change in sentiment would include a pivot in the narrative around monetary policy, energy prices rolling over, takeover approaches, or even the valuations themselves – having got so low – they attract attention from investors.

“In our opinion, this feels like a very rare opportunity in UK small-caps and is the right time to add to exposure.”

Lowen has made recent investments include furniture chain DFS, mining company Kenmare Resources, oil and gas firm Savannah Energy, and building materials firm Tyman.

Are investors too gloomy?

Laura Foll, manager of Henderson Opportunities Trust and Lowland Investment Company, is also getting more interested in smaller companies, arguing that investors are too gloomy about this part of the market.

Foll says that while the current narrative is dominated by doom, in recent weeks her team has been debating whether it is time to rotate back towards the small and mid-cap stocks that have had such a difficult time.

She said: “We cannot rule out more share tumbles, but markets seem to have largely priced in these expectations. I cannot imagine a more dismal scenario than we beheld at the beginning of the Covid crisis [when] markets crashed. This year, many stocks have experienced similar corrections.

“We are told to sell cyclical stocks as we enter a recession. But markets appear to have priced in a significant amount of bad news, with the median FTSE 350 share down almost 20% this year. And maybe – just maybe – this time round a recession may not be as painful for many of these companies as in times past.

“We are not calling the bottom, but for us it has made sense to pocket some of the gains we made from energy shares and begin moving gently back into some of these cyclical areas in readiness for their recovery.”

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Foll gives the example of DFS Furniture (LSE:DFS), saying that in 2020, when the Covid crisis struck, its share price fell nearly 60%, from £2.82 at the beginning of the year to £1.16 just three months later. By June last year, its shares had recovered strongly – to a high of £3.

Today, they are £1.57. The falls are similar for M&S – down 53% during Covid, followed by recovery, and then down 43% today.

Foll argues that there is a perception in the market more broadly that there could be substantial hits to company earnings, but in reality this may not come true based on her experience of talking to company management teams.

She said: “Reflecting on share price performance, managements seem quite bemused – and sometimes frustrated. Demand so far seems resilient, and we are impressed by how many companies have price escalation clauses within their contracts.”

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One area she likes is building materials companies, because she says even if house prices were to fall, housebuilders would have to carry on building homes – otherwise their earnings dry up. So they will still need bricks and other materials, Foll argues.

“One of our holdings in the Henderson Opportunities Trust is Sigmaroc, which produces heavy building materials for the UK and Europe.

“Its share price is down more than 40% over the past year, but this is a company with a history of smart acquisition and organic growth. We await its latest set of results, but the past five years have been impressive – earnings up from £6 million to £49 million and earnings per share more than doubled.”

“Brickmaker Ibstock, another company we like and whose share price is down around 13% in the past year, is paying nearly 4.5% in dividends. Epwin Group, a UPVC window manufacturer, is delivering over 5%,” she said.

US opportunities

In the US too, smaller companies are attracting attention. Brendan Hartman, of Royce Investment Partners, calculated that in America it was the only major asset class to have outpaced inflation in every decade since the 1970s.

Hartman says: “Additionally, since 2003, small-caps have on average delivered attractive returns when inflation expectations were rising. Finally, if all equity assets are undergoing a valuation reset, then it may be comforting to know that small-caps are at the low end of their relative valuation range over the past 20 years versus large-caps, which may limit their downside exposure relative to their larger siblings.”

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Steve Lipper, of the same firm, says there is a compelling case now to invest in small US stocks because of three key characteristics of smaller stocks.

Lipper said: “Small-caps’ superior valuation, the history of small-cap outperformance following high fear moments, and the relative outperformance of small-caps from points of deep decline make a compelling, if not table-pounding, case for putting fresh capital into small-caps now, possibly using large-cap as a source of funds.”

Cormac Weldon, manager of the Artemis US Smaller Companies fund, which is a member of interactive investor’s Super 60 list of recommended funds, echoes what Hartman and Lipper argued.

“It is the second-best buying opportunity in around 20 years, with valuation in the Russell 2000 index now below the S&P 500 index, despite smaller stocks growing faster.”

The fund manager has been adding to shares in companies in the power industry supply chain, such as Nextera Energy Partners and Valmont Industries.