Ellerston: 3 recession-resilient small and mid caps for the year ahead

Defensive large caps are beginning to look awfully crowded, but that doesn't mean you can't find resilience in the small end of the market.
Ally Selby

Livewire Markets

The market's appetite for risk has increasingly dwindled over the past 12 to 15 months. 

In 2023 alone, we've witnessed the second and third-largest US bank failures in history, globally recognised bank Credit Suisse was bought for mere pennies, and the Fed injected more than US$300 billion onto its balance sheet to offset the credit crisis. 

Despite all this, the Fed still raised rates by 25 basis points in March to a new range of 4.75%-5%.

It's no surprise then that investors around the globe have crowded into defensive, liquid large caps to safeguard their savings.

According to Bloomberg data, the top 20 stocks in the S&P 500 make up only 29.17% of the weight of the benchmark but have contributed to 7.08% of the S&P 500's 7.55% return year to date, as global investors flocked to liquid names amid major macro uncertainty. 

Yet, Ellerston Capital believes these companies have become overcrowded, and given their vast coverage, it's difficult to generate any performance upside by investing in these stocks. 

Instead, they believe global mid and small caps offer much more appealing upside. 

In this Expert Insights interview, Ellerston Capital's Bill Pridham shares his outlook on global markets over the coming 12 months, as well as three recession-resilient global small and mid-caps that won't break the bank. 

Note: This interview took place on Thursday 13 April 2023. You can watch the video or read an edited transcript below. 

Access global companies that you won't find in most portfolios

Ellerston Capital manages a concentrated global equity portfolio with a mid/small cap bias based on their highest conviction ideas from a filtered universe of sustainable securities. To learn more, please visit their website.

Managed Fund
Ellerston Global Mid Small Cap Fund
Global Shares

Edited Transcript 

LW: Which areas of the market are overcrowded right now?

Bill Pridham: When you think about what's happened over the last few weeks, there's been a lot of major events. So we've had the second and third largest US bank failures in history, with Signature Bank and Silicon Valley Bank. We've had a globally systemic important bank being taken over when UBS bought Credit Suisse as well. During that period, the Fed injected US$300 billion onto its balance sheet in a matter of days to help offset this credit crisis that was coming through. And through all this, the Fed still raised rates. So we had a number of different big events happening in the market.

And what that does is it creates concerns about global growth and also reduces the market's appetite for risk. And when that happens, typically what you'll see is a flight to large mega-cap companies, and we've seen that during March and early April as well.

Now when you think about where the market is invested quite heavily right now, you think of the S&P 500, it's a US$38 trillion market, so it's the largest market in the world. And yet the top five stocks are over 20% of that index. You think of Microsoft (NASDAQ: MSFT), Amazon (NASDAQ: AMZN), Alphabet (NASDAQ: GOOGL), Apple (NASDAQ: AAPL), and also Berkshire Hathaway. The market cap between the five of them is roughly US$7.8 trillion, so over 20%. So I'm not saying that's where you shouldn't be invested, but it's a really good indication of where there's a lot of investment already and potentially overcrowding.

Why are people crowding into this area of the market?

The reason a lot of people are crowding into those companies is because that is what has worked over the last decade. So we've had a decade of low interest rates, low growth, and that creates a need to be in higher growth, higher multiple, longer duration businesses. And that's really benefited mega-cap tech, and more of your lower profitable businesses as well. So that's what's worked over the past decade and that's what people know. That's what's really worked and that's what we're going to migrate to. The trouble now is the world's changed dramatically. We're in a higher rate environment, and a relatively higher growth environment, but much more inflationary. And rates have gone up dramatically in the last year. We've had the biggest rate increase in decades from the Fed and globally, as well.

So what's worked in the past, people are still extrapolating that's going to work in the future, so it does create a bit of a risk that it may not work. They're amazing businesses and I'm not putting anything against them as businesses, but as a differentiating trend or a differentiating thesis around it, it's worked in the past and they're extrapolating that they'll work perfectly in the future, which could be a risk as well.

What's your outlook on global markets over the next 12 months?

In terms of an outlook in the global markets. So firstly, when you take a step back, at Ellerston Global, we're not macro investors. We've focused on businesses, investing in secular growing businesses and high-quality companies. So we try not to get too caught up in the macro, but you really need to know where it is to get a base of where it's going to go. So if I frame that looking back on 2022. Last year, what happened was inflation was rampant. We had inflation going over 9% in the US and we had a very aggressive Fed raising rates at the fastest pace in decades. So you had that as your boogeyman last year, and that's what really created market multiple compression. So last year's earnings were actually really good. Earnings were actually fine last year, it was just your market multiple came down because of interest rates going up, and that created the massive downdraught last year.

I think this year's going to be the opposite of that. So inflation is now rolling over. Last night it printed below expectations, and the Fed is at the end of its rate rise cycle. So I don't think inflation or the Fed's going to be your enemy this year. But that said, I don't think the Fed's going to be your friend either. They have this mandate to get inflation under control, and I don't believe they're going to be too aggressive in terms of cutting rates anytime soon. But the big difference now is earnings. So we have all this tightening in the markets, financial conditions tightening, rates going up, so that's going to slow activity, and you can see that coming through now. Activity is slowing. So in terms of hard or soft landing, I don't know. But there is going to be some slowing, we're seeing that come through now, and that's why we've focused on businesses that have secular growth behind them and highly resilient earnings.

What are your three highest conviction holdings right now?

Earnings are going to come under pressure, there's no doubt about it, so we're laser-focused on earnings resiliency. And we think about the highest conviction stories in that resiliency bucket that we have, think of Cellnex Telecom (BME: CLNX). So Cellnex is the largest independent owner of mobile phone towers in Europe, so they have roughly a 20% market share. So if you go across Europe, one in five towers is going to be owned by Cellnex. And that creates a strong barrier to entry firstly, but also they have 110 billion Euro of contracted revenue in place. So their 2025 revenues and earnings are pretty much done today, because they have these deals with these big telcos. Their contracted revenues are linked to CPI, so you have inflation escalators in there as well. So that's one company that you can be pretty confident that earnings are going to come through.

You think of Graphic Packaging (NYSE: GPK). So it's the largest folding carton manufacturer in the world. When you think about your cereal box or your toothpaste carton, they make that. They have roughly 45% share in North America and just bought a big business in Europe as well. They're a business that is very resilient in this type of market. They have massive pricing power because they're able to pass through the pricing that they're seeing in terms of inflation costs. And when you think of the consumer themselves, you're still going to buy your cereal and your toothpaste, so they get that benefit as well.

And the third one is Option Care Health (NASDAQ: OPCH). So they are the largest provider of home infusion services in the US. So if you're coming out of a hospital, this is called acute, and you need antivirus home infusion, or you need nutritional infusion as well, they'll come to your house - their Option Care nurses will come to your house and give you that infusion. If you have a chronic disease such as Crohn's or let's say a heart condition, they'll come to your house. The nurses come to your house and give you that infusion, rather than you having to go to the hospital to do it. So it saves the system a lot of money. The payers, it's roughly, in some cases, half the price to get this home infusion service rather than going to the hospital. And as a patient, you love it as well, because it's so much more convenient.

So when you think of those three names, with Cellnex with the cell towers, you're not going to shut your mobile phone off likely, your subscription. I can't see that happening. You're still going to need to eat, so you're going to want to buy your cereal and have consumer staples consumption as well. And thirdly, and unfortunately with Option Care Health, you're still going to need your medical treatment. So those are very resilient businesses that should be quite supportive in any economic environment, and that's why we like those businesses.

Managed Fund
Ellerston Global Mid Small Cap Fund
Global Shares
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Ally Selby
Content Editor
Livewire Markets

Ally Selby is a content editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your...

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