At a recent boardroom briefing, the Paradice Global Small Cap Fund team discussed their views on what’s influencing movements in the small-cap sector. They said two main themes are occurring: global low interest rates have inflated asset prices to historical records and there has been an apparent shift from growth to value investing.
Here are five key takeaways from the discussion.
1. Growth outperforming value but at a price
The Russell 2000 Growth Index has outperformed the Russell 2000 Value Index by more than 70% since the financial crisis (31 March 2009-30 Sept 2019). This performance differential is the widest since the dot-com bubble.
However, the valuation premiums being paid for growth businesses are as high as they've been since the late 1990s. Paradice Global Small Cap Fund portfolio manager Kevin Beck says as interest rates have gone lower, the valuation premium that people are willing to pay for growth stocks has gone ever higher.
“If you look historically at the premiums that growth used to be at relative to value, they were around 20% to 30%,” he says.
“Today, the premiums are pushing 80%. In other words, people are paying any price for what is a slowing global economy right now. To us, that is a recipe for disaster.”
Paradice believes while growth is worth paying a premium for, the amount of growth you get for that premium is not all that dissimilar to what you get in value stocks. “With most growth stocks, the growth is never quite as much as you think it's going to be in terms of earnings,” he says.
Paradice Global Small Cap Fund analyst Paul Mason agrees. He says in the past decade, the Russell 2000 Growth Index has delivered 8.8% compound annual earnings growth per year. “But value stocks, which are considered to be the poor man’s investing, have returned 8%,” he says. “So the difference is just 80 basis points of growth a year to actual earnings.”
2. Private and public valuation premiums narrow in pursuit of ‘growth at any cost’
Valuations between private and public companies are narrowing, with yield hungry investors lifting demand for private equity and prompting buyers to pay record multiples for assets.
Beck cites a conversation with a private equity fund manager who revealed several years ago, his fund would never pay more than 6 times EBITDA for a business. “But today, he's one of 20 guys bidding at 10 to 12 times,” he says. “There's been inflation across the board in multiples, in both public and private equity.”
Beck adds in his view, Amazon has created a business model where businesses care little about profits. “Amazon have been able to do this as they’ve self-funded themselves, but most businesses need outside capital,” Beck says. “When rates are zero, people are willing to play that game but sentiment can turn on a dime.”
WeWork is a good example. In October, it was found to be one month away from running out of cash, despite two months prior being valued at $US47 billion.
“The situation that as long as somebody is funding your business model, you don't need to worry about profits is unique in the history of business,” Beck says. “I think that’s the hard lesson. Previously, 5% growth may have been worth 15 to 17 times earnings. Today, 5% growth could be worth north of 25 to 30 times earnings.”
Beck says that’s another way of saying the cost of capital is going down and people are willing to drive premiums several multiples higher. “People are saying, ‘If rates are at zero forever, what will the multiples go to?’ We've got an example of that, which is Japan.”
3. Value traps exist for unwary investors
Investors need to be aware that the market is becoming littered with value traps. Beck says the value side of value traps has increased and are going to multiples he’s never seen before.
“Retailers are a classic example,” he says. ”Retailers used to trade at eight to 15 times earnings or EBITDA depending on where they were in their growth trajectory. Now, certain retailers could be trading at three times EBITDA. These could be profitable retailers that might not be growing very quickly, but have short leases so they're not shackled with a huge store base.”
Abercrombie and Fitch, he says, has been a “yo-yo of a stock”. “When people think it's growing, it's off to the races and then when it misses a number, it's right back down 40%,” Beck says. “But these types of businesses have never traded at these multiples. You're talking about businesses that produce $US100 million a year in cash and have market caps after net cash of $US700-800 million.”
4. Rethink required on asset prices following failed IPOs
WeWork and its failed IPO, along with the disappointing performance of recently listed unicorns, such as Lyft and Uber, are examples of why growth investing is falling out of favour.
“WeWork is symptomatic of growth investing at the moment,” Beck says. “One week it was valued at $US47 billion and the next it was valued at $US8 billion.
The moral of the story is the valuation of these type of businesses that have no earnings is based on purely emotional reasons.”
Beck believes the world is beginning to rethink what is the right price to pay for an asset.
“There are two schools of thought right now: rates remaining at zero forever and so it’s staying in equities forever – because where else are you going to get a return – or the unconventional thought that we all know something's not quite right, so what do negative interest rates mean?”
He adds growth is slowing down, even with negative interest rates. “We've got leverage at all-time highs so something's going to happen,” he says. “To us it highlights more than ever the importance of diversification.”
5. Where to from here? Small-caps important for diversification
It’s difficult to say where the markets will head from here. Will central banks step in and support growth or is this a strange new world that requires as yet untried solutions?
The world is certainly throwing up some challenges and interesting scenarios. In the UK, for example, everyone is waiting on what will happen with Brexit while surprisingly, the best-performing market in the eurozone this year is Greece.
As interest rates continue to fall to record lows around the world, growth has become more valuable. Trade uncertainty and Brexit concerns have meant that “real world” sensitive stocks have experienced slowing earnings growth and underperforming share prices.
But anecdotal evidence suggests this may be changing. Paradice continues to believe global small-cap stocks play an important role in an investment portfolio given the potential for diversification and compounding. These types of stocks also appear to be approaching the lower bounds of underperformance versus large cap stocks, which may signal opportunities in this sector going forward.
“We think we can get back to double-digit compounding over the coming years, barring another big global recession or anything along those lines,” Beck says. “We're basically sticking to our knitting in terms of where valuation support is and that is largely in niche industrial businesses.”
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