Why bombed-out sectors might be the best place to look right now

Small and mid-cap stocks have been trading at a significant discount to large caps since 2022 and as capital has continued to pile into mega-cap names, that gap has only widened. Harvey Migotti, portfolio manager at Forager Funds, thinks it's now too large to ignore.

"They used to trade in line or at a premium for the better part of two decades plus. Since 22, you had a big derating and they've kind of been trading at a big discount. That's been pretty much significantly exacerbated by recent political events, macro concerns, AI."

It's the easiest part of the market to get sold off when investors get nervous but for Migotti, that's where the opportunity is. I sat down with him to discuss why he thinks the current volatility is creating the best opportunity set in global small and mid caps in years. Watch the interview above for all of the insights, or read an edited summary below. 

INTERVIEW SUMMARY

Why size matters

There are structural reasons why smaller companies are under-researched. Migotti points to the simple maths of analyst coverage - "There's 35 people covering Meta, for example, and 50 analysts covering Google and every single fund covers them.”

The companies Forager targets might have one or none. That lack of coverage creates the mispricings that Migotti is looking for.

“We're trying to find things that are flying under the radar, or just can be thrown aside by people when they fall out of favour or just when they're de-risking."

And because Forager deliberately keeps its funds at a manageable size, the team can actually take meaningful stakes in smaller companies, something a large global manager simply can't do without moving the price.

The flip side of this is liquidity risk. "By definition, lower liquidity means that just someone selling, or a fund shutting down and they owned a few per cent, it can significantly impact the share price."

His answer to that is a stable, long-term investor base.

"We're fortunate enough to have a very sticky, very loyal investor base, and that allows us to weather the storm like 2020, COVID, without redemptions and without the need to quickly sell and totally hammer our stocks."

Volatility as a shopping window

Migotti sees volatility as the mechanism that generates future returns. "Our best two years were after that huge volatility in 2020. When we had the tariff tantrum, same thing - we managed to pick up some amazing companies that had just been thrown aside."

But he draws a distinction between short-term corrections and longer-term structural shifts. The current moment, he argues, is more complex. 

"I think this is a longer term thesis. Companies can continue to beat in software, but you always have that five, ten-year horizon risk."

His approach isn't to predict macro outcomes but to find businesses where the value is compelling even in a bad scenario.

"If you find an amazing business that is impacted by it, but you just think even if the worst scenario happens, there's tremendous value here - we will look at that."

The Japan opportunity

One area Migotti keeps coming back to is Japan, particularly the smaller, domestically focused businesses that barely register on the radar of global managers.

"You have a tremendous amount of very liquid, very well-run businesses that have no research coverage. I'm talking about five, ten billion dollar companies covered by one broker. That company in the US or even Europe or Australia would be covered by at least a handful."

Beyond the coverage gap, he's watching two structural tailwinds. The first is corporate governance reform, and the second is digitisation. Japan remains meaningfully behind the rest of the developed world on software adoption and digital payments.

"Even just digital payments. Many, many places still take cash. There is a deep runway there in terms of catching up with the rest of the West. And it's funny how when it starts, it really starts, and it's almost parabolic to some extent."

The boring stock that wasn't

Migotti's best illustration of his process is Comfort Systems (NYSE: FIX), a US-based provider of heating, ventilation, and air conditioning services - "Comfort does sound a bit boring, but it's been an amazing compounder for 25, 30 years." 

The Forager team had done the work, watched it run away from them, and then waited. When AI sentiment collapsed and anything tangentially related sold off - including Comfort Systems - they bought it. The stock derated from around 30 to 17 times earnings.  

What the market missed, Migotti says, was the data centre exposure. 

"The data centres and the tech end markets that they are exposed to will continue to grow at a much faster rate than other end markets, but also they're higher margin, which people didn't appreciate. And they also have a 10-year maintenance contract attached to them generally."

Unlike a home or office building, where air conditioning runs intermittently, data centres run their systems around the clock. The margin expansion and backlog growth followed. "Lo and behold, it's happened even faster than we could have imagined," Migotti says. 

Migotti also points out how markets misprice second and third-order effects. 

"Comfort systems was a great example of a hidden AI play and data centre build out play, and we're finding more and more of them."

The case for Aussie investors

Migotti is staying in developed markets for now, keeping exposure balanced across regions and sectors. On where the upside surprises could come from, he points to sectors sold off from multiple directions at once - rate sensitivity, macro fears, and AI disruption layered on top of each other. 

"There are many sectors that are bombed out at the moment from multiple angles that I think have quite a lot of upside. And if you can marry that together with a good secular story or thematic, they aren't necessarily bad things to hold in the portfolio."

For local investors with a heavy home bias, the argument is partly one of access. Large-cap global exposure is cheap, easy, and well covered via ETFs and index funds. On the other hand, the small and mid-cap end is harder to access, more labour-intensive to research, and currently trading at a discount that Migotti believes is historically wide.

Nobody knows exactly when the discount closes. But Migotti's view is that waiting for certainty means missing the move entirely. 

"When they turn, they turn very viciously and very rapidly and you'll miss it if you're not positioned."

If you're interested in where the Forager investment team is currently finding opportunities, subscribe to the monthly and quarterly reports.

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