Doing the right thing in investment markets usually feels unpalatable. Finding value often means swimming against the tide and hunting for ideas where others are not.
Currently, and clearly for a few years now, it has been correct to follow the herd into the so-called, ‘Mag7’ companies, often via some form of passive, index vehicle. I am careful not to use the word investment as the ratings on these stocks are moving closer to the technique of ‘greater fool theory,’ – simply buying into them in the hope that someone else will pay more in the future.
The impact of investment decisions put on hold following the uncertainty of the Brexit vote, followed by COVID, the invasion of Ukraine and then the proceeding bout of inflation and rise in interest rates has reduced rates of growth and largely demoted investment in smaller companies to ‘nice to have when we get round to it’. Such an approach has paid off in recent years with the market being driven by macro-economic events as opposed to micro, stock picking fundamentals.
Whilst the doomsters always like their time in the sun and are now warning of an imminent crash, everyone should have gold and so on, what it all means is that the smaller companies world currently offers incredible value. Historically this has not been the case as typically investors would pay more for the higher rates of growth, hence why investors looked at the Mag7 in the first place.
Firstly, at McInroy & Wood, we take a global approach to investment, seeking out the very best ideas with the aim to smooth the woes of individual geographies.
I have no doubt that Artificial Intelligence (AI) will have a massive impact on economies and our lives generally, and the current Mag7 may well play an important part in this, but it is essential to remember that valuations are crucial to ultimate returns. Buying in as cheaply as possible should support longer term returns and dividends are always welcome. A recent piece by Deutsche Bank, with evidence over 70years, supports investing in lower price-to-earnings (PE), stocks over higher PE.
As a reminder of this point – had one bought into Amazon, one of the ultimate technology winners (a company I use regularly), later in the ‘tech boom,’ in late 1999, one would have to wait over 10years to get your money back – clearly a great company but totally the wrong entry point for an investor – valuation is key!
Using September data, we can see that Small & Mid Cap stocks populating the MSCI SMID Index, are trading on a more attractive forward PE multiple of 17.3x vs the large cap MSCI World of 20.4x, they also have a higher dividend yield, cheaper price-to-book and with higher forecast rates of growth.
In addition to this entry point being attractive, using an active fund can give fewer sector and geographic skews. Investing in the MSCI World Index means the top ten companies account for over 27% or the index with over 75% being in North America. This contrasts with the MSCI SMID 2.73% in the top ten and 65% in North America.
Having spent a huge chunk of my career looking at smaller companies a point that always struck me was why do so many people constantly look at larger companies. For instance, a company like Shell is followed by over 20 investment analysts and has many media column-inches devoted to it, I find it difficult to understand where I can add value. I also think that many of the larger companies are driven by factors outside the control of management, such as the price of oil, for banks it’s interest rates, mining is the price of minerals and so on. Yes, absolutely have these stocks in a portfolio for general exposure to the returns of a sector, but it’s difficult to find any new valuation angle.
Many smaller companies however have perhaps only a couple of analysts and few journalists show any interest down the size spectrum. It can make a difference therefore to find inefficiencies in markets by taking the time to visit the companies, talk through a business plan and understand how management will drive returns. Active fund management in this sphere can pay off.
It’s worth noting that there are risks investing in smaller companies vs their larger peers. Nothing in investing is straight forward, their shares can be less liquid and more volatile.
Overall however, with such metrics, it’s difficult to ignore smaller companies. There is significant value, a good spread of investment, management can have more control over their fortunes meaning that over a reasonable time frame, returns can be attractive.
Such a stance may well seem to be against the current flow, as investors continue to put money into passive, index trackers, but going against the flow never hurt ‘The Sage of Omaha,’ Warren Buffet – ‘be fearful when others are greedy and greedy only when others are fearful.’
The views expressed in this document are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument. The information contained in this document does not constitute investment research, investment advice or a personal recommendation and should not be used as the basis of any investment decision. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. This article reflects the author’s opinions at the date of publication only, and the opinions are subject to change without notice. This article has not been independently verified; no representation is made as to its accuracy or completeness, no reliance should be placed on it and no liability is accepted for any loss arising from reliance on it.
Doing the right thing in investment markets usually feels unpalatable. Finding value often means swimming against the tide and hunting for ideas where others are not.
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