Chris Wallis, CFA®, CEO, CIO, portfolio manager, and international team portfolio managers Kevin Ross, CFA® and Marco Priani, CFA® discuss macro and market trends, below.
Looking at the small-cap space, what’s more attractive – US or international names?
Wallis: If you look at the last decade, we saw the rallying US dollar as a headwind against international equities for much of that time. But for about a year and a half now, there has been a down trend of the dollar that I think is only just beginning. So this makes international names favorable.
At the same time, I don’t believe people are nuanced enough about investing internationally. Many think that if they own US large caps, then when they invest in non-US developed markets they should do the same thing. I think that’s a bad idea. Because those international indices are dominated by businesses that I believe are truly secularly challenged today. And when you dig into the nuances and you look at international small caps in the developed markets, many are high quality companies.
By the way, I’m not finding as many high quality companies in the US small cap universe today. I don’t think it’s an apples to apples comparison to look at non-US developed market small caps and US small caps.
Ross: But when you look at the profitability of international developed market small caps, they are very attractive to us. Overall, we are identifying niche regional businesses with high ROAs (return on assets), growth rates, and attractive valuations compared to the larger companies.
Can you give an example of a niche business providing value today?
Priani: A Japanese manufacturer of compact construction machinery is a good example. They have high market share in both the European and North American markets. They are an exporter, so about 97% of their sales comes from outside of Japan. Their strong competitive advantage is drawn from the products themselves. And they cover a wide range of applications, including things like road building, housing foundation work, and civil engineering.
Ross: In early 2020, its stock was trading well below our estimate of intrinsic value for a couple of reasons. Including a typhoon in Japan causing outages at several production plants, a strengthening yen, and then Covid-19 fears in China hit – with construction machinery demand in China representing about 5% of their overall sales. As you can imagine, demand in their industry took a hit during the first half of 2020 because of the pandemic. However, we have seen a strong pickup in residential housing demand in the US and Europe during the second half of 2020 and into 2021. So we see long-term value at play for this niche business.
Where are you finding value in the US?
Wallis: Probably the area where we are seeing select opportunities is in the energy space – more so than anywhere else. I think market participants are still woefully underweight energy and there is still a lot of value to be had in that sector.
Is a rotation from growth to value under way?
Wallis: When you look at the current market setup, it’s easy to see that a lot of indices have reached all-time highs and exceptionally high valuations. And at the same time, people like to talk about the rotation from secular growers to value. But I believe it is going to be much more nuanced than that. We already see that about 30% of the industries in the S&P 500 are facing secular disruption. We think that number is only going to increase as we move through this decade. Therefore, it’s going to be much less important to pick the right sector and much more important that you pick individual securities that are going to win no matter what the binary outcome may be in some of these industries. We will be looking to take advantage of these nuances below the sector level to capture the alpha that is necessary to be a successful investor over the next decade.
What’s your take on 2021 market dynamics?
Wallis: We appear to still be in what I call Never Never Land. Meaning many investors can just pretend what the backdrop is going to look like a year or two years from now, and how strong things are going to be. There is lots of stimulus. We’re still seeing accelerated real growth in the US economy. We are seeing, for the first time, real inflation. This may prove to be transitory, or it may not. I think it will depend on the stimulus driven from infrastructure spending we have in the back half of the year.
Still, we have a very strong industrial recovery under way. There have been a lot of supply interruptions across multiple supply chains. One example is the shortage of semiconductors to run plants. You could carry that down the chain to the consumer. If you have had to replace an appliance in the last six months, you probably realized you cannot just run down to the store and get the equipment and parts that you need.
Ross: That said, we’re finally starting to see the first indications that a slowdown could take place in the back half of the year. And I think all that means is, the Fed was successful in pushing liquidity out, and driving personal incomes higher during the pandemic despite unemployment. Unless we continue the same level of stimulus going forward, there is a fiscal cliff – and while the economy is recovering, you could see liquidity withdrawn.
Are you concerned about bubbles?
Wallis: I do think there are real bubbles in the markets. It’s in certain verticals and narratives. A lot of it is centered on clean energy or other narratives around Bitcoin and things of that nature. But it’s similar to the level of activity we saw in late ’99 leading up to the 2000 tech bubble. It is going to continue to be in the market until we see liquidity withdrawn. This could probably come when the US economy reopens and there is real demand on liquidity.
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