Portfolio Manager Justin Tugman discusses factors to consider when seeking small cap stocks that can not only survive the COVID-19 crisis but could potentially deliver value over the long term.

  Key takeaways

• While both small cap and value stocks have generally suffered since the COVID-19 crisis began, we continue to believe in their long-term prospects, especially companies with defensive quality characteristics.
• A wide range of sectors and industries are being disrupted and may face significant change because of the pandemic. As valuations have reached more reasonable levels, we believe there may be opportunities to capitalise on current price levels and structural shifts.
• We believe that it will be important to own ‘survivors’ – those companies with healthy balance sheets that not only have the potential to weather the contraction but also thrive in the long term.

 

The market’s reaction to the COVID-19 pandemic thus far has followed a two-phase path. First, we saw indiscriminate selling due in part to lofty valuations heading into the crisis. More recently, we saw the market become more focused on analysing the specific impacts to individual businesses and companies’ abilities to adapt to a drastically changed environment. We anticipate volatility will likely remain elevated for the foreseeable future. However, we also believe there are opportunities in high-quality small cap stocks that have the potential to survive and emerge from the recession relatively unscathed.

Small cap and value in recession and recovery

In general, small cap and value stocks have been punished more than larger-cap and growth stocks during the downturn, which we believe is the result of several factors. Stocks with value characteristics tend to be more cyclical and economically sensitive in nature. As the economy has slowed substantially and entered a recession, these stocks have been hit disproportionately. Small cap stocks, on average, also tend to rely more heavily on leverage than their larger counterparts. As earnings decline in a recession, investors worry about companies’ ability to continue to service their debt. As a result, we have seen the market broadly penalise companies that are more leveraged during the crisis.

Despite the recent relative underperformance of small cap and value, we continue to believe in the long-term prospects for small cap value stocks – so long as investors focus on defensive quality. By that, we mean looking for companies with defensive characteristics, such as durable revenue and earnings streams, strong balance sheets and the ability to generate free cash flow, all of which should help firms perform better during a prolonged downturn. In our view, during periods of heightened risk, a defensive investment strategy affords investors the opportunity to stay invested in the market while ideally mitigating downside risk. If the economy can stage a rebound, small cap and value stocks could thrive as they have in the early stages of previous recoveries.

Sector and industry impacts

Our sense is that the impacts of this downturn will be last longer than many expect, due in large part to high unemployment and reduced consumer spending. In addition to changes in consumer behaviour, we anticipate a host of other impacts, including a lower-for-longer interest rate environment, a more aggressive shift to remote work environments, modifications to supply chains and logistics management and an altered energy landscape.

We have already begun to see consumers cutting costs, increasing online shopping and utilising local delivery services for food and household supplies. As consumer spending represents the largest portion of US gross domestic product (GDP), decreased and shifting spending habits could have a broad impact on the consumer-centric economy.

For financials, the likely lower-for-longer interest rate environment puts pressure on rate-sensitive business models. As unemployment rises and customers struggle to make loan payments, credit costs will also likely go higher. However, in general, we believe bank capital is at healthy levels – certainly healthier than during the last recession sparked by the Global Financial Crisis.

Under stay-at-home orders, known as lockdown in Europe, there has been an increased need to provide workers with remote access via corporate technology applications. Post-pandemic supply chains and logistics that were severely impaired because of the crisis will need to be re-examined to identify critical components and alternative sourcing as well as production and distribution capacity to help mitigate any future disruptions.

In energy, oil prices collapsed when Saudi Arabia and Russia engaged in a market-share war. In conjunction with the demand shock experienced from the pandemic and an outlook for global economic contraction, we believe the energy landscape may be materially changed in the long term.

Owning survivors for the long term

In the current environment, we think it will be important to own ‘survivors’, which we define as companies with healthy balance sheets that not only have the ability to weather the contraction but also thrive in the long term. We cannot say when things will return to normal, but we will continue to stay focused on the impacts that the recession and changing behaviour from both businesses and consumers will have on long-term company values. As valuations have reached more reasonable levels, we believe an active defensive approach to small cap value investing may be more suited to uncovering opportunities amid uncertainty.