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Small-cap dynamics shift to earnings prospects

By Lauren Romeo
 — 1 minute read

After enjoying a year of very strong returns in the global small-cap equity market, investors should prepare for a change in the market’s dynamics.

Lauren Romeo

We expect that small-cap returns are more likely to be tied to future earnings growth as opposed to multiple expansion. While the broad sector enjoyed the benefit of fiscal year 2021’s increase in valuation multiples, stock selection should begin to take precedence as investors focus on companies that have visible prospects of long-term earnings growth.

The MSCI ACWI Small Cap Index (USD) rose 54.7 per cent in the 12 months to 30 June this year. Many lower-quality companies benefited as the market recovered from the sell-off in early 2020. We believe companies with more durable business models are now poised to emerge with greater earnings and cash-flow power as the economy reopens.

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Inflation and rising interest rates, both by-products of robust economic growth, are a source of increasing concern for investors. However, they should be less of a headwind for quality companies. If current inflation proves to be more than transitory, quality companies should fare well since pricing power is a key facet of their business models.

One of the holdings in our Royce Global Small-Cap Premier Fund portfolio, Inter Parfums, illustrates this point. The company is a global developer and designer of prestige fragrances, operating primarily under licence to such high-end brands like Montblanc, Coach, Jimmy Choo and Guess.

So far in 2021, the stock is up more than 25 per cent, with better-than-expected growth flowing from improved store traffic, as vaccinations are being rolled out and pandemic restrictions are loosened.

After postponing new product launches in 2020, Inter Parfums has a particularly robust launch schedule for its major brands, as well as product launches for new licensees. What insulates the company from inflation is that consumers are willing to pay up for the brands in its portfolio.

We favour cyclical sectors as attractive areas for high return on invested capital. We look for companies in industrials, information technology, financials and consumer discretionary that have durable business models and attractive valuations.

With rising vaccination rates, accommodating central banks and aggressive fiscal spending policies, economic growth projections are robust for the next two years. All this bodes well for economically sensitive businesses. And valuation for small-cap cyclicals remain below their long-term averages.

Another Royce stock holding, ESCO Technologies, is a US manufacturer specialising in aerospace, radio-frequency shielding and utility solutions. It has a high proportion of recurring revenue, thanks to defence contracts.

COVID had an impact on the business, with a decline in the commercial aerospace industry, which makes up around 25 per cent of its revenue. However, aircraft build rates are starting to pick up again. ESCO’s revenue will track this recovery. One thing we have seen among the better-quality companies is that defensive measures they took last year to preserve cash flows, such as smaller real estate footprints, have become permanent reductions in their cost structures.

These actions have strengthened their moats and increased their operating margins relative to pre-pandemic levels.

Lauren Romeo, CFA, portfolio manager, Royce Investment Partners

 

Small-cap dynamics shift to earnings prospects
Lauren Romeo
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