Fund managers are lauding the promising outlook for small caps amid favourable macroeconomic conditions, but Franklin Templeton’s analysis suggests that mega caps beyond the Magnificent Seven could steal the spotlight, driven by the market’s heightened emphasis on valuation and earnings quality.
The fund manager has suggested that the decline in recession risk has removed a potential headwind for small caps, making them less appealing than they were a few months ago when a slowing economy and rate cuts were a near reality.
On the other hand, Franklin Templeton highlighted that large caps spanning various sectors possess the potential to deliver consistent earnings quality, a crucial advantage in a market forecast to experience heightened earnings disappointments in 2024.
“We see some of the best opportunities one level removed from the Magnificent Seven, in the other mega caps that make up the top 20,” said Chris Galipeau, senior market strategist, and Lukasz Kalwak, senior analyst at Franklin Templeton Institute.
“Companies in this group are likely to see steady improvement in earnings per share. They are extending their recovery after the challenges of the COVID pandemic. While the average earnings growth across the Magnificent Seven is expected to be 24 per cent in 2024, the next 13 companies are expected to grow earnings by 15 per cent; both rates are well above the forecast for the broad market,” the pair continued.
They assessed that active managers could hold an advantage in pinpointing and choosing these unique “idiosyncratic opportunities”.
“The fundamental characteristics across the largest companies imply superior earnings power than in the past, with valuations more attractive for those outside the Magnificent Seven,” Galipeau and Kalwak said.
Supporting this opportunity in large caps, the pair explained, are a number of factors including certain parallels to the dot-com era, and valuations and interest-rate sensitivity.
“The ‘dot-com’ period, which featured similar index concentration and falling interest rates, offers clues to trends this year,” they said.
“At Franklin Templeton Institute, we expect similar conditions in 2024, with the global economy likely to slow and central banks likely to cut rates.
“We believe market leadership might shift to areas of undervalued earnings power outside the Magnificent Seven, including both mega caps as well as small caps that offer sustainable earnings quality.”
Last month, speaking on an episode of Relative Return, American Century Investments’ Christopher Chen highlighted the potential for small caps to benefit from a more favourable macroeconomic environment.
For Chen, the world of small caps is currently brimming with potential.
“The key thing, I think, for small caps is that the headwinds against small caps over the last couple of years, that has gone away and it can become a tailwind,” Chen said.
“That’s on the macro side, that we think that there’s going to be some tailwinds for the asset class. And I think we can talk also more about fundamentals on valuation, even timing. I think many of these sorts of stars are aligning for small caps, which is why we think it’s pretty exciting.”
Chen is one of the speakers at Momentum Media’s upcoming Australian Wealth Management Summit, which will be held in Sydney on Wednesday, 8 May.
