After a dismal 2018, stock markets seem to be on an upswing so far in 2019. The S&P/TSX Composite index has returned over 6% year to date, while the S&P 500 has returned almost 3% in Canadian dollar terms.
“What a rocky end to 2018!” says Virginia Au, vice president and portfolio manager at Invesco. She believes that 2019 may be more of the same with a number of high impact events on the table such as interest rate movements, Brexit, US politics, Eurozone macro, trade wars and oil prices.
In volatile times, it is important for long-term investors to remember that volatility is part and parcel of investing, and not something that should be feared. Remember the old adage – patience pays off.
But if you want to invest right now, where should you put your money? For investors with a higher-risk appetite, and a longer-term horizon, small cap stocks might make sense. Last month, we discussed four Canadian small cap stock ideas. Today, we’re casting the net wider – to global small cap opportunities.
“Investors must remember that uncertainty is the only certainty in the stock market – the key is to get compensated adequately for these risks”, Au says. She manages the four-star, Bronze-Rated Invesco Global Small Companies Class Series F.
Small cap stocks are riskier than large caps, which can be seen in the returns posted in 2018. “In the fourth quarter of 2018, US small caps fell over 20%, their worst three month stretch since 2011. It was also the worst yearly return for small caps since the financial crisis, ending 2018 down -11%.
"We saw similar returns on a global basis where the global small cap benchmark lost 17% in the fourth quarter of 2018, and 14% for the year. While it currently might not be the time to back up the truck indiscriminately, the risk and return profile is more reasonable today than it was three months ago,” she says.
Small caps less sensitive to macro events
Au believes that for investors with a long-term investment horizon, small caps make sense, because these companies have long-term drivers that are less dependent on unpredictable near-term macro events.
“Smaller companies generally have better growth prospects than larger companies because they usually partake in higher-growth areas and can be more agile to market changes. Plus, they are growing from a lower revenue base,” she points out.
These trends play out favorably in the long term with returns in small caps outperforming large caps.
The best way to manage volatility is a disciplined investment approach that understands not only what you are buying but also how much you are paying, Au says. She held more cash than normal in the past two years, because the stock prices of many companies she liked did not account for any potential negative conditions. However, she acknowledges that valuations have changed since then.
“We are seeing a surge in attractive investment opportunities, especially some that have sold off 40-50%.” She finds that one benefit of having a concentrated portfolio of 25-35 names is the ability to cherry pick quality companies that have been disproportionately punished, which allows her the opportunity to take advantage of the price correction and added some new names.
Au has a bottom-up investment strategy, which emphasizes a company's competitive advantage and its ability to sustain above average profitability and returns. When picking global stocks, she considers the country's macro as part of the company's overall outlook and risk profile.
She also does not typically make sector calls, though the fund is overweight on information technology, communication services, consumer cyclicals and industrials. It is underweight its category on financial services.
“We historically have a high weight in information technology because it's a diverse sector with many attractive characteristics. First, the sector encompasses many products and endmarkets, not just smartphones and computer chips. We own companies from government IT consulting to 5G communications equipment to credit card payment networks; an assorted business model with growth drivers. Secondly, many of these businesses have high cash flow generation and differentiated products, which is what we look for in our holdings,” Au explains.
Three global small cap picks
Au likes three global small cap stocks to hold for the long term: UK-based Equiniti Group (EQINY), Poland-based Inter Cars and U.S.-based Encore Capital Group (ECPG).
Equiniti Group provides technology-based complex administration, processing, and payment services, both commercially and individually. Its business activities are divided into three operating segments; investment solutions, intelligent solutions, and pension solutions.
“For Equiniti, barriers to entry are high because they provide mission critical services that require robust software to deal with heavy regulation compliance. It is growing earnings in the low-teens and trading at 11 times 2019 earnings”, Au says.
Her second pick is Inter Cars, which she calls the O'Reilly Auto Parts (ORLY) of Poland and Eastern Europe. Inter Cars distributes aftermarket car parts for repair shops and garages.
“In this business, inventory availability and speed of delivery are key because professional mechanics care most about turning over their service bays, so they can repair as many cars as possible each day. Inter Cars is the biggest player in the market ... with massive price, systems and geographical coverage advantages over its competitors,” Au says, noting that the company has grown EPS at 26% CAGR over the last 10 years and trades at 11 times 2019 earnings. She believes it has tremendous opportunity to grow market share and points out that margins have been held back by growth investments, providing a long runway.
Her last pick is Encore Capital, a US and European collector of credit card debt that the banks have charged off and sold for pennies on the dollar.
“The competitive landscape has been heavily consolidated since the Global Financial Crisis, especially in the US, due to higher regulatory hurdles. Encore is the number one player in each of its key markets with a large tailwind to come in the form of rising credit card balances coupled with increasing delinquencies. It should grow mid-teens in the next few years and is currently trading at six times 2019 earnings,” Au says.
