Trade war talk has unleashed a wave of volatility that may be best surfed by looking at small-cap cyclical stocks.
Tariffs and trade wars have again taken center stage in the market, as the U.S. and China embark on a battle in which there are likely to be no winners, at least in the short run. Until cooler heads prevail to sort out this weighty situation, stocks are likely to remain volatile, as the first few weeks of May have already demonstrated.
Unsurprisingly, the down days have so far hit cyclical names hardest, as these more economically sensitive stocks typically take it on the chin when the prospect of slowing global growth rears its unsightly head.
From our perspective as experienced small-cap specialists, however, much of the pessimism about cyclicals—and global growth more generally—seems excessive. We feel confident that solutions will ultimately emerge that promote global growth.
The three bar charts below illustrate the current state of our target zone at the intersection of quality and value for investments in cyclicals. It shows three different current perspectives on our preferred valuation metric, EV/EBIT (Enterprise Value over Earnings Before Interest and Taxes).
Our Target Zone – Intersection of Quality and Value – Often in Cyclicals
Source: FactSet
EV/EBIT: Enterprise Value/Earnings before Interest and Taxes. “Small-Cap” is represented by Russell 2000.Cyclical is defined as follows: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.
We think the charts reveal both the pessimism and the opportunities that exist today for small-cap cyclical businesses. With the Russell 2000 up 16.0% year-to-date through 5/16/19, the richer valuations—along with a chunk of the corresponding share price increases—have mostly gone to defensive stocks.
“While small-caps as a whole are trading higher than they have over the last 20 years, the current small-cap premium comes mostly from defensives, with cyclicals trading much closer to, and only slightly higher than, their 20-year average.” — Steve Lipper
While small-caps as a whole are trading higher than they have over the last 20 years, the current small-cap premium comes mostly from defensives, with cyclicals trading much closer to, and only slightly higher than, their 20-year average. And when we go company by company, we often see even more attractive valuations for companies with earnings and other attractive characteristics.
In fact, our experience has taught us that the market frequently over-penalizes cyclicality, and doles its punishment out most regularly to cyclical stocks. To one degree or another, of course, every company is cyclical. No stock enjoys consistent, straight up growth. Yet at times of market stress, investors often behave as if cyclicality will remain in a permanent corrective phase and that defensive names are immune to cyclicality.
Much of today’s pessimism about cyclical stocks is based on this misperception. Interestingly, this misjudgment not only contradicts our own experience, it also contrasts with what we’ve been hearing in our meetings with company managements, who remain guardedly optimistic for continued growth.
Most recently, we’ve invested in several cyclical areas that we think are particularly promising, including specialty chemical producers, laser manufactures (and other innovation-centric tech and industrial businesses), specialty finance companies, and those that make precision agricultural products.
Of course, our different small-cap strategies generally have a heavy cyclical tilt. For example, the Russell 2000 Index, the benchmark for our major domestic strategies, for example, consisted of almost 70% cyclical companies at the end of March, while our largest portfolios ranged from 86%-92% in cyclicals.
This cyclical tilt is also the latest iteration of our effort to turn the difference between how a stock is classified and the reality behind its business into strong long-term performance.
Stay tuned…
Mr. Lipper's thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.
The performance data and trends outlined in this video are presented for illustrative purposes only. All performance information is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.
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