Edmond de Rothschild AM: „We are in an unprecedented market anomaly“
Ms Gauthier, you specialize in small caps. These have recently lagged behind the blue chips.
Yes, since April 2022, small caps have lagged behind large caps by 29 points. This is an unprecedented market situation that far exceeds the last period of underperformance. During the financial crisis from 2008 to 2009, the underperformance was only 14 points.
Why is that?
Firstly, small caps have suffered greatly from the rise in interest rates, which has depressed valuation multiples - it is important to bear in mind that this universe consists mainly of growth stocks. Secondly, they have suffered from unjustified investor mistrust because risk aversion on the market has been very high since 2022 with the war in Ukraine, energy prices, inflation and fears of a recession.
And this is weighing more heavily on small caps than blue chips?
Yes, this stress environment is very unfavorable for small caps, and investors have preferred to withdraw from this asset class because they see it as more at risk of default. Yet the financial health of small caps is intact. If you look at the European small-cap index, 30% of companies have a net cash situation. But because of this misconception, there are continuous outflows.
And what happens now?
We believe that we are in an unprecedented market anomaly. A situation where the valuation of small caps has never been so low, both in absolute terms and relative to large caps. If you look at the last 20 years, small caps have always paid a premium over large caps due to their higher growth rates, averaging almost 25%. This growth premium has completely disappeared today. We even have a huge discount of 16% in relation to the price/earnings ratio. More than just a recession has been priced in. So there is now considerable scope for upward movement. However, it needs a catalyst.
And what could be a catalyst?
A change in ECB policy should provide strong support for the asset class. Interest rate cuts could contribute to a revaluation and would also help to dispel the exaggerated fears about creditworthiness. A second catalyst for me is the fact that earnings momentum in 2024 is likely to be in favor of small caps again. If we look at the analyst consensus, they expect EPS growth of 8% for small caps and only 3% for large caps in 2024. The third catalyst is a recovery in PMI. Small caps are often seen as more cyclical than large caps. We need a return of capital flows to this asset class and I am quite optimistic that this will be the case, the question is when. Recently the markets have been unusually focused on the mega caps, but investors will soon be looking at the rest of the market and then small caps will be back on the radar.
Among the big companies, stocks associated with AI have been particularly popular recently. Is this similar for SMEs?
In the small and mid-cap sector, you will also find players from the semiconductor industry. However, bear in mind that these names are very volatile and correlate strongly with Nasdaq momentum. So I would be more cautious on these smaller names, although I'm sure there will be opportunities as the technology matures. We're not just talking about AI, but also consulting or IT services companies, data centers, which will require investment in the coming years.
What other sectors are you looking at?
We have a pure stock-picking fund. This means that we don't look at specific sectors or specific countries. We focus on the growth and profitability prospects of companies. All sectors are represented in our small-cap fund, the most important being industrials, technology, healthcare and consumer goods.
How do you go about identifying promising small caps?
In our small-cap funds, we mainly focus on quality companies whose management teams implement a clear and convincing growth strategy with a long-term vision. The DNA of our fund consists of four selection criteria: Firstly, growth. This is often supported by long-term trends, which we call megatrends. Competitiveness, because if you want growth to be visible and sustainable, the company must have a high barrier to entry and a competitive advantage in order to maintain this advantage and be able to grow in its market niche. The third criterion is value creation, because we are looking for growth, but we want it to be profitable in the long term. And the last criterion is management, the quality of management and good and transparent communication to deal with the financial markets.
On what time horizon are your investments based?
We invest in the small-cap sector with a perspective of at least five years, because we want to accompany the companies and the management on their path, their growth path, over a longer period of time. We look at the business plan for the next three, five, ten years. And we expect our investors to have the same investment horizon as we do. We focus on quality growth companies, but also integrate ESG criteria. And we only invest in companies that we believe will be able to create jobs over a period of three to five years.
Can you also give our readers a few names of companies that you think are strongly positioned?
Amplifon. The Italian company is the global market leader in the distribution of hearing aids with a strong commitment in Europe, but also in the USA, where they have stable growth prospects, and in the Asia-Pacific region. We appreciate Amplifon's very good positioning within the value chain, with strong purchasing power given its size and good pricing power. The company serves a growing market driven by a megatrend: the ageing population. They are also strengthening the growth of the platform through mergers and acquisitions, consolidating the market and also capturing market share.
Do you have another tip?
From the German region, we like SAF-Holland, which specializes in equipping trucks and trailers. They are currently valued at less than five times EBITDA - a significant discount to the long-term average valuation.
They are able to generate a high free cash flow yield and are still in a transformation phase following the acquisition of Haldex. This brings synergies and upside potential at the margin level. We like their global leadership position, which is either number 1 or number 2 depending on the market. They have a strong commitment in the USA and also in fast-growing countries such as India. We also like the strong share of the aftermarket business in their revenues, which gives SAF-Holland a fairly resilient profile.
