What’s Played Out and What’s to Come
The impact of the decision by the Federal Reserve (Fed) to end easy money policies and begin to raise interest rates in response to higher inflation (what we have referred to as “Regime Change”) had an immediate impact in 2022 on financial assets, especially equities. While we haven’t yet seen a significant impact on the economy from higher rates (given the lag effect of rising rates), there are some warning signs flashing. Despite the potential challenges of an economic slowdown, we believe opportunities remain in small cap stocks.
While our approach is driven by proprietary research and the evaluation of factors such as healthy balance sheets, high or improving return on invested capital (ROIC), or fundamentally stable growth models, we are also continuing to monitor the impact of different sectors within the small cap space. Our investment professionals within our Small Cap Core, Small Cap Growth, Small Cap Value, and Fundamental International Small Cap strategies discuss how they see different sectors playing out and what they are tracking and expecting in 2023.
Technology
Rapidly increasing interest rates and deteriorating macroeconomic activity drove significant valuation compression in the Technology sector during 2022. Despite many companies within the sector maintaining a strong competitive position in end markets that benefit from secular trends including digitalization, automation, and simplification, valuation multiples declined 50% or more for some companies. The COVID pandemic, subsequent reopening, and now the potential for recession have driven abrupt changes in investor preferences within the sector the last several years. We have since rotated the portfolio multiple times in response to reward/risk attractiveness of different industries. The portfolio is currently tilted toward higher ROIC, strong free cash flow generation, and less macro-sensitive companies given our view that ongoing macroeconomic softness will drive continued weakness in corporate fundamentals. Moving through 2023, should fundamental weakness begin to accelerate and translate into further market weakness, we would expect to rotate the sector’s composition again to more improving ROIC companies, particularly in the semiconductor industry.
–Small Cap Core perspective
The mantra over the last decade has been growth at all costs, particularly in Silicon Valley, where technology investors were happily rewarded for higher growth that was based, in many cases, on only promises of future cash flows down the road. As interest rates have risen, the valuation of these companies has appropriately come under immense pressure and was the primary theme of 2022.
We believe 2023 will be a year marked by meaningful fundamental weakness amongst the Technology cohort, but ultimately lead to stabilization. In fact, we already are seeing a sharp fundamental deterioration in many profitable bellwether companies, as years of aggressive hiring have now created margin headwinds as growth rapidly slows. As it turns out, companies fueled by near-zero interest rates with little consequence for a focus on ROIC are now pivoting by rationalizing costs. This is certainly welcome news and should sow the seeds for a brighter, more profitable growth path after demand stabilizes.
The backdrop of compressed valuations, an increased focus on profitability, and ultimately an improved macro environment should help technology regain its footing in time. The portfolio is slightly overweight the sector, primarily due to elevated exposure in the semiconductor industry, which is further along in the process of negative earnings revisions and cost initiatives than the software and services industries.
–Small Cap Growth perspective
“Should fundamental weakness begin to accelerate and translate into further market weakness, we would expect to rotate the Technology sector composition to more improving ROIC companies, particularly in the semiconductor industry.”
— SBH Small Cap Core perspective
In 2022, the CHIPS and Science Act was signed into law. This will help drive semiconductor investment in the U.S., which is correlated to the reshoring theme that’s emerging based on the geopolitical environment we’ve seen over the last year. Reshoring should help to eliminate some volatility in 2023 for many areas of the market, which is why we have positioned many of the strategy’s companies around this trend to help offset a potential recessionary hit through 2023. One area of technology that is not necessarily new but is being discussed more broadly with reshoring is the use of artificial intelligence (AI). We believe the use cases for AI are just beginning to emerge in a broader way and are therefore looking for companies that can utilize this technology to enhance their own businesses and create value for customers.
–Small Cap Value perspectiveThe Technology sector remains one of the most fertile hunting grounds in international small caps. As valuations and multiples compressed in 2022, the attractiveness of the sector has been amplified in 2023. While we have seen some reversion of certain trends post-COVID, we continue to believe in the pace of digitalization and the strength of many of those businesses driving it. As is true for us in any sector, our focus has always centered on well-managed businesses that demonstrate strong, resilient growth runways, realize high returns on capital, and consequently produce high levels of free cash flow for shareholders. As 2023 has brought higher costs of capital, lower multiples, and more volatility, it presents a much more favorable M&A environment for many of our portfolio holdings and prospects that augment their organic growth with well-executed acquisitions. This is a key benefit of a tougher business environment for those strong and well-capitalized operators.
–Fundamental International Small Cap perspectiveIndustrials
There has been a bifurcation within Industrials, with housing-related businesses coming under pressure, engaging in destocking, and rightsizing staff. However, most of the commercial and industrial end markets are not seeing the same pressures. These end markets continue to see robust demand given long-term build cycles, robust backlogs, and labor constraints and, in certain instances, they continue to navigate supply chain disruptions. An economic slowdown in 2023 would likely be helpful to improve the supply chain and labor-related pressures for many of these companies. We believe continued secular drivers around electrification, infrastructure expansion, and reshoring parts of manufacturing will help buffer the impact of economic slowdown for the Industrials sector in 2023 and beyond.
–Small Cap Growth perspective
“The Inflation Reduction Act of 2022 will fund new investments in the U.S. and bolster supply chain resiliency.”
— SBH Small Cap Value perspective
The government has implemented several programs that should help mitigate a recession in 2023; these types of programs were not available going into past recessions. The bipartisan Infrastructure Investment and Jobs Act was passed in 2022 which will increase the Fed spending by 44% ($1.2 trillion total) on an annual basis for the next five years. The spending will be a meaningful driver for the industrials that participate in the infrastructure space. In addition, the Inflation Reduction Act of 2022 (IRA) was passed, which will fund new investments in the U.S. and bolster supply chain resiliency. Heading into 2023, we are optimistic about the value creation of the Industrials companies in the portfolio, with changes and improvements expected at multiple levels.
–Small Cap Value perspectiveIn 2022, the Industrials sector was faced with supply chain and labor pressures that were not trivial. Despite this headwind, we continue to see what we believe are attractive businesses that are managed by excellent operators scattered throughout what is ultimately a very large and broadly categorized sector. We have, through the portfolio holdings, prioritized smaller regional champions and specialist providers that have proven their strength and prospects far more resilient than many investors realize.
–Fundamental International Small Cap perspectiveEnergy
The Energy sector was the best performer within the market as defined by the Russell 2000® Value Index in 2022. Post the invasion of Ukraine by Russia, oil prices spiked, and energy stocks went up materially. Energy, as part of the Russell 2000® Value Index weight, was about 5% at the beginning of 2022; however, by the end of June it was near 11%. A significant swing of that nature underpinned by volatility contributed to a challenging environment for any strategy that had been underweight the energy space. Year-over-year through December 2022, the price of oil was up about 10%; however, energy equities were up between 60% and 100%, resulting in a large dislocation. This dynamic will be interesting to watch throughout 2023 and we believe opportunities will emerge with disciplined strong management teams to which we feel comfortable allocating capital.
–Small Cap Value perspective
In 2022, Energy sector companies were generally unwilling to invest in growing production, equipment, and capacity. Many management teams continue to highlight (unlike prior cycles) the desire to limit incremental capital deployment into business expansion, and instead focus on cash dividends, share buybacks, and paying down debt. Given continued capital discipline, we believe the sector could exhibit lower volatility than it has in the past due to more limited oil and natural gas supply growth. We are constructive on specific assets in the Permian Basin, carbon capture, storage opportunities, and competitively advantaged capital equipment manufacturers.
–Small Cap Growth perspective
“Given continued capital discipline, we believe the Energy sector could exhibit lower volatility than it has in the past due to more limited oil and natural gas supply growth.”
— SBH Small Cap Growth perspectiveConsumer
In 2022, we saw large corrections in the stocks of many COVID beneficiaries, primarily driven by multiple contraction. Much of this was and still is warranted as certain consumer niches that benefited over the last two years are continuing to, or starting to, cycle off inflated demand and face increasing cost pressures. We have seen very few companies spared within the Consumer sector and believe attractive opportunities now exist for investors with time horizons that extend beyond merely the next fiscal quarter or two. Our focus remains on businesses with resilient fundamentals and competitive positions as demonstrated by stable growth and cash flow generation, as well as market share gains.
–Fundamental International Small Cap perspective
The leading edge of the Fed tightening effects was felt in the housing market. Early cycle areas such as housing, transportation, and semiconductors are more clearly demonstrating the negative impact of higher interest rates in business fundamentals, indicating the economic dominos could already be starting to fall. With the most aggressive rate-raising campaign by the Fed since the early 1980s, housing already significantly weakened, ISM PMIs below 50 in the U.S. (contractionary; 75% of global PMIs below 50), there is no doubt that 2023 will be an interesting tug of war (i.e., hard landing versus soft landing) in the financial markets. Companies within the Consumer sector, particularly in areas like retail and housing that tend to be among the first to benefit in an economic recovery, face a similar tug of war where significant valuation compression came before fundamental deterioration. While risk is still present, we have begun to augment the portfolio with these stocks. They have been decimated already and we believe they present very attractive risk/reward ratios as we look out over the next 18 months.
–Small Cap Core perspective
“Very few companies were spared within the Consumer sector, and we believe attractive opportunities now exist for investors with time horizons that extend beyond the next fiscal quarter or two.”
— SBH Fundamental International Small Cap perspective
Looking Forward
2023 is not likely to be any easier than 2022 from a market volatility perspective given the headwinds we see in the data and that are emerging in corporate earnings results. We see these markets providing our clients a major opportunity. The pressures that we think will weigh on many companies are precisely those in which companies we favor tend to really differentiate themselves from the crowd. Small cap companies that exhibit high ROIC, solid balance sheets, and the ability to generate solid free cash flow should be well positioned to thrive as we continue in 2023. While we cannot forecast when this “sorting out” will play out in the markets, market stresses will inevitably highlight winners and losers, and our expectation is that quality small caps will be at the forefront of these volatile times.
Please reach out to your SBH contact with any questions or visit www.sbhic.com to learn more.