The global small cap funds left behind in the market rally

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Global smaller companies have been one of the hardest hit areas in stock markets since the pandemic sent investors fleeing from risk assets.

From its peak on 16th Jan to the trough on 18th March the Russell 2000, an index of US small-caps, declined by 42%. In comparison, the US large-cap S&P 500 index declined by 34%.

Stock market declines and increased volatility are a terrible combination, but amid the losses for many companies, they are also the basis for long-term wealth creation.

It is well-known that small-cap companies are under-researched. In a market panic, sell-side analysts barely have time to update their forecasts. Their focus is on large-cap companies. Small-caps become further neglected, leading to more mispricing. Increased volatility drives blanket selling of small-caps with often little regard for the underlying businesses.

Bottom-up small-cap stock pickers should be thrilled by the opportunity this creates, and since the bottom in March to the end of April, the Russell 2000 index, for example, has jumped 32%.

Bottom-up stock pickers that have done their homework and don’t rely on sell-side research have a prime opportunity to pick small-cap compounding machines trading at significant discounts to intrinsic value. These small-cap gems rarely make a misstep, and infrequently trade at a significant discount to intrinsic value. Investors shouldn’t try to time the bottom, but rather buy great businesses at a discount whenever the stock market offers the opportunity.

So, what should be catching investors’ attention now? Below are five standout small-cap opportunities from around the world.

Genpact

Genpact is a leader in digitally powered business process outsourcing. It leverages its expertise in digital solutions such as cloud, machine learning and robotics with its best-in-class knowledge within the banking, capital markets & insurance sectors.

Founded back in 1997 as the internal business process management unit at General Electric, it was spun off and listed on the NYSE in 2012 and its client base now covers 25% of Fortune 500 companies.

Companies search for the right partner to help them increase the use of technology in their operations as well as a partner that can run these operations with those technologies embedded inside.

Its shares have fallen alongside the wider US index, but Genpact has 80% renewal rates due to high switching costs for its customers, and 85% of its solutions are mission critical, leading to long-term recurring revenues.

This resilience has been proven in previous downturns, and while shares have recovered some of their lost ground after halving in March, there is much more upside to come.

GMO Payment Gateway

Japanese listed payment processor GMO Payment Gateway is having an incredible 2020 in terms of its share price, up almost 30% year-to-date as the world shifts to online for nearly every purchase.

While the gains for GMO have been strong, the fact remains that the long-term structural growth story remains intact in Japan. Japan’s e-commerce penetration is surprisingly much lower than many other countries with only 6% e-commerce penetration, versus 18% in the UK and 10% in the US.

As the market leading independent payment processor GMO is well positioned to benefit. If there is a full lockdown in Japan, consumer spending will decrease, so there are risks, but given its strong balance sheet, we are confident GMO is well positioned to whether any temporary drop in transaction volumes.

Aluflexpack

Listed in 2019 on the Swiss stock exchange, Aluflexpack is a premium packaging company in Europe which makes packaging from aluminium rather than plastic. Crucially, part of its customer base is the pharmaceutical industry, and its role as a key supplier in what is known as a ‘critical industry’ amid the pandemic is a real differentiator.

What SilverCross also like about this business is that client retention is very high. It has not lost any customers involuntarily in the last seven years and has focused on increasing business with large customers by working together on new products or via dual-sourcing contracts for existing products.

Clients can be retained for decades, as is the case with Ferrero Rocher, for example, for whom it makes the foil for its bonbons. In the current crisis, given the fact that food and medicines cannot be sold in stores without packaging, demand for its services is climbing, not falling, but the shares year-to-date are virtually flat.

Pool Corporation

Another name shrugging off the downturn is Pool Corporation, the US-listed home pool provider. It has been resilient throughout the epidemic, with shares rebounding off lows seen in March, and as its competitors run into issues around funding, the business has an opportunity to accelerate its market share gains.

Investors should not look past the long-term potential for the business either – the effects of the pandemic could unfortunately be with us for a long time, and they may likely change consumer behaviour.

We expect to see more families investing in ways to entertain themselves within the confines of their own homes, and Pool Corp will be a direct beneficiary of that.

Pitfalls

It is important to stick to a proven process when investing in smaller companies, and more so than ever in the current environment. While there may be opportunity out there, some stocks have fallen for the right reasons and will face a torrid time going forward.

How can investors avoid them? There are three key company characteristics investors should look out for when investing in small-caps.

Firstly, it is important that companies have strong balance sheets. Financial strength has always been core to our investment process, but now more than ever a company’s ability to survive the coming storm is crucial. Contrary to many views out there, many high-quality smaller companies can survive for months, and sometimes years, with no revenues.

Stock specific due diligence is key, as while many smaller companies are well capitalised, the average company in the MSCI Global Small Cap Index has a net debt position of 1.8x Ebitda.

Another factor to look at is the resilience of a business. You could argue that given the current uncertainty, this is more important than ever. In practice this means investing in profitable companies with proven resilience either in the form of recurring revenues, or where there is a non-discretionary need for its products. People will always need to buy contact lenses and hearing aid batteries, for example.

Finally, small-cap investors must look for aligned management teams who share the same long-term goals as investors. Looking for executives with skin in the game gives investors comfort that their interests are aligned. You also want to see a proven track-record which includes experience of successfully managing businesses through past crises.

Citywire AAA-rated Chris Andrews and David Simons are the founders of Silvercross Investment Management and run the Silvercross Global Small Cap fund, which has returned 32.5% over three years versus a peer average of -2.2%

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