Article first published in the Australian Financial Review, 30 November 2022, by Tony Featherstone.

Vaughan Nelson Investment Management chief executive Chris Wallis says the next commodities super cycle is just starting, and he expects small stocks to outperform large ones in the next few years.

Wallis likens this equity market to that in 1999 to 2002. Then, tech stocks crashed, inflation rose and a commodity super cycle began. Small-cap stocks outperformed.

In baseball terms, the commodities super-cycle is still in the first innings. 

“This is the time for bargain hunting,” says Wallis. “With the volatility and broad selling pressure that has occurred … we are finding opportunities in nearly every sector.”

Vaughan Nelson manages about $21 billion. In June, the Houston-based firm launched the Vaughan Nelson Global SMID Fund (VNGS) on the Australian Securities Exchange. VNGS is the local market’s first actively managed exchange-traded fund (ETF) in global small- and mid-cap (SMID) stocks.

Wallis is bullish on commodities. In baseball terms, he says this commodity cycle is only “deep in the first innings (of nine)“. He favours the energy sector.

“What we see now is typical of the transition to a new commodity super cycle,” says Wallis. “Normally, we’d be in the third innings of this cycle by now, but COVID-19 and global politics around energy security have interrupted and delayed things.”

Wallis, an economic historian, focuses on market cycles that usually last seven to 10 years. “For a decade, money crowded in the US dollar and US stocks. Within that, investors crowded into US technology and other growth stocks because central banks took interest rates to zero. We are now in the process of reversing that trend.”

Great rotation

The rotation from growth to value stocks has been a key theme this year as rates rise. Growth stocks typically trade on higher valuation multiples and outperform when rates are low. Value stocks have lower relative valuations and growth prospects.

Wallis believes investors could underestimate the duration and strength of the rotation from growth to value stocks – and how it plays out this decade.

“In 2000, US small-cap stocks rose 30 per cent even though US large-cap stocks moved into a secular bear market for two years. As money rotated out of large-cap growth stocks, small-cap value stocks benefitted. We see the same trend happening again.”

If Wallis is right, investors should consider adding small-cap exposure to their portfolio – a part of the market smashed this year when sharemarkets fell.

Another option is using managed funds, listed investment companies (LICs) or ETFs that specialise in small-cap stocks. Broadly defined, small caps are those outside the top 100 on ASX by market capitalisation. They are measured by the S&P/ASX Small Ordinaries Index.

Globally, the MSCI ACWI SMID Cap Index measures 7861 small- and mid-cap stocks in 47 countries and is a barometer of small-cap performance.

In $US terms, this index fell 21 per cent from January 1 to October 31, and traded on a forward price earnings (PE) of about 13 times.

Calling all contrarians

That could be a buy signal for contrarians. However, retail investors typically avoid small-cap stocks when markets fall and volatility is high. They prefer large-cap stocks that are seemingly safer, or they hold more cash in their portfolio.

Horrible returns from some small-cap managed funds in the past 12 months in Australia are another turnoff. But the best time to invest in quality funds is usually after a period of poor performance.

Moreover, Australian retail investors who buy small caps typically have a “home bias”. They focus on a narrow group of local stocks, ignoring opportunities in thousands of small- and mid-cap stocks overseas that are large by this market’s standards.

Wallis believes a rotation from large-cap to small-cap stocks will quicken in the next few years. “Global small- and mid-cap stocks have more attractive valuations and better organic growth than many of their large-cap peers.”

All fund managers “talk their book” to some degree. Like Vaughan Nelson, asset managers in Australia say small-cap investing is ripe with opportunity after a period of unusually large underperformance.

Small industrial stocks in Australia last month traded at a 26 per cent discount to large industrials, Goldman Sachs research shows. That gap is almost as large as it was when global sharemarkets crashed in March 2020 on COVID-19 fears – and among the largest in more than a decade.

Globally, small-cap stocks trade at 15 per cent -20 per cent below their long-term valuation averages, says Wallis. “Small- and mid-cap value stocks are cheap on an absolute and relative basis. Small-cap growth stocks are still expensive.”

He says a small-cap recovery will take time. “Earnings expectations across the board still have to come down over the next two quarters. And the market still hasn’t fully priced in that the Fed (US Federal Reserve) can no longer have their back”.

Against that, Wallis expects US inflation to fall below 5 per cent by July 2023 and says US interest rates have peaked “without a major accident” in financial markets. A weakening US dollar next year will also support small-cap valuations.

“By mid next year, we’ll be talking about the shape of the recovery and negotiating letters again like we did after the global financial crisis. That is, whether we are going to have a ‘V’, ‘U’, ‘L’ or ‘W’ shaped recovery. You have to position for that now.”

Attractive energy

Wallis says energy is the only sector that is “broadly attractive”, although stock-specific opportunities exist across sectors. Vaughan Nelson reduced its energy holdings this year after soaring returns from global energy stocks.

“We’re expecting more debate in the next few months about windfall taxes on energy producers and other government interventions in that sector. That could hurt sentiment towards energy stocks and provide an opportunity to buy back in. The reality is that the world is massively ‘short’ energy. Energy has very attractive long-term fundamentals.”

Elsewhere, investors who prefer Australian exposure could consider a range of active and index funds that invest in small-cap equities on ASX. Most small-cap unlisted funds have double-digit losses over the past 12 months, Morningstar data shows.

“It’s been a very challenging market for small-cap managers,” says Shamir Popat, Morningstar’s senior research manager. “When investors look to liquidate part of their portfolio during market volatility, small caps are often the first thing sold.”

Popat says small-cap growth funds have been particularly hard hit this year. “In our meetings with managers, a recurring theme is companies facing greater earnings pressure this year. There seems to be larger cost pressures than is widely realised.”

In the listed investment company market, Bell Potter LIC analyst Hayden Nicholson favours small-cap LICs and international equity LICs. Many LICs that own small- and mid-cap stocks are trading at a double-digit discount to their Net Tangible Assets (NTA).

“We think several small-cap LICs are oversold,” says Nicholson. “That’s not surprising given the bearish sentiment towards small-cap stocks right now and because investors tend to favour large-cap LICs that are more liquid, in these market conditions.”

Nicholson’s top three small-cap LICs are Acorn Capital Investment Fund, Spheria Emerging Companies and WAM Microcap. The latter, from Wilson Asset Management, trades at a large premium to NTA. But Nicholson says this market suits WAM Microcap’s investing style.

DISCLAIMER

This information is provided for general information purposes only and does not take into account the investment objectives, financial situation or needs of any person. Investors Mutual Limited (AFSL 229988) is the issuer and responsible entity of the Vaughan Nelson Global Equity SMID Fund and the Vaughan Nelson Global Equity SMID Fund (Quoted Managed Fund) (‘Funds’). Vaughan Nelson Investment Management, L.P. is the investment manager.

This information should not be relied upon in determining whether to invest in the Funds and is not a recommendation to buy, sell or hold any financial product, security or other instrument. In deciding whether to acquire or continue to hold an investment in the Funds, an investor should consider the current Product Disclosure Statement and Target Market Determination for the appropriate class of the Fund, available on the website www.VaughanNelson.com.au or by contacting us on 1300 219 207.

Past performance is not a reliable indicator of future performance. Investments in the Funds are not a deposit with, or other liability of, Investors Mutual Limited and are subject to investment risk, including possible delays in repayment and loss of income and principal invested. Investors Mutual Limited does not guarantee the performance of the Funds or any particular rate of return.