Could small cap stocks be a sweet spot in 2024?

Chris Wallis: Yeah, the small cap space is set up really well as we move forward. For the most part, valuations have already compressed with a higher equity risk premium. There’s a wide valuation disparity versus the large cap universe, and quite frankly, the underlying economic fundamentals for the economy will remain positive. As we get into the second half of ’24, we start to see it pick back up in fiscal spending, and we also start to see an increase in liquidity as well. Look, I think the opportunities in small caps are as good as we’ve seen.

Multiple areas of opportunity in small cap universe

Chris Wallis: We are finding opportunities across every sector because we’re moved from a world where there was plenty of capital, there was a very low cost to capital. Inevitably across multiple sectors, there’s companies that have impaired balance sheets, which means their competitors are in a very good position to take market share and continue to grow as we move forward. Where we had under weighted the financial sector as we entered ’22 and the early part of ’23, we’re starting to see opportunities there as well. With the flattening of the yield curve, acknowledging the near term economic headwinds, it means the threat of higher rates are kind of now in the rear view mirror. The question really is going to be as we move forward is what’s the inflection in the growth rate? Right now, there really isn’t an area of the market or sector that we’re not finding opportunities and we feel really good about what we own today.

Macro factors in a presidential election year

Chris Wallis: Yeah, I think as we look at 2024, being an election year, it’s going to be two very different halves. We’re going to see weak economic data really starting with the December data releases of 2023. The data’s going to be weak through the first part of the first quarter, and then we’re going to start to see some stabilization, then an acceleration in economic activity. A lot of that’s going to have to do with the funding cycle of the federal government. We’re going to see a buildup in their TGA account and then, which is typical in election years, they’re going to push that liquidity out into the economy. They’re going to drive economic growth higher as we get closer to the election. I think we’re going to see earnings estimates come down, which for the most part are already reflected in the small cap value multiples, and then we’re going to start to see the opportunity for earnings revisions higher as we enter into the second half of 2024.

Why active matters in today’s landscape

Chris Wallis: Look, active management going forward is going to be really critical. As we’ve seen, we’ve seen an increase in equity risk premium. We’re seeing a diversion of capital away from the private sector to the federal government in order to fund deficits. That trend is not going to reverse in the near to medium term, which means companies that have healthy balance sheets, have high ROAs, are going to be able to take advantage of the tighter funding markets. Those that have impaired balance sheets, or quite frankly, don’t earn a sufficient return, are going to seed market share. I think whereas the overall index may struggle, active management is going to have lots of opportunities to exploit the disparity in outcomes.

Australian investors can access Vaughan Nelson’s best investment ideas in global small-mid (SMID) cap expertise as a managed fund Global Equity SMID Fund and an active ETF ASX:VNGS Global Equity SMID Fund (Quoted Managed Fund)

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