Tony DeSpirito, chief investment officer of U.S. fundamental equities at BlackRock, wrote in a recent research note that higher quality stocks are trading at their largest valuation discounts since the early 2000s. DeSpirito defines these stocks as consistently profitable companies that manage their balance sheets and cash flows effectively, and earn a high ROE from a high return on invested capital (in other words, not from debt). These are among some of the key analysis metrics we consider when reviewing companies for the SmallCap Informer.
Though large-cap stocks have performed well in the last nine months, DeSpirito’s research shows that higher quality companies have trailed other market segments as investors scrambled aboard riskier stocks that boasted strong rebounds after initially getting massacred by the pandemic (think travel companies), “meme stocks,” and speculative equities (such as SPACs). Investors have eschewed solid fundamental performers with their “boring” rates of return in favor of jumping on the bandwagon of headline stocks with low-quality fundamentals.
This pattern can’t last. With history as a guide, quality stocks are more than likely to come back in favor in the coming months. At the same time, more speculative investments will see their valuations fall if their fundamentals don’t improve, and the excessive valuations being paid for these stocks may mean that even if their fundamentals do improve, the downside may still be considerable.
On another topic, Gerard O'Reilly, co-CEO and chief investment officer at Dimensional Funds, pointed out on CNBC that small-cap value stocks have performed unusually well year-to-date. Dave Nadig, chief investment officer and director of research at ETF Trends, explained how this is an inversion of the usual performance of stocks in which large companies lead small-caps.
This is reminiscent of the point I made in the last issue of SCI when I wrote about the shift from growth to value that the current market seems to be demanding of investors. The “TINA” factor – “There Is No Alternative” to stocks – remains in full force, keeping investors out of the terrible bond market and thus positioned heavily in equities. With so many investors snapping up large-cap stocks, there has been a trickle-down effect as opportunities in the small-cap segment become all that’s left at reasonable valuations.
With economies in the U.S. and globally beginning to open up from pandemic shutdowns, fears of an interest rate hike off the table for now, and employment picking up, there is plenty of room for stock market optimism for the rest of 2021.
While we are not in the business of trying to predict the direction of the market, these trends bode well for investors who continue to focus on healthy companies that have prospects for growth and that are available for purchase at reasonable valuations. Over time, this approach has proven to deliver results for disciplined investors.
Reprinted from the July 2021 issue of the SmallCap Informer.
Not a subscriber? Subscribe to the SmallCap Informer and get great small company stock ideas each month.