Speaking in Sydney this week, Kathryn McDonald, director of investment strategy at AXA Investment Managers-owned firm Rosenberg Equities, said investors are often mistaken when it comes to small-caps.
“In some ways, global small stocks are indeed riskier along many dimensions, but in other ways, perhaps in surprising ways, they may not be quite as risky as investors might think,” she said.
Ms McDonald pointed out that while there are a large proportion of companies leaving the market within the small-cap space, it is the nature of the exit that’s important.
“Small-caps stocks are indeed individually riskier when it comes to drawdown, they are individually more likely to exit the market, but that reason for exit might not be wholly negative and certainly we believe that investors are overly pessimistic,” she said.
Ms McDonald argued that when looking at the median relative performance of small-caps 12 months prior to exit, they often deliver positive relative returns.
As a result, “it is quite unlikely that the bulk of the exit has been associated with stocks going out of business; rather, we would interpret this as the bulk of the exit being related to some corporate activity like acquisition", she said.
Ms McDonald noted that this is beneficial both to the companies and the shareholders.
Moreover, investors are also overly pessimistic when it comes to "cheap" small-cap companies.
A common trait of value stocks, according to Ms McDonald, is that they experience a dip in operating earnings in the year after portfolio formation, but subsequently recover and continue on a growth trajectory.
“Investors extrapolate that first year slope too far into the future and they are overly pessimistic about these names relative to what actually unfolds in the earnings space,” she said.
In contrast, investors are over-paying for expensive stocks versus the market.
While these stocks deliver “spectacular” earnings “right out of the gate”, this trend is unlikely to continue and growth inevitably becomes more market-like, she said.
“[Investors] are extrapolating this widely positive slope way into the future and they’re willing to pay more than they should for actual earnings outcomes.”
Ms McDonald said when investing in small-caps, active management is essential.
"You don't have to buy the bad with the good if you are open to stock picking and if you're open to a valuation approach," she said.