Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 372

A game plan for managing volatility in global equities

The unfortunate reality is that we are in the late stages of an incredibly long bull market in equities, but changes to the ‘growth’ component of a global equity allocation may prove appropriate for investors.

Four types of global equities

Traditionally, Australian investors have achieved growth exposure in their global portfolios by allocating to three buckets of global equities:

1. large cap growth
2. emerging markets
3. global small caps.

It’s not hard to see why. For the better part of the last decade, we have seen large companies - like the FAANG stocks – proving generally to be stellar performers, while emerging markets and global small caps have also performed well for many years.

However, no one was fully prepared for how the COVID-19 pandemic exposed the multitude of risks in global markets.

For those investors who were contemplating changes in global equity portfolios earlier this year but did not act, the recent rally could present a timely opportunity to make some changes to sub-allocations within global equities.

This is where we believe global small and mid-cap (SMID) stocks play an important growth role in diversified portfolios.

Investors have previously not been as aware of this fourth type of asset class as of others. A lack of analyst coverage and investor attention to global SMID stocks has meant that investors have been missing out on an asset class that exhibits strong potential growth opportunity, lower valuation risk than other growth assets and diversification opportunities.

They may not be named brands, like Apple, Facebook, or Google, but what these stocks do offer is an opportunity for investors to access them during their ‘sweet spot’ of the business cycle.

So is it too late to enter the global SMID space for investors?

Allocating to global SMID equities

Global SMID companies can improve the risk-return profile by playing a growth role in investor portfolios over the medium term. They have less valuation risk than large cap growth, less absolute risk than emerging markets and less liquidity risk than small caps alone.

Further, global SMID companies have the best mix of upside and downside capture over 20 years when compared to other global market indices, as shown in Exhibit 1 below. This is an important metric when comparing returns and offers one way to measure expected performance during both market rallies and declines.

An upside capture ratio of greater than 100 indicates historical outperformance of the market during periods of positive returns (the MSCI World SMID Cap Index at 112.50), and a number less than 100 indicates relative underperformance.

Similarly, a downside capture ratio of greater than 100 would indicate a historical decline greater than the broader market during periods of stress, and a downside capture ratio of less than 100 (the MSCI World SMID Cap Index at 99.18), indicates that it historically has protected capital and declined less than the broader market during these negative periods.

Exhibit 1: Upside and Downside Capture (20 years)

Source: eVestment. MSCI Median is the median of the five indices shown in the chart. Period is for 20 years ending June 2020, run on a monthly basis. All results are in AUD terms and measured against MSCI World-ND. 

The remarkable rebound in global equities following the dramatic losses in the first quarter of 2020 has caused many investors to question whether they have ‘missed the boat’ when it comes to investing in global stocks.

The simple answer is no. We believe the current environment makes a good case for an allocation to global SMID stocks.


Register here to receive the Firstlinks weekly newsletter for free

Valuations have lagged but fundamentals are strong

When we look at global equities as a whole, valuations are not that high, considering the MSCI World Index as a proxy. The current forward price-to-earnings ratio (P/E) is about 20x earnings, or in other words, an earnings yield of about 5%. In the context of a 0% interest rate environment, a 5% earnings yield is reasonable. But within these valuations there is massive dispersion, particularly between large cap growth stocks and value stocks.

Within the global SMID space, there is far less dispersion. As much as stocks have been rebounded off their lows, global SMID stocks have effectively gone sideways over the last three years, lagging the MSCI World Index by 4.2% per annum. As an asset class, they are almost back to where they were in Q3 2017.

In terms of valuations, the MSCI World SMID Cap Index is currently trading on a 2020 P/E of 23.1x, compared to 30.5x for MSCI World Growth Index. As another ‘growth proxy’ in global equity markets, we would argue that a 24% valuation discount is compelling. The absolute P/E of 23.1 might not sound overly cheap in an absolute sense but 2020 earnings will be well below 2019 levels.

We also think investors should acknowledge how valuations have changed over the past five years. Global SMID stocks are currently trading at a 12% premium to the broader market which is in line with its 5-year average. Global large cap growth stocks on the other hand are trading on a 43% premium to the broader market versus its 5-year average of 23%.

This discounted valuation is an attractive proposition for investors seeking diversification potential compared to large cap stocks. 

And while these stocks are not predicted to grow much this year, once we come out of the other side of COVID-19, the organic growth drivers of SMID stocks should come back. The combination of corporate cost-cutting, COVID-19-related stimulus and the reopening of global economies, positions global SMID companies for a strong rebound over the next two to three years.

Companies poised to win in a COVID-19 world

While many industries are suffering because of the COVID-19 pandemic, others have thrived in this environment, especially in the healthcare and consumer discretionary spaces.

The healthcare sector continues to boom, particularly towards research and development in pharmaceuticals and biotech industries. We believe dental orthodontics, which saw a negative impact in the short-term due to lockdowns, will present excellent earnings leverage in 2021.

Stocks that we are watching in the healthcare space include Align Technologies, Idexx Laboratories, and Danish medical devices maker Ambu.

Likewise, consumer discretionary has seen increased demand during COVID-19 as consumer behaviour changes materially. Opportunities include sectors such as home improvements, localised vacations and outdoor activities. However, overseas travel and the hospitality industry will continue to struggle.

Consumer discretionary stocks that we believe are poised to win include Tractor Supply, Pool Corp, O’Reilly Automotive, and YETI Holdings.

For investors looking to diversify their global large cap exposure, global SMID equities present investors with some strong opportunities in names we believe will do well over three to five years and beyond.

 

Ned Bell is Chief Investment Officer and Portfolio Manager at Bell Asset Management, a Channel Capital partner. Channel Capital is a sponsor of Firstlinks. This information is not advice or a recommendation in relation to purchasing or selling particular assets. It does not take into account particular investment objectives or needs.

For more articles and papers from Channel Capital and partners, click here.

 

RELATED ARTICLES

What’s the outlook for global small companies?

Boring can be beautiful when investing

The investment bias against small companies

banner

Most viewed in recent weeks

Who's next? Discounts on LICs force managers to pivot

The boards and managers of six high-profile LICs, frustrated by their shares trading at large discounts to asset value, have embarked on radical strategies to fix the problems. Will they work?

Four simple things to do right now

Markets have recovered in the last six months but most investors remain nervous about the economic outlook. Morningstar analysts provide four quick tips on how to navigate this uncertainty.

Welcome to Firstlinks Edition 374

Suddenly, it's the middle of September and we don't hear much about 'snap back' anymore. Now we have 'wind backs' and 'road maps'. Six months ago, I was flying back from Antarctica after two weeks aboard the ill-fated Greg Mortimer cruise ship, and then the world changed. So it's time to take your temperature again. Our survey checks your reaction to recent policies and your COVID-19 responses.

  • 9 September 2020

Reporting season winners and losers in listed property trusts

Many property trust results are better than expected, with the A-REIT sector on a dividend yield of 4.8%. But there's a wide variation by sector and the ability of tenants to pay the rent.

Have stock markets become a giant Ponzi scheme?

A global financial casino has been created where investors ignore realistic valuations in the low growth, high-risk environment. At some point, analysis of fundamental value will be rewarded.

How the age pension helps retirees cope with losses

It's often overlooked how wealthier couples can fall back on the age pension if a market loss hits their portfolio. The reassurance is never greater than in a financial (and now epidemic) crisis.

Latest Updates

Weekly Editorial

Welcome to Firstlinks Edition 376

The US tech index, the NASDAQ, peaked on 2 September 2020 at 12,058 and three weeks later closed at 10,632. On the same days, Apple hit US$137.98 and then fell to US$107.12. These falls of over 10% and 20% seem high but both were simply returning to their early August levels. It's hardly a rout when a month's gains are given back. The bigger issue is whether such stock corrections will scare off the retail 'Robinhood' traders.

  • 24 September 2020
  • 2
Interviews

Interview on new technologies with more potential to grow

For many global tech companies, COVID has boosted their revenues and pushed share prices to all-time highs. We are on the cusp of amazing technical advances and there are plenty of new opportunities.

Shares

Five reasons why Tesla is the everything bubble

As fewer professionals actively research the merits of a company’s prospects, stocks become disproportionately driven by capital flows. Prices disconnect from fundamentals and there's no better example than Tesla.

Retirement

Three retirement checks for when you have enough

Not every retiree needs to gun for higher returns, but a conservative portfolio can court its own risks, especially with bond rates so low. But some retirees prefer to settle for a lower income.

Shares

Hide and seek: the FX impact on global equity investments

As more Australians tilt their investments to global equities, they often overlook the exchange rate risk and fees. The move from US57 cents to US73 cents in six months shows the unhedged impact.

Economy

When America sneezes, the world catches a ...

The recovery from COVID-19 is looking more like a K-shape, with some companies doing well while others struggle. The pandemic seems more akin to a black swan, exogenous shock than a structural downturn.

Retirement

How the age pension helps retirees cope with losses

It's often overlooked how wealthier couples can fall back on the age pension if a market loss hits their portfolio. The reassurance is never greater than in a financial (and now epidemic) crisis.

Sponsors

Alliances

© 2020 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.