Investors need to break free from the herd to deliver sustainable long-term performance: when everyone is crowded into one corner of the market, like today, history shows it pays to be contrarian.
The artificial intelligence (AI) ‘hype cycle’ has delivered massive valuation multiple expansion, meaning even companies that deliver strong growth may fail to be good investments from here.
There are currently exciting opportunities in global smaller companies. For example, we have positioned 30% of the portfolio in sub-$10bn market capitalisation companies against a 6% weighting in the MSCI ACWI global benchmark.
Having outperformed the headline MSCI ACWI index by 2 percentage points per annum since 2001, the current year-to-date relative performance by small-caps is on-track to be the weakest year on record. This has created an extreme relative value opportunity, which is accessible globally.
Most regional small-caps are trading below the long-term average price-to-earnings (P/E) multiple relative to the headline benchmark’s, with many near trough.
The contrast with large- and mega-caps is very stark. In the US, effectively all the year-to-date S&P 500 index return has come from multiple expansion, whereas typically half might come from earnings growth.
Multiple expansion is a finite source of long-term performance, particularly if the starting point is elevated in the context of history, as it is for many of the largest components of the global benchmark.
That this has happened while the cost of capital has been rising points to great optimism baked in around future earnings for these companies; most likely, returns have simply been pulled forward – or ‘borrowed’ from the future – by the valuation re-rating.
In short, we think it’s a good time to ‘lean in’ on contrarian positioning, because the risk-reward is very favourable as market participants have become incredibly crowded in the apparent ‘sure things’ in the market, like the AI theme, once again.
In the current earnings season, we’ve seen a trend of share prices rising for companies who warn on the current quarter’s profits but guide that conditions aren’t getting worse. This is often a sign that valuation dispersion has become too extreme.
Companies to watch
Specific companies where this contrarian approach applies include Carlisle, Mondi and Henry Schein. All are out of favour with the market but we have built stakes in them due to fundamental changes the market has failed to appreciate.
Since the US regional banking crisis in March, commercial real estate (CRE) exposure has been considered untouchable by many. Some 70% of revenues at Carlisle’s largest division, CCM, come from commercial real estate, primarily in roofing and insulation. Its shares de-rated from 15x P/E a year ago to 10x, reflecting fear around this exposure.
However, the vast majority is non-discretionary re-roofing paid out of maintenance budgets and not debt funded, so should be sheltered from the risks the market fears most. Insurance requirements and increasingly stringent building efficiency regulations incentivise companies to act (Carlisle’s energy-efficient products lower annual greenhouse gas emissions more than 30%).
The twin structural tailwinds of a renovation cycle and generous government subsidies should drive earnings growth and support a re-rating over time.
Only recently, the focus for the packaging industry was on demand tailwinds from e-commerce and substitution from plastic to paper. Mondi’s market valuation sat at a large premium to the value of its assets.
A toxic combination for the industry of energy costs, new capacity and destocking – plus in Mondi’s case having a profitable asset located in Russia – have combined to drive its current valuation below its asset replacement cost.
Destocking is typically short and sharp and we are nearer to the end than the start today. Mondi has a strong balance sheet and its assets have low production costs. These features buy us time to ride out the cycle and enhance shareholder value through good capital allocation.
Dental and medical distributor Henry Schein has only 20% ‘buy’ ratings from sell-side analysts. When the average proportion of ‘buys’ is 53% this represents a deeply unloved company.
The shares trade on 13x future earnings, close to the past decade’s trough level. A protracted unwind of Covid-related revenues is obscuring solid trends in the core businesses, including growth in higher margin software and services.
Its management expect to grow revenues 6-8% over the medium-term and the company has a good track record of buying back shares at attractive prices – the share count has reduced from 158 million to 131 million over the past five years.
Conclusion
The recent market dynamics remind me most of October-November 2021 during the speculative blow-off phase of the latest tech/growth bubble.
When the world’s financial markets are intently focused on a narrow band of ‘guaranteed’ winners, whose valuations have already expanded a lot, history suggests there are usually better opportunities for future returns in corners of the markets which are not currently in the spotlight.
William Lough is portfolio manager of the River & Mercantile Global Sustainable Opportunities fund. The views expressed above should not be taken as investment advice.