When looking at the US smaller companies space six months ago, it was slightly difficult to bang the drum for this segment of the equity market – as valuations at the time were well ahead of their historical average.
However, fast forward six months, the picture today has certainly improved, with the market’s current P/E valuation of 18x no longer a major headwind for the asset class.
The positive drivers for investing in small and mid-cap US stocks remain in place. The equity market has been supported by solid US economic data, strong corporate earnings and the positive effect of tax reform changes.
With the US small- and mid-cap market a larger beneficiary of recently-enacted tax reform compared to US large-cap, we expect earnings growth to come in at about 30 per cent this year. However, stripping out the effect of tax reform and the market can still deliver underlying earnings growth in the double digits.
Within our T. Rowe Price US Smaller Companies Equity portfolio, we have a collection of core holdings in high-quality companies expected to compound value over time. We also look for select ‘deeper value’ opportunities, companies experiencing a challenge or controversy that we believe can be resolved over time.
While our positioning on a sector basis tends to be relatively neutral versus the benchmark, the recent volatility in the market has contributed to some shifts in position.
We remain modestly overweight the high-quality compounding companies within the strategy, but have been finding opportunities in financials, technology and cyclicals. We used the elevated volatility to add to some of our highest-confidence ideas.
Exploiting elevated market volatility
One such interesting recovery story we took advantage of recently was Banco Popular. The largest financial institution on the island of Puerto Rico, Banco Popular has roughly 165 deposit franchises on the island. The bank has witnessed controversy due to past headwinds from the Puerto Rican debt crisis, while more recently it was negatively impacted by Hurricane Maria.
While most investors were still sceptical on Puerto Rico due to negative press surrounding the hurricane, recent analyst visits to the island indicated a sense of return to normalcy after the significant storm damage. We took advantage of the bank’s decline in the aftermath of the storm and its shares have since recovered strongly.
Banco Popular shares traded at an attractive tangible book value per share level and longer-term we expect the group to be a beneficiary of the massive rebuilding stimulus Puerto Rico will demand.
Another stock where we recently noted an attractive entry point was Novanta, the high-quality supplier of critical components for advanced industrial and medical products.
Customer losses at a large acquisition masked Novanta management’s progress of shifting to more consistent and profitable end markets and products. We like the group’s developments in machine vision in the industrial space, as well as laser scanning, precision motion within the medical arena.
Novanta management continues to execute well and confidence in the group is building. Its operational results have been robust, while the undertaking of M&A has improved business mix and created shareholder value. We believe the group’s strong balance sheet and cash flow supports its continued M&A goals.
Fundamental research remains key
While concerns related to valuation have been largely alleviated from the US smaller companies space, fundamental bottom-up research remains vital, as broad valuations still sit modestly above long-term averages. Investors should remain vigilant, as rising interest rates will eventually act as a headwind to economic growth – with another two to three hikes likely in the US this year.
With the US economy somewhere in the mid-to-late stages of the economic cycle, it will be imperative to look to quality stocks as the cycle continues to age. However, now is not time to go ultra-defensive, as the backdrop for US smaller companies investing remains positive.
We continue to find opportunities to invest in a variety of select companies where we believe other investors do not fully appreciate the long-term potential value of the business.
Ryan Burgess is portfolio manager of T. Rowe Price US Smaller Companies Equity. The views expressed above are his own and should not be taken as investment advice.