Is it time to buy the dip? You might think it’s way too early to ask that question — and I tend to agree — but it hasn’t stopped investors from asking.
Given the pullback in US markets (the S&P 500 is down about 18 percent so far and the tech-focused Nasdaq an even steeper 30 percent), the urge to either “buy the dip” or change strategy may be understandable. .
But as further tightening looms, very sane people are warning that this is just phase one of the bear market. Now that valuation foam has blown, the next risk is that corporate earnings will fall below analysts’ expectations – particularly worrying for cyclical stocks as consumers and businesses pull the pockets – leading to a further decline.
Nevertheless, I was intrigued to read that small caps and value stocks in the US are already proving to be popular with investors.
Here in the UK there isn’t much “dip” to buy, due to the FTSE 100’s idiosyncratic sector composition (very little technology, but lots of big oil, big miners and banks). Total returns, including dividends, have fallen only about 2 percent so far, although the feared “earnings recession” could change all that.
It’s a different story for British small caps. Total returns on the Numis Smaller Company Index fell by 18 percent over the same period and the Numis Aim Index fell even steeper at 26 percent.
London Business School stock scientists Paul Marsh and Scott Evans, who compile the Numis indices, note that small caps have historically underperformed during rate cuts and recessions. In the long run, however, they will tend to perform better†
While Professor Marsh zealously avoids getting into forecasting, he even wonders if this small-cap sell-off isn’t over the top.
Seduced? Aside from my regular monthly investments in my stocks and shares of Isa, the only dip I plan to buy right now is one that you would serve with raw vegetables.
But as inflation picks up, I’m getting more and more excited to put some of the cash reserves I’ve built up and, like many private investors, I’m willing to take a long-term view. Maybe it’s time to put some select small caps in the UK on my watchlist?
I must confess that I have a nostalgic fondness for the shallow end of the UK market. I covered many small-cap and Aim-traded companies in the Investors’ Chronicle 15 years ago; the pull to get into the next big thing at the bottom had a particular pull on our stock-picking readers.
Deteriorating economic conditions will pose a greater challenge to this sector, but at the stock level, some companies may prove stronger than others.
However, selecting individual stocks is high-octane investing. You have to be willing to do tons of research and even then you need a well diversified portfolio – you depend on a few hoped-for winners to make up for the inevitable loss-making disasters.
Risky, yes – but undoubtedly a much nicer way to lose your money than investing in crypto! There is a diminishing amount of professional research, but investors can get to the bottom of the company’s business model by attending AGMs and meeting management teams, where they have a high chance of actually asking a question.
In addition, certain Aim-traded companies benefit from inheritance tax exemption if held for more than two years, making them more attractive to older readers.
Given the pitfalls, this is one area where it makes more sense to outsource the excitement to a specialist fund manager.
One manager who confidently predicts a return to the market from a stock selector is Katie Potts of the Herald Investment Trust, which specializes in small-cap technology and media stocks.
“There are very few times in the economic cycle when fund managers are better able to forecast corporate earnings than they do” [the companies themselves] can,” she says. “We see a lot of different management teams and can quickly see the meaning of changes across the board, whether that’s labor costs or who’s smart enough to have contracts with prices tied to RPI and who’s not.”
One of the trust’s largest sectors is software, which Potts says is more defensive than meets the eye due to the recurring revenues of companies with leases and maintenance contracts. But the tightening labor market could be an opportunity for growth: “There is an even greater incentive to automate — and that requires technology.”
Looking at factors to avoid, highly indebted small businesses look particularly vulnerable in a recessionary environment where interest rates are rising.
Gervais Williams, experienced small cap manager at Premier Miton, says investors should be wary of smaller companies that have negative cash flow.
“We’ll see the strong catch up with the weak,” he predicts. However, this also opens up opportunities for smaller companies generating excess cash that can gain market share or pick up the debt-free stragglers from administrators.
Another major concern is how well placed consumer-facing companies are to maintain current profit margins. In his meetings with management teams, Williams relentlessly questions them about customer service standards: “Those who don’t know the answers stand out”.
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And then there’s the “Lord Lee Strategy” – an ultra-long look at select small caps (and dividend income while you wait) in the hopes that they will eventually be acquired at a significant premium.
Currently £120m of the Herald Investment Trust’s portfolio is up for auction (including healthcare software maker) EMIS Group and FTSE 250 publisher Euromoney) and Potts says private equity money is a good driver behind that.
“Valuations are falling to a level where merchant buyers and private equity seem to be very aggressive on the hunt,” she adds.
One last lesson from my Investors’ Chronicle days. Small businesses tend to have wider bid/ask spreads, and some can be relatively illiquid – we used the term ‘lobster pots’ because it can be easy to get your money in, but much harder to get it out.
Small companies. † † can be relatively illiquid – we used the term “lobster pots” because it can be easy to get your money in, but much harder to get it out again
You may not be ready for bargains, but sitting on cash makes it harder to be patient as inflation continues to climb.
So far this year my investments have indeed had a very domestic theme. I’ve paid to renew my flat’s lease (another column will follow in due course) and also to maintain my house, replacing all sorts of stuff that will probably run out in a few years, by which time the price of repairing or replacing will have skyrocketed.
My husband’s best investment idea? Buying wine for six months when Waitrose had the last 25% off. Predictably, buying this “dip” turned out to be a false economy, albeit a very enjoyable one.
Claer Barrett is the consumer editor of the FT: claer.barrett@ft.com† Twitter @Claerb† Instagram @Claerb