Trade war talk has unleashed a wave of volatility that may be best surfed by looking at small-cap cyclical stocks.
Tariffs and trade wars have again taken center stage in the market, as the U.S. and China embark on a battle in which there are likely to be no winners, at least in the short run. Until cooler heads prevail to sort out this weighty situation, stocks are likely to remain volatile, as the first few weeks of May have already demonstrated.
Unsurprisingly, the down days have so far hit cyclical names hardest, as these more economically sensitive stocks typically take it on the chin when the prospect of slowing global growth rears its unsightly head.
However, much of the pessimism about cyclicals—and global growth more generally—seems excessive. We feel confident in our opinion that solutions will ultimately emerge that promote global growth.
The three bar charts below illustrate the current state of the target zone at the intersection of quality and value for investments in cyclicals. It shows three different current perspectives on our preferred valuation metric, EV/EBIT (Enterprise Value over Earnings Before Interest and Taxes).
Our Target Zone – Intersection of Quality and Value – Often in Cyclicals
Source: FactSet, as of May 17, 2019. See notes for definitions of terms. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
We think the charts reveal both the pessimism and the opportunities that exist today for small-cap cyclical businesses. With the Russell 2000 up 16.0% year-to-date through 5/16/19, the richer valuations—along with a chunk of the corresponding share price increases—have mostly gone to defensive stocks.
"The current small-cap premium comes mostly from defensives."
While by our measures small-caps as a whole are trading higher than they have over the last 20 years, the current small-cap premium comes mostly from defensives, with cyclicals trading much closer to, and only slightly higher than, their 20-year average. And when we go company by company, we often see, in our opinion, even more attractive valuations for companies with earnings and other attractive characteristics.
In fact, we believe experience has taught us that the market frequently over-penalizes cyclicality, and doles its punishment out most regularly to cyclical stocks. To one degree or another, of course, every company is cyclical. No stock enjoys consistent, straight up growth. Yet at times of market stress, investors often appear to behave as if cyclicality will remain in a permanent corrective phase and that defensive names are immune to cyclicality.
Much of today’s pessimism about cyclical stocks is based, in our view, on this misperception. Interestingly, this misjudgment not only contradicts our own experience, it also contrasts with what we’ve been hearing in our meetings with company managements, who remain guardedly optimistic for continued growth.
Most recently, we’ve been attracted to several cyclical areas that we think are particularly promising, including specialty chemical producers, laser manufactures (and other innovation-centric tech and industrial businesses), specialty finance companies, and those that make precision agricultural products.
Of course, our different small-cap approaches generally focus heavily on cyclicals. For example, the Russell 2000 Index, the benchmark for our major domestic approach, for example, comprised almost 70% cyclical companies at the end of March, while our largest biases ranged from 86% to 92% in cyclicals.
This cyclical inclination is also the latest iteration of our effort to turn the difference between how a stock is classified and the reality behind its business into a strong long-term approach.
Terms and definitions:
EV/EBIT: Enterprise Value/Earnings before Interest and Taxes.
“Small-Cap” is represented by Russell 2000.Cyclical is defined as follows: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.
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The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.