Why the risk/reward ratio looks good for quality small caps
Sales have been going on in world markets since January. As a result, a number of quality small businesses are now trading at very attractive multiples. Is now a good time to invest in a quality small cap?
Back in June, I asked a question in my document: we are already there. At this point, while noting that the sell-off in the stock market has been entirely driven by lower price-to-earnings (P/E) ratios, we’ve pointed to the fact that EPS forecasts remain positive and require some downward revision, leaving the market is vulnerable to further declines.
By June, the S&P500 had fallen 23.6 per cent from its January 3 high, dragging the ASX200 down 15 per cent.
Today, it’s reasonable to assume that analysts have been given a significant amount of time to revise their earnings forecasts so that they can now more reasonably reflect the outlook for the rest of 2022 and 2023.
Perhaps it was these analysts’ conversations with professional investors that drove the latest investor sentiment survey released by Bank of America Merrill Lynch. This survey of 212 managers with more than $610 billion in assets confirmed that professional equity investors are now significantly “underserved.” Indeed, a record 52 per cent of respondents are underweight stocks, while cash levels have surged amid bearish sentiment, surpassing levels seen during the 2008/09 Global Financial Crisis (GFC).
We can safely say that sentiment among expert equity investors is at its bearish extreme. And their bearish sentiment is supported by concerns in the bond market that rates will continue to rise. A survey released last week by Deutsche Bank found that 73 percent of investors believe the 10-year Treasury bond yield is more likely to reach five percent than one percent. Back in June, 60 percent of investors thought rates were more likely to reach five percent than one percent. The 10-year bond yields about 3.49 percent.
The degree of bearishness can also be seen in the P/E ratios for US small caps. As Figure 1 shows, the P/E ratios of the S&P600 SmallCap are also on par with those of the GFC.
Figure 1. Yardeni S&P600 SmallCap P/E Ratio
According to Ed Yardeni’s latest set of P/E charts, published on September 16, 2022, the small-cap P/E ratio has only been this low twice in the past 23 years. The first time was during the GFC and most recently during the outbreak of the COVID-19 pandemic.
According to the latest survey by the Association of American Individual Investors (AAII), which was notably conducted before the markets fell significantly, bearish sentiment – the expectation that stock prices will fall within the next six months – fell 7.3 percentage points to 46 .0 percent. (Table 1.). The bearish sentiment is above the historical average of 30.5 percent for the 42nd time in the last 43 weeks and is at an unusually high level for the 27th time in the last 35 weeks. The break point between typical and unusually high rates is currently 40.5 percent.
Table 1. AAII Sentiment Survey
AAII’s bearish spread (bullish minus bearish) is -19.9 percent and is the 28th unusually low in 34 weeks. The break point between typical and unusually low is currently -10.9 percent.
Breakthroughs, like all market changes, come amid uncertainty, and with leveraged debt reportedly down sharply, along with meme stocks and cryptocurrencies, it could be argued that some of the financial excesses have been eliminated.
The combination of lower P/E ratings, downward revisions to EPS forecasts and the elimination of financial overhangs suggests that investors with a longer time horizon are in a better position to see a reasonable return from owning higher quality small caps. Of course, the possibility remains that profits could shrink further as the economy slows, and the move to safety could prompt further selling beyond what was inspired by the end of the previous boom. I continue to invest in both the Montgomery Small Caps and the Polen Capital Global Small Cap Fund and will continue to add if further declines occur. Indeed, bearing in mind that the lower the price you pay, the higher the profit, price cuts should be welcomed, not feared.
We can never be sure what the markets will do next. V-shaped recoveries are a rare exception. Typically, bear markets bottom over extended periods of time amid a process that involves retesting lows and wild volatility. However, what I can be sure of is that my returns from investing in these small-cap funds at or below these levels will be better than the returns I will get from investing at market highs.
Learn more about today’s low P/E ratios set investors up for attractive returns, read this.