High valuations among global small-cap stocks are making it harder to find opportunities, says investment strategist Kara Lilly of Mawer Investment Management Ltd.
"If investing is like a baseball game," says Lilly, "we are probably in the later innings. Small-cap stocks tend to have more difficult balance-sheet valuations later on in the cycle, and that's where I think we're probably at right now."
The lofty valuations appear to be attributable largely to stimulative monetary policies. Over the last two years, central banks in both developed and developing economies have "overwhelmed markets" with unprecedented amounts of stimulus, Lilly says. "Very low interest rates seem to be pushing investors into higher-yielding asset classes such as global small-cap stocks."
Other signs that point to the later stage of the cycle are more mergers and acquisitions, and a reduction in the valuation discounts that you normally get in small-caps. The combination of factors is making it more difficult today than three years ago to find high-quality companies at reasonable prices, says Lilly.
A former analyst, Lilly specializes in oil, energy, world currency and the global economy at Calgary-based Mawer. For the past six years, she has worked closely with the investment team on Mawer Global Small Cap, rated Gold in its category by Morningstar analysts. The fund won the award for the Global Small/Mid-Cap Equity category at the Morningstar Awards in 2014.
Lilly thinks you can "win big in global small-caps by not losing." And the way you can avoid losing is through a really prudent, thorough and due-diligence framework. "It's really been through that investigative process," she says, "that we've been able to suss out which companies are high quality." That process includes on-site visits and research into competitors, suppliers and customers.
Mawer's team takes a long-term view, seeking companies with resiliency through market cycles. The managers seek to invest in sustainable businesses, and their holding periods for stocks may be 10 years or longer.
Lilly says Mawer has benefited from taking advantage of long-term structural growth trends. UK-based NCC Group PLC, which is among the Mawer fund's top holdings, is an example of this approach. The company's activities for its corporate clients include software escrow services that protect intellectual property, and prevention of Internet hacking by improving the security of websites. "Both of those business models provide a valuable service that is less tied to the business cycle," says Lilly. "We believe they have many years of earnings growth ahead of them."
Another holding that Lilly cites as having a sustainable business model is UK-based PayPoint PLC, which helps facilitate cash payments for bills, utilities and parcel pick-ups. The business model is entrenched, says Lilly, "because people need to pay their bills and there is still a segment of the population that needs to do it in cash." With a company like PayPoint, "we have some greater confidence that if the macro economy falls off the earth tomorrow, they're going to have the ability to generate earnings and still have a company in place."
Constellation Software Inc. (CSU), a Canadian company, is the top holding in Mawer Global Small Cap. It's an example of a small-cap success story that has graduated to Mawer's large-cap mandates.
"Constellation is led by a team that has demonstrated continuous success in its ability to grow its business and in prudent acquisitions," says Lilly. "They're a software company that has a very deep customer base, and management has continuously diversified." While Mawer doesn't consider Constellation shares to be cheap, the team has concluded that the stock price makes sense for the quality of the business they are getting.
Lilly downplays the impact of the slump in oil prices on the global small-cap environment as a whole. "Unless you're in Canada, Norway, Nigeria," she says, "you're really looking at a whole bunch of geographies that are more or less indifferent to whether oil is low."
Looking ahead, Lilly says it's impossible to predict what might trigger the next downturn in global equity markets. "We don't know if it will be an interest-rate rise in the U.S. or the Chinese financial system coming down. We don't have that visibility."
Lilly adds that uncertainty over the future interest-rate policies of central banks is making it hard to know how long the current market cycle will last. She cautions that small-cap stocks are more volatile than the markets as a whole. "Investors may want to proceed with caution on their small-cap exposure, "given this point in the cycle," she says. "Small-cap stocks tend to be less liquid than large-cap stocks to trade, and often warrant a discount to compensate investors for this additional liquidity risk."
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