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While 2020 has been challenging for small-cap value stocks, Fidelity Asian Values PLC portfolio manager Nitin Bajaj outlines why he believes the current market environment offers an unprecedented opportunity to invest in high quality Asian smaller companies at attractive valuations.

Key points

  • Small-cap value companies are trading at >50% discount to growth companies, compared to a 65% discount seen during the peak of the tech bubble in 1999-2000.1
  • We believe that the current situation will reverse in favour of small-cap value stocks, but it will be difficult to predict the catalyst and the timing of this reversal.
  • However, the market is giving us a great opportunity to own high quality companies at attractive prices and this should reward investors over time.

The last few months have been unprecedented as we went from crisis to optimism on recent vaccine news. From an investment perspective, what we see today is a two-speed market where we can find stocks at both valuation extremes.

Importantly, smaller value companies were trading at over a 50% discount to growth companies. This compares to a 65% discount seen during the peak of the tech bubble in 1999-2000, which was the peak of the previous growth cycle.2

Value headwind

Our strategy focuses on buying small and medium-sized companies that have strong management but are mispriced - essentially aiming to invest in the ‘winners of tomorrow’ before they become well-known. 

This value bias has been a significant headwind to performance over recent times following a significant sentiment swing in favour of growth companies – both large and small. On a relative basis, this hit us twice – as stocks we did not own went up, while the ones we owned fell.

We have also been impacted by some stock-specific disappointments relating to Covid-19. For example, our investments in Indian mortgage companies have suffered due to unprecedented economic hardship, while low-cost airline Cebu Air has also felt the brunt of the pandemic.

That said, a number of attractively valued stocks in our portfolio have delivered good operating performance and have not appreciated, as a narrow group of stocks in a few specific sectors have carried the market.

The rise and rise of growth stocks

Our philosophy of investing in interesting but unloved companies has been the key driver of performance over the years. Historically, value stocks have tended to perform better than growth stocks, but this has not been the case recently. 

There are a couple of reasons for this: firstly, growth companies have delivered reasonably good operating results during the economic downturn as many of them operate in the technology and health care sectors. Many of these businesses have benefited during lockdowns due to an accelerated shift towards online services, as well as the remote working trend which has led to an increase in demand for computers and peripherals.

Secondly, the valuations of these businesses have expanded even further. We are seeing extreme valuations which are close to what we saw during the tech bubble in 1999-2000. In my view, this multiple expansion is not supported by facts, as on average, there is a big difference in perception of growth and actual earnings delivery. 

As a fundamental investor, the primary anchor for valuing any business must be earnings and cash flows. This has always been the case and I do not think it is different now. I have no doubt, therefore, that this situation will reverse in favour of small-cap value stocks. What will be the catalyst and when that will happen is, however, difficult to forecast.

Despite the outsized performance of growth stocks, the most interesting fact for me is that over time, value companies, especially in Asia, grow earnings faster than growth companies. So, we believe value stocks not only offer a higher margin of safety, but these businesses are also able to deliver superior earnings growth. As a result, it has paid to be invested in small-cap value stocks in the longer-term. They have outperformed growth companies by a significant margin over the last 20 years.3

In the meantime, the market is giving us an opportunity to own high quality companies at attractive prices. This does not happen often and hence it’s important to maintain discipline and take advantage of the current environment.

Looking ahead

There is no doubt that our style is at the wrong end of the current pendulum swing. But I do believe this offers us a unique opportunity - one that is not too different from 1999-2000 - to invest in overlooked businesses. The road ahead may be strewn with challenges, but we remain encouraged by the extreme valuation differential between highly and lowly valued companies and the opportunities inherent in that. 

This is what we are focused on and we are working harder than ever to find these businesses and then test every assumption made on business fundamentals. A sound investment process, hard work, discipline and patience have always been important for investing success. I don’t think this will change over the coming years.
 

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