While Asian smaller companies have outperformed their large-cap peers of late, small-cap value stocks still trade at significant discounts to growth across the market cap range. Nitin Bajaj, portfolio manager of Fidelity Asian Values PLC, discusses how market dynamics could evolve from here and what this means for regional investors over 2022.

In Asia, small-caps have materially outperformed large-caps in the last 12 months and since the beginning of 2020. This looks like a partial mean reversion (returning to its secular trend) from what happened between 2016 and 2020 when large-cap stocks significantly outperformed small cap stocks, especially small-cap value stocks.

Over the last few years, the difference in valuation between large growth stocks and small value stocks had reached an extreme last seen in tech bubble of 1999/2000. Hence, there was an expectation that investors would rotate out of growth stocks and into value names in the hope that value would benefit from an economic recovery.

This has played out in the Asian large-cap space so far in 2021, but not to the extent we expected in the Asian small-cap segment. Valuations remain very bifurcated and many small-cap value stocks continue to trade at significant discounts relative to large and small growth companies. Our sense is that we may have quite a way to go on this journey as historically small-cap value stocks, in aggregate, have had a good track record of growing earnings faster than small-cap growth stocks.

We continue to believe that fundamental analysis and owning good businesses which are run by competent management teams at attractive prices leaving sufficient margin of safety is the most time-tested way to make money in the stock market and we remain committed to this process.

What could surprise markets in 2022?

The biggest risk continues to be global economic impact of Covid-19 and the level at which the economy will stabilise once government stimulus programmes are withdrawn. We have seen extreme monetary and fiscal policy over the last year or so and we are now in the realm of the unknown. US inflationary pressure continues to build with unemployment easing and a huge cost push. Almost every company we speak with is raising prices - often materially. It is surprising that inflation is running at 30-40 year high, yet interest rates are at an all-time low.

On the other hand, equity market valuations are stretched across countries. It will be important to stay vigilant and react quickly if facts change.

Positioning for what lies ahead in 2022

As an investor, the biggest problem from the pandemic is the ongoing mobility restrictions and my inability to visit companies, factories, and markets I invest in. As a result of this, my average position size has become smaller.

Having said this, one area where we are finding more opportunities is China, where the market has derated materially this year both due to structural reasons (policy changes) and cyclical reasons (slowing economic cycle). Given my value bias, I am finding incredibly cheap stocks in China, in many cases with dividend yields higher than their one-year forward price to earnings ratios.

We continue to avoid stocks that are in fashion and where high valuations do not leave enough margin of safety as well as businesses with high debt levels.

Sustainability considerations

Our process focusses on owning good businesses run by honest and competent teams. This has mostly kept us away from controversial stocks and we do not own any stock that is rated C or below on Fidelity’s proprietary Sustainability Ratings. *

Formalised ESG policies are becoming more commonplace around the world. It is fair to say that these rules can be a challenge for smaller companies, who are much focussed on running their businesses and find ESG disclosure requirements challenging as it is still an evolving area. With these companies, we are committed to engage and guide them on this journey. However, this must be done in a gradual manner as it is more about reporting, rather than changing behaviour in companies which we already consider to be “good businesses”.

* The Fidelity Sustainability Ratings were launched in June 2019. As at 30 September 2021, they cover a universe of c. 4,200 issuers in equity and fixed income. Fidelity has a five-scale rating of A (best) to E (worst).

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