Is it time to buy the dip? You might think it’s far too early to ask that question — and I’d be inclined to agree — but it hasn’t stopped investors from asking it.
Considering the pull back in US markets (the S&P 500 is down about 18 per cent year-to-date, and the tech-focused Nasdaq an even steeper 30 per cent) the urge to either “buy the dip” or change strategy is perhaps understandable.
Yet, as further tightening looms, very sensible people are warning that this is just phase one of the bear market. Now that the froth has been blown off valuations, the next risk is that company earnings will undershoot analysts’ expectations — particularly worrisome for cyclical stocks as consumers and businesses tighten the purse strings — leading to a further leg down.
Nevertheless, I was intrigued to read that in the US, small-caps and value stocks are already proving popular with investors.
Here in the UK, there’s not much “dip” to buy, owing to the peculiar sector composition of the FTSE 100 (very little tech, but lots of big oil, big miners and banks). Total returns including dividends have only declined by about 2 per cent year-to-date, although the feared “earnings recession” could change all that.
It’s a different story for UK small-caps. Total returns on the Numis smaller companies index have dipped 18 per cent in the same period, and an even steeper 26 per cent on the Numis Aim index.
Stock market academics Paul Marsh and Scott Evans at the London Business School, who compile the Numis indices, note that small-caps have historically done badly in interest rate tightening cycles and recessions. However, over the long-term, they tend to outperform.
Although Prof Marsh studiously avoids getting into forecasts, even he wonders if this sell-off in small-caps has been overdone.
Tempted? Aside from my regular monthly investments into my stocks and shares Isa, the only dip I’m planning on buying now is one that you’d serve with crudités.
Yet as inflation rises, I’m becoming more eager to deploy some of the cash reserves I’ve built up and, like many private investors, I’m willing to take a long-term view. Could it be time to put some selected UK small-cap plays on my watchlist?
I must confess to a nostalgic affection for the shallow end of the UK market. I covered plenty of small-cap and Aim-traded companies on the Investors’ Chronicle 15 years ago; the allure of getting into the next big thing at the bottom had a particular appeal to our stockpicking readers.
Worsening economic conditions will be more challenging for this sector, but at a stock level, some companies could turn out to be stronger than others.
However, selecting single stocks is high-octane investing. You need to be prepared to do tons of research and, even then, you need a well-diversified portfolio — you’ll be reliant on a few hoped-for winners to make up for the inevitable lossmaking disasters.
Risky, yes — but undoubtedly a much more fun way to lose your money than investing in crypto! There’s a dwindling amount of professional research, but investors can get their heads around the company business model by attending AGMs and meeting management teams, where they have a high chance of actually getting to ask a question.
Additionally, certain Aim-traded companies benefit from inheritance tax exemptions if held for over two years, increasing their appeal to older readers.
Considering the pitfalls, this is one area where outsourcing the excitement to a specialist fund manager makes more sense.
One manager confidently predicting a return to a stockpicker’s market is Katie Potts of the Herald Investment Trust, which specialises in small-cap tech and media stocks.
“There are few periods in the economic cycle where fund managers can forecast company profits better than they [the companies themselves] can,” she says. “We’re seeing lots of different management teams, and can quickly see the significance of changes across the board whether that’s labour costs or who’s clever enough to have contracts with prices linked to RPI and who isn’t.”
One of the trust’s biggest sectors is software — which Potts argues is more defensive than it might first appear due to recurring revenues from businesses with rental and maintenance contracts. But the tightening labour market could be an opportunity for growth: “There’s even bigger incentive to automate — and that needs technology.”
When looking at factors to avoid, small companies with high levels of debt look particularly vulnerable in a recessionary environment where interest rates are rising.
Gervais Williams, veteran small-cap manager at Premier Miton, says investors should be wary of smaller companies that are cash flow negative.
“We are going to see the strong overtake the weak,” he predicts. However, this also presents opportunities for smaller companies generating surplus cash who could gain market share, or pick up the stragglers debt-free from administrators.
Another big concern is how well consumer-facing companies are placed to hold on to current profit margins. In his meetings with management teams, Williams quizzes them relentlessly about customer services metrics: “Those who don’t know the answers stand out”.
And then there’s the “Lord Lee strategy” — taking an ultra-long view on selected small-caps (and dividend income while you wait) in the hope they will eventually be taken over at a significant premium.
At present, £120mn of the Herald Investment trust’s portfolio is under the hammer (including healthcare software maker EMIS Group and FTSE 250 publisher Euromoney) and Potts says private equity money is driving a good slug of that.
“Valuations are coming down to a level where trade buyers and private equity seem to be on the hunt very aggressively,” she adds.
A final lesson from my Investors’ Chronicle days. Small companies tend to have wider bid/ask spreads, and some can be relatively illiquid — we used the term “lobster pots” as it can be easy to get your money in, but much harder to get it out again.
You might not be ready to snap up any bargains, but if you’re sitting on cash, it’s getting harder to be patient as inflation continues to rise.
So far this year, my investments have had a very domestic theme indeed. I’ve paid to extend the lease on my flat (another column will follow in due course) as well as spending on home maintenance, replacing all kinds of stuff now that’s likely to conk out within a few years, by which time the price of fixing or replacing it will have soared.
My husband’s best investment idea? Buying six months’ worth of wine when Waitrose had its last 25 per cent off deal. Predictably, buying this “dip” proved to be a false economy, albeit a highly enjoyable one.
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