Despite the continued earnings downgrades and dour corporate outlook statements, investors have clearly chosen to ‘look through’ 2020 towards a post COVID-19 world where normality returns.
In the first quarter of 2020, we watched as heightened market volatility and continued uncertainty tore through markets in what was a ‘value led’ drawdown. The crisis exposed the financial vulnerabilities of companies that exhibited varying combinations of cyclical earnings, poor pricing power, capital intensity and balance sheet weakness.
Despite this drawdown, we have seen a remarkable rebound in global equities, and while we believe the global economy and corporates will continue to recover, we do expect the pace of recovery to be more staggered than what is implied in valuations.
While current 2020 earnings per share (EPS) estimates are much more realistic than they were a few months ago, the same cannot be said for 2021. Although we would expect corporate earnings to stage a recovery of sorts in 2021, the ~29% year on year increase implied in current estimates seems overly ambitious in light of the COVID-19 crisis.
From our perspective, this scenario highlights the fact that global equity markets are effectively pricing in a seamless return to normality in 2021 with relatively few bumps along the way.
It is encouraging to see some countries reopening their economies having controlled the spread of COVID-19, however the economic bruises are still unfolding. Investors should be focused on the direct and indirect COVID-19 ramifications for the companies in their portfolios.
We expect the current corporate earnings season to be more instructive for investors and arguably temper the current optimism priced into equities. The Q1 earnings season only really captured roughly two weeks of COVID-19 conditions and therefore reported earnings were subdued but not materially lower in most cases. The almost universal lack of guidance from corporates arguably sets the scene for a volatile period ahead.
This earnings season will be the first opportunity for investors to fully understand what a full business quarter of COVID-19 conditions look like from an earnings perspective, and we believe the remainder of 2020 will prove to be a little more volatile as the reality of a post COVID-19 world dawns on investors.
The likely recalibration of 2021 earnings projections is set to trigger further market volatility, which we believe will provide investors with more buying opportunities of the ‘best of the best’ in global small and mid cap (SMID) stocks.
As history would suggest, generally the best time to allocate to the global SMID sector is when earnings are depressed – and that time is now.
In terms of valuations, the MSCI World SMID Cap Index is currently trading on a P/E of 23.1 x ‘depressed earnings’ compared to 29.4x for the MSCI World Growth Index, based on FY21 earnings expectations. This valuation is an attractive proposition for investors seeking diversification potential compared to large cap stocks.
And while these stocks may not grow much this year, once we come out of the other side of COVID-19 the organic growth drivers of SMID stocks will come back, and we believe that these high-quality companies will be the ones that are going to rebound the fastest. The combination of corporate cost cutting, COVID-19 related stimulus, and the reopening of global economies, should position global SMID for a strong rebound over the next 2-3 years.
Further, global SMID stocks offers less valuation risk than large cap growth stocks, less earnings risk than emerging markets, and less trade risk than both large cap and emerging market stocks.
While many industries are doing it tough due to the COVID-19 pandemic, others have thrived in this environment. We have seen growing companies in the healthcare and consumer discretionary spaces.
The healthcare sector continues to boom as spending support flows from consumers and governments, particularly towards research and development in pharmaceuticals and biotech industries. Within this sector, we believe dental orthodontics, which saw a negative impact in the short-term due to lockdowns where only emergency work was permitted, will bounce back and present excellent earnings leverage for investors in 2021.
Stocks that we are watching in the healthcare space include Align Technologies, Idexx Laboratories, and Danish medical devices maker Ambu.
Likewise, consumer discretionary has seen increased demand during COVID-19 as consumer behaviour changes materially. We believe that these changes will lead to opportunities for investors in sectors such as home improvement plays, localised vacations and outdoor activities. However, overseas travel and the hospitality industry will continue to struggle.
Consumer discretionary stocks that we believe are poised to ‘win’ in a world transformed by COVID-19 include Tractor Supply, Pool Corp, O’Reilly Automotive, and YETI Holdings.
For investors looking to diversify their global large cap exposure, now may be the ideal time to invest in global SMID equities, given where valuations are at. The ongoing market volatility has presented investors with some fantastic opportunities to start positions in names that we think will do well over 3-5 years and beyond.
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