According to research by the Bank of America, global risk assets have lost over $35T since November 21, 2021¹. This should come as no surprise as we are seeing: the co-dependency of Wall Street and the Fed, stop-go economic policies, zero COVID policy in China, headline inflation, political instability, war, oil and food shocks, fiscal excess, and industrial unrest.

Given all this volatility, recession is a common topic of conversation among investors and companies. The general consensus? Avoid small cap stocks and stick to the so-called safer large cap companies.

In today’s weekly, we’re busting this myth by explaining why small cap is back and why exposure to this asset class is your best bet during a recession. We’ll begin with a brief trip down memory lane.

1970s – Small caps shine amid economic volatility

Investors assume that for small cap to outperform, we need economic certainty, lower rates and better credit conditions. But history proves otherwise. The 1970s were one of the best decades for small cap, and yet this era was plagued with a wide variety of economic volatility.

Throughout the 70s, inflation averaged 7.1% with a high of 13.3%. Fed rates peaked at 14% in 1979 from 3.5% in 1971. The economy faced oil shocks, embargoes, and taxes were high. Real economic growth was below the previous decade by 1%, and productivity was even lower. Meanwhile, President Richard Nixon became the first U.S. president to resign, and the dollar abandoned the gold standard and devalued.

Incredibly, in the midst of all this uncertainty, small cap outperformed large. Why?

Why small cap succeeds during unexpected inflation

What really helped small cap outperform during the 70s was the unexpected inflation. According to Aswath Damodaran, a finance professor at NYU Stern, there are two reasons why unexpected inflation benefits small cap companies.

1. Nimbleness in price adjustments – Large cap stocks, with their layers of management, have very entrenched pricing models. On the contrary, small cap can quickly change pricing structures to reflect the new inflationary environment. Hence, small cap reports much better margins.
   
2. Less long-term investment projects – Large cap generally undertakes investment projects, which can have a 10 to 30-year timeline. They need to think much longer term just to maintain their growth rates. The problem is during high inflationary and interest rate environments, the Net Present Values for the projects drop drastically as cost and revenue inputs change. By contrast, small cap companies are in growth ramp-up mode and have a long runway for potential expansion.

Why is now the time to buy small cap?

With inflation at 8.3%, the probability of a recession in the U.S. is almost certain. Earning season is already indicating lower earnings growth, especially for large caps.

Meanwhile, central banks are raising rates across the globe. It goes without saying, we are in a very uncertain economic environment.  So let’s break down the top seven reasons to invest in small cap right now.

1. A history of long-term outperformance – small cap stocks have consistently outperformed large cap over the long term by a considerable amount.

2. Unexpected inflationary environment – The data shows that small cap consistently outperforms large cap during unexpected periods of inflation.

3. Valuation – Perhaps most compellingly, small cap is very cheap compared to large cap stocks. The below chart shows that the relative P/E of the S&P 600 (which excludes negative P/E stocks) versus the S&P 500 is the lowest since at least 1992.

The story is similar if we look at the Russell 2000. The last time it traded at this depressed relative multiple to the S&P 500 was during the dot-com bubble burst. From 10/9/2002 to 10/9/2007, Russell 2000 outperformed the S&P 500 by more than 50%.

4. Small cap does well from early in the recession – While we do not know exactly when a recession will begin, it certainly feels like we’re getting close. So, getting exposure to small cap now would be a great idea for long-term investors. Small cap stocks have outperformed large cap in each of the previous six recessions that we have data for, going back to 1980.

5. Low exposure – The percentage of small cap in the U.S. equity market now stands below 4%, a level last seen at the COVID bottom. Prior to this point, we must go back to the 1930s to see such little exposure to small cap. As investors will increase their allocation to the asset class, patient investors will be rewarded.

6. M&A is another consistent tailwind for small cap – Small cap represents approximately 95% of all deal volumes globally. The average acquisition premium is in the range of 35-40%.

7. Undercovered – Small cap is far less researched than large cap. Globally, small cap is covered on average by three brokers, versus 16 that cover the average large cap. There are hundreds of small caps in any region still not covered by a single broker. This provides bigger alpha opportunities for investors.

Final thoughts

When it comes to small cap outperforming large cap during recessions, we see the same trends play out across the globe. For example, valuations in Europe have dropped to levels last seen during the Global Financial Crisis (GFC).

So, now is the time to increase exposure to small cap, as most investors are underweight in this asset class. At Global Alpha, we are patient long-term investors who should benefit as small caps return to their historical outperformance and take a market leadership position.

¹BoA Securities Global Research: The Flow Show – The Next Big Thing is Small, November 3, 2022

The UK has been going through an unprecedented time. From the death of the Queen, to three prime ministers in a little over two months, what the country needs now more than ever is stability and unity from both the new monarch and incumbent governing party.

A disastrous 44 days as prime minister by Liz Truss led to tremendous turmoil in the gilt and sterling markets. The pound hit a record low against the US dollar towards the end of September, forcing the Bank of England to step in and stabilize markets.

New Prime Minister Rishi Sunak has an unenviable task ahead of him. While being the sole candidate to achieve enough support from MPs to stand for the Prime Minister position prevented further infighting within the Conservative Party, the fact remains that there are still factions and loyalties pitted against each other. With this as a backdrop, it is even more difficult to regain the confidence of voters ahead of the next general election. Latest opinion polls show the Conservative Party facing a 26-point deficit.

Perhaps the most difficult task of all will be to reassure investors and increase credibility concerning public finances. Initial reactions to Sunak’s appointment were positive due to some goodwill built up through his handling of COVID and furlough schemes as Chancellor, a reputation for being fiscally conservative and the belief that he and the current Chancellor, Jeremy Hunt, are both singing from the same hymn sheet. Contrary to his predecessor, Sunak has already stressed the importance of government policy working hand in hand with the central bank to combat inflation, while emphasizing the independence of the Bank of England over interest rate decisions.

The next financial statement, due on November 17, will go a long way to re-establishing some credibility. Difficult, but necessary decisions on increased taxes and spending cuts are to be expected. Even freezing income tax thresholds will see more people enter the income tax system, or into a higher tax band, due to the wage inflation currently being experienced. Only one area has been designated as off limits for cuts – the National Health Service. Other areas such as welfare, education and­—perhaps controversially given the current geopolitical environment, defense—could be in the firing lines, as well as reviewing the HS2 rail project.

Fiscal responsibility is at odds with regaining the favour of the voting public. Just this week the Bank of England hiked interest rates by 75 basis points to 3%, the largest hike since 1989, and said that the UK is potentially facing its longest ever recession. Unemployment is expected to almost double, albeit from its lowest level in 50 years.

The instability surrounding the UK government and future economic prospects means investors want a discount on UK equities to compensate for current additional risk and uncertainty. However, based on the forward price-to-earnings ratio, the UK is at its lowest valuation versus global peers since records began. The attractive valuations combined with weak sterling and/or strong dollar leads us to believe that there is a significant opportunity for international and more specifically U.S. corporates or financial institutions to increase takeover activity. Longtime holding, Clipper Logistics (CLG.LN), was acquired by U.S. peer GXO Logistics (GXO.US) earlier this year. Current holding, Biffa (BIFF.LN) is being acquired by a private equity firm, with the transaction expected to close by the end of Q1 2023 at the latest.

The larger question is if there remains compelling reasons to own UK equities right now given the warning of a deeper recession than other regions. We would argue that this is a good environment for bottom-up fundamental stock pickers. Some quality international companies are now available at a significant discount. The FTSE 100 derives around 70% of its revenues internationally, while the FTSE 250 is at 50%.

When looking at our holdings in the UK, we have a diverse mix of companies, many of which have diversified their source of revenues away from just the UK. Often the market leaders can capitalize in economic downturns and increase market share while competitors struggle. This could also be the case for our holdings, briefly summarized below.

Our UK holdings with significant overseas revenues include:

Coats Group (COA.LN) is the world’s leading industrial thread manufacturer with market-leading position in apparel and footwear, plus a leading and growing position in performance materials. The company derives the overwhelming majority of its revenues from Asia and the Americas.

IWG Pls (IWG.LN) is the world’s largest provider of hybrid workspace with a network of 3,323 locations across 120 countries. The UK accounted for 16% of group revenues in 2021.

Oxford Biomedica (OXB.LN) is a leading cell and gene therapy group and does not disclose the geographical segmentation of revenues.

Safestore (SAFE.LN) is the UK’s largest self-storage group with 130 stores located in the UK and 48 stores located in Europe, mostly in Paris but with locations in the Netherlands and a growing presence in Spain. Around 25% of revenues come from overseas.

Savills (SVS.LN) is one of the leading real estate advisors in the world with 57% of revenues coming from outside the UK.

Our UK holdings with largely domestic revenues include:

Biffa (BIFF.LN) is a UK-based waste management company whose operations include collection, recycling, treatment, disposal and energy generation. As mentioned above, the company is in the process of being acquired.

CVS Group (CVSG.LN) is one of the largest integrated veterinary services providers in the UK (plus a small presence in the Netherlands and Republic of Ireland). The firm has four main business areas: veterinary practices; diagnostic laboratories; pet crematoria; and e-commerce (non-prescription medicines, pet foods and pet care products).

Onesavings Bank (OSB.LN) is a UK specialist lender which targets market sub-sectors that are underserved by the mainstream banks, most notably the professional landlord buy-to-let market.

In the past year or two, semiconductors have been under the spotlight across industries and countries, even in our everyday conversations. People around the world have started to realize just how much this small component affects their daily lives in significant ways, from long lead times in car purchasing, to being unable to get hold of a PS5 game console. Modern defense capabilities also rely on sophisticated electronics systems powered by advanced semiconductor components. No wonder semiconductors are considered the new oil, given their wide-spread consumer, military, and strategic significance.

However, the key difference is that chipmaking is even more concentrated geographically than oil production. The three biggest oil producing countries, the United States (U.S.), Russia, and Saudi Arabia, accounted for 15%, 13% and 12% respectively of global production in 2021. Taiwan, on the other hand, supplies 20-25% of the world’s semiconductors every year, while the U.S. only accounted for 12% in 2021. When it comes to leading-edge chips (10 nanometers and smaller), Taiwan has 92% of global production capacity. Meanwhile, China is expected to emerge as a leading player in chip manufacturing. The country plans to add about 40% of the global new capacity by 2030 and is expected to reach 24% of world’s total capacity by that same year, according to Semiconductor Industry Association. China’s potential leading position has raised concerns that it might threaten the economic advancement and national securities of other countries, especially the U.S.

In light of these threats, the U.S. government has been tightening regulations on chip exports to China. Last month, on October 7, the U.S. Department of Commerce announced reinforced regulations on cutting-edge semiconductor technology exports to China. Export controls to China already existed before this new round. So what’s new this time, and why has the market been so nervous about it? Well, this new set of restrictions have been broadened substantially. First, the expanded list of restricted exports to China now includes the most cutting-edge chips as well as chips that are one to two generations behind the cutting edge. In addition, the new rule restricts the ability of Americans to support the development or production of Integrated Circuits (ICs) at China-located semiconductor fabrication facilities without a license.

The cumulative effects of these restrictions could have major implications on the industry. For example, many scientists and engineers with U.S. citizenship or permanent residency work in the Chinese semiconductor industry, including several top executives in Chinese companies. The new controls will likely force them to choose between their U.S. citizenship or their jobs.

The new rules will affect Chinese companies the most. Without new supplies of equipment from the U.S., Chinese chipmakers could be unable to expand their production lines and wind up stuck with existing capacity for the time being. Even for existing capacity, they may not be able to get maintenance services from the U.S. suppliers, which could affect the quality of the products.

The global market for wafer fabrication equipment is also expected to be hurt by these regulations. According to Jefferies, total investment value by Chinese companies in this market in 2022 is projected to be US$18 billion. This makes China the largest investor in this global sector by far.[1] However, the impacts of these new regulations on chip exports might affect around US$5 billion of Chinese investments in wafer fabrication.

American companies could suffer as well. China is the largest market for the three biggest U.S. semiconductor equipment manufacturers, accounting for roughly 30% of the revenue at Applied Materials, Lam Research and KLA Corp. Applied Materials declared the new regulations will reduce its fourth quarter net sales by US$250–$550 million, and a similar impact is to be expected for the following quarters. Applied Materials’ 2021 annual sales, as a reference, was about US$23 billion. Similarly, Lam research also warns the U.S. ban could lead to sales loss of US$2–$2.5 billion in 2023 (their 2021 annual sales was about US$17 billion).

Japan also has a major presence in the semiconductor production equipment (SPE) industry. At present, Japanese companies are not subject to regulatory constraints if U.S.-made parts and software are 25% or less of their products. This may potentially give Japanese SPEs a boost versus their U.S. counterparts. However, a regulation-induced slowdown of investment by Chinese companies could eventually diminish overall orders with Japanese SPEs.

What is the potential impact of all this on our portfolio?

While we do not invest in semiconductor manufacturing companies directly, a few companies we invest in Japan do have semiconductor equipment manufacturers as their clients.

Horiba (6856 JP) is a Japan-based manufacturer of measurement equipment. We have introduced their automotive emission measurement business in previous commentaries. Horiba is also a leading supplier of mass flow controllers, with 60% global market share. Their measurement equipment is used to regulate gas and liquid flow rates and is a key component in the production of high-quality semiconductors. Over half of the segment revenue comes from their Japanese customers, but Lam Research and Applied Materials are also among their key customers. The revenue from its semiconductor segment is over 40% of total revenue, the demand for this segment has been strong, and the company has revised up its 2022 guidance as a result. Horiba will report its third quarter result on November 11 and is expected to comment on the impact of the new regulations.

Kurita Water (6370 JP) is a Japanese manufacturer of water treatment equipment and chemicals. There is a growing need in the water treatment industry for advanced, comprehensive solutions, especially in the semiconductor and electronics manufacturing industries. Kurita is the only company in the world that has businesses in both water treatment chemicals and facilities. The company is the leading manufacturer in the water treatment industry in Japan, and over the past several years, Kurita has expanded its presence in the U.S. and European markets. As the semiconductor makers and other U.S. high-tech companies are bringing production bases home, this will present Kurita with business opportunities. There are still many uncertainties on the magnitude of this new set of restrictions and its potential impact. We will provide updates in future communications as we gain more clarity.

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[1] Masahiro Nakanomyo, “Impact of Stricter US regulations on Exports to China”, Jefferies, Oct 16, 2022

Recently, we have seen a pullback in commodity prices after the rally they experienced earlier in the summer. As many global economies are forecasted to enter recessionary environments, the demand trajectory for commodities remains uncertain. Over the longer time horizon, we believe some commodities will outperform others due to resilient demand, despite short term volatility. This week, we would like to highlight one metal that we are closely monitoring.

Following the general direction of metal prices this year, copper is down a little under 20% year to date, according to Bloomberg. The recent down trend in copper prices has mainly been attributed to the slowdown in Chinese demand. Economic doubts in the region and many other factors have been attributed to the disruption in the Chinese economy.

The troubles started this summer when the country suffered its worst heatwave in years. Being one of the regions most vulnerable to physical stress, the heatwave in China resulted in many energy generation sources going offline, causing widespread power shortages. Additionally, the country continues to keep tight COVID controls in place, with no end in sight for their zero-COVID policy. As cases spike in certain regions, they have not shied away from locking down affected areas. Finally, Xi Jinping’s political agenda to push greater state control at the expense of the private sector growth cast questions on what rate of GDP growth the country can actually achieve. 

With the rapid acceleration of the Chinese economy in the last decade, their demand for copper followed suit. The outsourcing trend accelerated in the 2000s further bolstered demand in the region. China currently accounts for 53% of the global copper demand, an increase from 38% in 2010. So, it is no surprise that downgrades in the speed of their economic development have caused a nervous sell off in the copper markets.

Traditionally, copper has been highly correlated to economic growth as it is an important material for construction, consumer durables, industrial equipment and ventilation and air conditioning. This type of demand for copper is called traditional demand. We are now seeing a more prominent demand driver for copper emerge, and it stems from the energy transition. Countries committing to net zero goals and setting strategies to achieve these ambitious targets will give copper demand an additional boost. Over 50% of countries around the world have net zero targets. Most are not yet legislated, but momentum is increasing as many feel the firsthand effects of climate change.

Energy transition enabling technologies are highly reliant on copper. For instance, electric vehicles require three times as much copper as internal combustion engine cars. Additionally, with wind and solar becoming more widely adopted energy generation sources, transmission and distribution lines require an increasing amount of the metal as well. These transport and infrastructure needs will experience a 3.9% compounded annual growth rate between now and 2040, contributing to an overall copper demand growth of 53%.

The supply side, however, is expected to experience a squeeze. Mines have been seeing declining copper grades. Additionally, new mine commissioning takes up to ten years from initial phase to operation as environmental permits, financing and operations are all lengthy processes. Other sources of copper supply will be critical to meet the roughly 14 million tons shortage (BNEF). Solutions such as copper recycling and yield improvement technologies will play a key role.

Aurubis (NDA GR) 

We currently hold Aurubis in our portfolio, a world leading copper smelter and refiner. The company is also one of the largest copper recyclers in the world. As was the case with many European companies, they experienced rising energy costs as a result of the war in Ukraine, weighing on their performance. However, we strongly believe in the positive long-term trend for the industry. Aurubis is extremely well positioned to benefit from the energy transition. Their main smelter is one of the most efficient in the world and the company outperforms its peer group in terms of GHG emission intensity. Suppliers with better performance should benefit as more and more emphasis is put on managing Scope 3 emissions. Additionally, their recycling division is bound to thrive as regulations impose higher recycling rates and natural copper deposits continue to decline. 

We believe that given the strong demand, copper prices should find a floor and stabilize, experiencing a more favorable pricing environment than other metals.