abrdn US Small Cap Quarterly Update podcast: Q3

In this episode, Tim Skiendzielewski, an Investment Director with the North American Equities Team who manage the US market portfolio for abrdn. Tim will discuss the current landscape for small caps, as well as expectations for the asset class for the second half of 2021. 

Transcript

Joe Summers:              Hello, and thank you for listening to the abrdn US Small Cap Quarterly Update podcast. My name is Joe Summers and I'm an Advisor Consultant here at abrdn. Joining us today is Tim Skiendzielewski, an Investment Director with the North American Equities Team who manage the US market portfolio for abrdn. Tim will discuss the current landscape for small caps, as well as expectations for the asset class for the second half of 2021. Tim welcome and thanks for joining us today.

Tim Skiendzielewski:   Great, thanks a lot Joe. Happy to be here.

Joe Summers:              Tim, to start off could you provide us with a recap of what you saw in the market during the second quarter as it relates to small caps.

Tim Skiendzielewski:   Yeah, absolutely happy to. It was -- happy to say for our client’s perspective as another positive quarter for the Russell 2000 with the index finishing up just above 4% extending year to date gains to just over 17%.Within this good from a stock picker’s perspective, there was a good amount of sector dispersion, with the communication services sector up just over 32% largely due to one stock AMC and energy up 21%. Then on the downside with rates heading lower and yield curve flattening, we saw utilities, industrials and financials were the primary laggard is during the quarter.

Now there's a couple things at play here. I think the market obviously was continuing to get a boost from the strong pace of COVID-19 vaccinations, the helping with the US economy reopening. Really in view that all of this, you know, positive news will flow through to strong earnings growth, when we have second quarter earnings here in the next few weeks. I think there was also just a generally positive tone from management teams across industries as they went out and spoke to investors and spoke at conferences. Again, I think the market expects that will translate into strong earnings growth in the second quarter, and hopefully an increase in full year guidance.

We did see two big shifts during the quarter that has actually continued into the third quarter here, primarily style and size. So from a style perspective, what we found interesting is that after lagging for much of the quarter growth, rebounded in June due in large part to that, tech strength, and growth finished roughly in line with value. While market prognosticators were making so much of this kind of value renaissance late last year and early this year, growth saw pretty strong comeback, so that's something we're continuing to keep our eye on.

Then from a size perspective, small caps did give back some performance to their larger cap counterparts during the quarter, and that's continued as we moved into the third quarter. I think a lot of that has to do with kind of that sector dispersion that I mentioned, with some of the more cyclical areas of the economy. The cyclical areas of the market lagging, Russell 2000 has more exposure to those areas, as opposed to kind of, tech, which was very strong during the quarter and where there's more exposure in the S&P 500, so I think that had a lot to do with it. Then as we got into the third quarter here, with the rise in COVID cases and the view that maybe we're in for a tougher market environment, I don't think it's surprising to see that small caps have continued to lag in the early part of the third quarter.

Joe Summers:              Tim the market appears to be harboring concerns around increasing inflation. Do you share these concerns? What do you believe will be the ultimate impact on the small cap asset class?

Tim Skiendzielewski:   Yeah, absolutely. I think while we're at the end of the day bottom up stock pickers, I think, to dismiss what is occurring from an inflation perspective would be a bit foolish on our part. I think the concerns are obviously grounded in reality. You've seen this rapid easing of restrictions is leading to pretty significant bottlenecks in the labor market. Management teams across industries that we speak with are noting that it's difficult to find workers, and that's everything from low skilled jobs to more highly skilled jobs like programmer, definitely inflation from a wage perspective. Then the second thing that you're seeing is that increasing demand as the economy has reopened, this increasing demand, pretty much everywhere in the economy has led to supply shortages and supply chain issues. That's manifested itself in higher prices for everything from semiconductors to lumber, to used cars.

The concern in the market, I guess, the question then becomes what does that mean at the company level at the fundamental level, obviously, the concern is obviously that margins will be pressured as companies need to absorb much of this cost inflation and ultimately, potentially with higher prices we could see negative demand impacts. It’s definitely something we're monitoring and speaking with our companies about, we haven't kind of seen that in the numbers just yet, but a lot will be learned as we get into second quarter earnings here in the next few weeks.

I think we're still taking a somewhat optimistic view that inflation should coincide with stronger domestic growth so revenue growth will benefit from a healthier economy and we could see kind of strong operational leverage from higher volumes coming out of the cycle. But at the end of the day what can you do to kind of combat inflation, or How can you protect yourself from portfolio perspective, it's really all about focusing on companies with pricing power, the power to pass on these costs either because they have differentiated products or strong market positions or things like that.

Really, as we speak with our companies, it's really understanding what impacts they are seeing, and then also kind of trying to better understand which are best positioned from a pricing perspective.

Joe Summers:              And Tim, you touched on earnings growth, can you dig a little bit more into earnings growth, and what specifically you're expecting small caps to deliver and how that compares to large caps?

Tim Skiendzielewski:   Yeah, absolutely. I think in short, earnings growth outlook is very strong. I mean, if you look at the economy, and in purely GDP terms, the expectation is that we will surpass 2019 levels this year, which I think is far sooner than we expected as we thought about it in the middle of 2020, or late 2020 so that's good. Then when you look at the actual, the earnings growth expectations that are embedded in consensus estimates right now, these numbers kind of change by the week, but the expectation is that small caps will be able to grow earnings year-on-year in the kind of 50% plus range in 2021 that compares to about 30%, for large caps you're seeing kind of much stronger earnings growth for small relative to large.

Then also interesting to look at is when you compare 2021 earnings relative to 2019 figures, you're kind of well ahead where you were a couple of years ago and again a stronger for small cap. I think the earnings estimates have been accelerating at a stronger pace for small caps, so over the past several months relative to large caps, so that's all good.

But ultimately what I think you need in order to keep the markets moving higher is really a view into 2022 earnings and what that's going to look like. I think it's probably a little bit too early to get that this quarter, but ultimately investors will start looking towards next year to the sustainability of the strong earnings growth that we're seeing coming out of the pandemic.

Joe Summers:              Lastly, Tim, could you give us some concluding thoughts on your outlook for small caps for the balance of the year and into 2022?

Tim Skiendzielewski:   Yeah, I think we always have to take it in two parts, fundamentals and valuation. From a fundamental perspective, I think the outlook remains quite positive, notwithstanding the kind of the weakness that we've seen here in July, and the kind of nervousness that a lot of investors have around increasing COVID cases.

First and foremost, continued vaccine progress, continued benefits from stimulus has created a very favorable demand backdrop, and that's translating into accelerating GDP growth. I think the stronger economic growth is manifesting itself and significantly accelerating earnings growth at the individual company level. Again, as I just mentioned, for small caps to significantly outstripping growth for large caps and notwithstanding the inflationary impacts. I talked about earlier, we do expect companies to report good results in the upcoming second quarter reporting season and really be in a position to raise full year guidance.

I think the other thing that is important to know from a small cap perspective is that the M&A markets remain very strong, and that that typically bodes well for small caps and services as some valuation support, so that's good. I mean, obviously a strong fundamental backdrop is an important precondition for a positive outlook, but then the question obviously becomes, is all the good news priced in or our valuation supportive of further market gains. I think clearly, multiples, even though they come in a bit, these multiples are elevated, there's no denying that but I think it's very important to recognize that we're at the beginning we think of a true acceleration in earnings growth, which could last for several years.

Clearly, earnings need to catch up and as I said, as well, we’ll have a keen eye on what earnings growth looks like in 2022. But even with a stronger growth outlook, we've always been pointing investors to that valuation disparity between small caps and large caps, small caps valuation remain at a significant discount to large cap. I think in total, we think about stronger growth, attractive relative valuations and the strengthening M&A market all favor shares of smaller companies. I think you could characterize us as positive on the prospects for the asset class.

Joe Summers:              Any other trends that you're currently following for the asset class?

Tim Skiendzielewski:   Yeah, I think ESG continues to be top of mind, but I think that ESG is becoming more prominent, more of a focus for investors is probably a significant understatement. But I think from our perspective, when ESG and ESG considerations started coming to the forefront a few years ago, it felt to us a little bit like small caps, got a pass, so to speak, with the view being that the businesses are smaller, somewhat less mature, smaller companies really didn't have the financial wherewithal or resources to focus on. ESG management, reporting on ESG issues, communicating their kind of key ESG risks to investors, but as this for good reason as ESG considerations have become more prominent and more important for investors, investors have started to look at smaller companies and have the expectation that they're focused on these risks. Really, they're investing more to report on them and really kind of manage their key ESG risks.

It's something we engage with companies a lot about, it's something that investors care a lot about. I think the companies that are kind of putting resources behind this and investing in reporting are going to be best positioned going forward.

Joe Summers:              Tim, thank you for your insights into the US small cap asset class, and thank you to everyone who listened in today. If you have any questions or need any additional information, please don't hesitate to call us at 866-667-9231. We look forward to having you join next quarter’s installment at the abrdn US Small Cap podcast.  Thanks again and have a great day.

Important Information:

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.

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