Small-Caps Are Finding Their Footing
The bounce back rally continued for a second week, with mega caps back in favor as the S&P 500 advanced +1.8%, and the Nasdaq gained nearly +2%. Small-caps continued to lag the field, with the Russell 2000 slipping -0.4%. On Friday afternoon I discussed our view of the state of small-caps on Yahoo! Finance. On their news feed, the teaser quote they used is, “Small-cap stocks are ‘trying to find a footing,’” which sums it up well, but here are some of our other talking points:
Small-caps are down 8% for the year and 6% in the last 12 months. Both the small-cap growth stocks and the small-cap value stocks have been challenged within the asset class. In the last two weeks, our research team met with 25 small-cap companies and asked each management team a series of questions to get a sense of the impact from the recent macro events that are influencing businesses globally.
We consistently heard the same answers:
- Supply-chain related delays have not improved and will persist longer than the anticipated Q2 2022 recovery estimate.
- No company seemed to want to revise their predictions on how much longer these headwinds last because they were all surprised these issues have not been resolved and have only eased modestly.
- Across the board, higher energy prices and wage costs were a theme.
- Consistently, wages used to be around $13-$15/hour pre-pandemic versus around $17-$18/hour now.
- Good news: most companies have adjusted to the required minimum wage to incentivize workers to reenter the workforce.
- Domestically, COVID-19 severity is less influential on workplace participation.
- Most of these companies are consumer oriented. These workers are in the same demographic as their customers. So, whereas the rising wage rate is a negative for costs, it is a positive for demand. Overall, no company we talked to seemed to be concerned about the demand for their products.
- Pricing: On average, these companies are passing on cost increases at around a 3-month lag. Very few companies are exposed to long-term contracts, whereas companies such as Build-A-Bear Workshop Inc (BBW) can take pricing actions in real-time.
- China and Russia
- It is undeniable that many if not most companies source products in China.
- Fortunately, over the last 3 years or so, most companies have been trying to redirect sourcing which really stemmed from the concern over tariffs during Trump administration.
- Also fortunately, China’s economy is heavily dependent on US and European trade relations; this is evidenced by currency weakness and signs they intend to grow their export business. China is pragmatic and it is unlikely they would do something to disrupt its global trade partnerships.
- The war is sad and disturbing but because most of our companies are domestic in nature, they have zero or very low exposure to the Russian economy and most of the impact is felt from the second derivative effect of higher energy prices.
- Financial Flexibility & Valuation
- Many companies refinanced in 2020 and took advantage of locking in lower rates for longer periods with better terms. While small-caps are historically less leveraged than other asset classes, these companies are particularly not worried about rising interest rates.
- Given strength in demand and solid balance sheets with net cash positions across a variety of our holdings, we still believe there are many inexpensive opportunities in the small-cap space.
- These companies have really good balance sheets, are not as affected by rising interest rates, and are trading inexpensively.
The combination of these headwinds will likely lead to a more cautious tone during the upcoming earnings season.
In short, we think a strong valuation argument can be made for small-caps as they ‘find their footing’ after 12-months of negative share price returns, although short-term headwinds persist that will be focused on during the earning season that kicks off next week. If you would like more information about how we select the best candidates for our mutual fund portfolios, contact your designated advisor or email email@example.com and we will send you our fact sheets and a sleeve of North Star golf balls.
Turning back to the bounce back rally in the other equity indexes, the best explanation seems to be that the market had become “too oversold”, because the news flow certainly didn’t seem to warrant any enthusiasm. The rebound came despite the continued war in Ukraine, the Fed suggesting that 50 basis points interest rate hikes are likely in the next two meetings, another 12-basis point increase in the 10-year Treasury, and crude oil advancing to almost $120 per barrel. Oil and Gas stocks fared the best, rising almost 8%, followed by Basic Materials, while the defensive Health Care sector posted a modest decline. Both Gold and the Dollar inched back up towards recent highs. The recent rise in short-term rates has resulted in somewhat reasonable available yields of over 2% on several investments such as VCSH, and even T-bills finally offer a decent spread over deposit rates.
Madness in March
The war, energy prices, and interest rates will likely dominate the headlines. On the economic calendar the Bureau of Labor Statistics will be releasing the Jobs Openings and Labor Turnover Survey (JOLTS) on Tuesday, and the U.S. jobs report for March on Friday. Expectations are that unfilled jobs remain near record levels and comfortably exceed the total number of unemployed workers, while economists are forecasting an additional gain of 450k jobs for the month. Employment has been an area of continuous improvement, and evidence of additional strength will further embolden the Fed to tighten monetary policy more aggressively to combat inflation.
I haven’t talked about the exciting NCAA “March Madness” tournament, probably because my Big Ten bias once again blew up my brackets remarkably swiftly. I guess Illinois, Iowa, and Purdue won’t be playing next weekend in the final four.
Stocks on the Move
-12.6% Century Casinos Inc (CNTY) operates as an entertainment company. The Company owns casinos, hotels, and luxury cruise vessels. There was no significant company news last week.
-11.6% Green Brick Partners Inc (GRBK) operates as a homebuilding and land development company. The Company develops residential homes, complexes, and communities. Green Brick Partners invests in a range of real estate investments, as well as provides land and construction financing to its controlled builders. There was no significant company news; however, U.S. housing numbers released last week showed a month-over-month deceleration in new home sales, pending home sales, and MBA mortgage applications. This shift is likely due to concerns over the future impact of rising mortgage rates and is weighing particularly hard on the home building stocks.
The stocks mentioned above may be holdings in our mutual funds. For more information, please visit www.nsinvestfunds.com.