Small-cap stocks are trading at historic discounts relative to large caps, presenting a compelling opportunity for investors. With key catalysts like Fed rate cuts, a resilient economy boosted by AI to name a few, small caps are well-positioned for strong growth. Geoff Daily head of US equities and lead portfolio manager for the BNP Paribas US Small Cap explains how to tap into the potential of small cap investments.
A compelling opportunity to master small caps today
From a valuation perspective, we see the opportunity for small caps to relocate higher on an absolute basis, the PE multiples are in line with their historical averages, but we see a nice path forward for earnings acceleration. And we also see the opportunity for small cap stocks to trade above their long-term historical averages given the positive environment that we’re in today.
Three powerful catalysts
On a relative basis, small caps are very attractive versus large caps. Investors have to go back multiple decades to get to a point where there’s been this big of a discount of small versus large. In addition, we are at a point where not only do we have the valuation opportunity, but we also finally have the catalysts that are going to unlock that valuation discrepancy, namely:
1. We finally reached the Fed pivot: We’ve already seen 75 basis points of cuts. We expect more cuts going forward. This is an immediate benefit to small cap companies on a financial sentiment and valuation perspective. Fed easing is positive for small caps.
2. A resilient economy: The economy has been very resilient of late, and we expect that resiliency and growth to continue going forward. We have some nice tailwinds, including:
- A reshoring that’s going to continue very strongly
- Robust AI investments
- A new administration with pro-growth pro domestic policies
This strong economic growth is beneficial for the BNP Paribas US Small Cap.
3. Mergers and acquisitions: we are expecting a big cycle of M&A going forward driven by lower rates. Financing is available and companies are becoming more optimistic. As a result, we are going to see pipeline of deals coming through which is a big benefit to small cap companies.
How does the BNP Paribas US Small Cap achieve a low tracking error and performance?
We have a team of seasoned sector experts that are conducting rigorous fundamental analysis to find those great stock ideas for the portfolio. These sector experts have been covering the same industries, companies and management teams for, in many cases, multiple decades. As such, they have been able to identify secular themes that drive long term alpha. Clearly identification of these themes is very important, but also, they are doing that rigorous fundamental analysis to ensure they find the best ideas within those themes.
In parallel, these themes create a great hunting ground for new ideas. We are strong believers that you do not have to take excessive risk in a small cap portfolio to drive absolute or excess returns. We focus our stock picking, on finding idiosyncratic, mispriced ideas that drive the alpha in our portfolio. We try to minimise risk everywhere else through strong and strict portfolio construction and risk management. We are not taking massive sector bets, we try to minimise our style and factor bets, and we are not taking macro or event risk. Alpha is driven from the stock specific picks.
Over time, this has led to very strong risk adjusted returns. The Fund has beaten its benchmark nine of the last eleven years and generated a relatively low tracking error of approximately 5%.
Which sectors are poised to disrupt with competitive advantage?
We are finding disruptive, innovative, share gaining companies in every sector. Within small cap, you can find these innovative companies even in the traditionally cyclical or defensive categories. But clearly, we are finding better ideas and the best fishing ponds in technology and healthcare, both of which are innovative growth sectors. Its in these two sectors that we are finding great ideas that are levered to artificial intelligence, automation, cloud computing, robotics, medtech and genetics.
You can also watch Geoff Dailey’s video here:
