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The Magnificent Gap

There is currently a unique dislocation in global equity markets, which might prove to be a generational opportunity to create alpha. In this article, I will explain this investment opportunity and why our contrarian global small and mid-cap fund, SKAGEN Focus, is uniquely positioned to capture value from the reversal of this anomaly. Importantly, we also believe that this dislocation has created severe concentration risks for global passive equity investors over the next 2-3 years which have yet to unravel.  

Recently increasing amounts of capital have been allocated to the largest stock market companies, driven by the herd mentality of penguin-like and career-managing investors. Consider the momentum behind the so-called “Magnificent Seven” of Microsoft, Google, Amazon, Apple, Tesla, Nvidia and Meta in 2023 as investors feared missing out on the craze for Artificial Intelligence.   

Other drivers have been the growth of so-called “ESG” mandates with alarmingly little focus on real future green transition impact or value, and the rise of passive and semi-passive investing where size is the main consideration rather than valuation merit. These factors have combined to lift the valuations of the largest companies increasingly higher and created huge concentration risks in global passive equity mandates.

On the other hand, small and mid-cap companies have been increasingly ignored by mainstream investors, especially value companies within this complex. Smaller companies have also been hard hit recently by economic pressures, higher interest rates and risk premiums, and a slowdown in M&A activity, which have all helped to push select areas of the small and mid-caps complex to record low valuation multiples.    

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Mean reversion opportunity

An interesting observation from the chart above is that small and mid-caps have historically traded at a premium to large caps (defined as above USD 10bn). This is because smaller companies have generated superior shareholder returns over time and tend to be more focused, more agile and better equipped to deal with changing business environments. Since 2020 this has reversed and smaller companies now trade at the largest discount to larger ones since MSCI data began in 2004, creating the foundation for a massive mean-reversion investment opportunity.

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The shaded blue bars in the above chart indicate previous recessions following the Global Financial Crisis and the Pandemic, with the upcoming recession that many anticipate shaded in green. A key observation is that global small and mid-cap valuations, especially for the most cyclical companies within this complex, are already pricing in a recession.

This points to an interesting risk/reward as smaller company valuations have historically recovered steeply on entering recession (indicated by the yellow arrows), while the consensus among economists and investors is increasingly that we may avoid recession altogether as central banks successfully deliver a soft economic landing, which could provide an even greater re-rating boost.

The valuation gap between larger and smaller companies is even starker when comparing price to book (P/B) ratios. Interestingly, this discount started to take shape earlier in 2015 when the Big Tech Complex, primarily centred in the US, began to emerge and the book value multiples of companies which now have massive market caps started to become elevated.

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We can take this analysis one step further and compare the Magnificent Seven, which are now the largest ever companies in the US. Interestingly, the P/E valuation of this group has de-rated recently, but the gap between it and the SMID global equity space remains vast. Compared to the global small cap value index, which trades at or below 10x mid-term earnings power, the gap is particularly striking.

So, instead of talking about the Magnificent Seven, maybe we should talk about the Magnificent Gap?  

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Finally, if we compare the market capitalisation of different areas of the global equity market, it is easy to conclude that common sense is not the ruling principle. The Magnificent Seven are now almost 25% bigger than the entire European stock market and over 50% larger than the 6,000 constituents of the global small cap index in aggregate. For passive investors, they represent more than a quarter of the S&P 500 index and 17% of the entire global equity market – a huge concentration risk.

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Small caps' time to shine

There are reasons to believe that we could have the “mother of all mean reversions” ahead of us as market and macro dynamics change and the unusually large valuation gap between the two asset complexes closes. As we move into a rate-cutting cycle in 2024, reduced pressure from inflation and borrowing costs could act as a powerful re-rating driver for small caps, particularly for those which are exceptionally cheap compared to normalised earnings power. We are also observing an increasing number of consolidation events as industrial and strategic buyers are attracted by knock-down prices, something evidenced by our fund, SKAGEN Focus, which had three buyouts driving positive portfolio returns at the end of 2023.

On a gross return basis SKAGEN Focus has outperformed the MSCI All Country World Index four years in a row. In 2023, we returned 18% net of fees in EUR. Currently trading at around 9x earnings power and 0.8x book value, the valuation across our fund is attractive, both on an absolute basis and relative to our benchmark. We see an elevated and unusually large 70% upside to our price targets, consistent with the valuation anomalies highlighted above.

We sincerely hope that you join us on our journey to close the Magnificent Gap and capture the alpha opportunities ahead in global small and mid-cap equities.

 

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Historical returns are no guarantee for future returns. Future returns will depend, inter alia, on market developments, the fund manager’s skills, the fund’s risk profile and management fees. The return may become negative as a result of negative price developments. There is risk associated with investing in funds due to market movements, currency developments, interest rate levels, economic, sector and company-specific conditions. The funds are denominated in NOK. Returns may increase or decrease as a result of currency fluctuations. Prior to making a subscription, we encourage you to read the fund's prospectus and key investor information document which contain further details about the fund's characteristics and costs. The information can be found on www.skagenfunds.com. Storebrand Asset Management administers the SKAGEN funds which are by agreement managed by SKAGEN's portfolio managers.

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