Small-cap stocks: big opportunities
FUND MANAGER SAYS ECONOMIC CYCLE HAS ROOM TO RUN
Small-cap growth stocks outperformed t he broader market in 2016, and are poised to repeat that performance this year.
After disappointing in 2014 and 2015, as investors fearing pending interest rate hikes by the Federal Reserve and other macro concerns weighed on risk appetite, things started to change in February 2016. That’s when small caps began to lead the market.
In addition to a general reversion to the mean, whereby this group of stocks trended back toward their historical average, a big factor driving small caps was the strong U.S. dollar.
As Tom Antony, president and portfolio manager at Toronto- based Peregrine Investment Management explains, large cap U.S. multinationals are hurt when the greenback rises because of their often hefty foreign operations. They lose out in the currency translation, while small caps are much less vulnerable because they typically have less international exposure.
While the Canadian small cap universe is often skewed by its high weighting in resources, Antony noted that non-resource small caps tend to trade in sync with their U.S. peers.
The portfolio manager of the Peregrine Investment Management Fund LP, which has more than $ 100 million in assets and was up 17.5 per cent in 2016 as of Nov. 30, also noted that Donald Trump’ s victory in the U.S. election gave the market a boost, but it was going to be a good year for small caps regardless of who won.
“Although Trump’s policies aren’t entirely clear, it’s fair to say that in general, they are economically positive,” Antony said. “The market has certainly focused on the positive — tax cuts, a potential increase in infrastructure spending, and less regulation.”
That’s only part of the reason he thinks the economic cycle still has room to run.
Antony also noted that the Fed is closer to the start of its tightening cycle than the end, while bull markets tend to be brought to an end by re- cessions.
“Recessions are usually caused by high interest rates, and are typically preceded by an inverted yield curve,” he said, noting that rates inverted at about five per cent at the end of the last economic cycle.
Other factors Antony cited in support of his bullish outlook are the tendency for P/E multiples to rise as the economic cycle progresses, and the resumption of earnings growth.
“Earnings growth is back and will likely accelerate next year as the drop in oil prices is no longer a headwind,” he said.
“We don’t know how big the U. S. tax cuts will be, but they should be sizable and therefore increase after- tax corporate earnings.”
As for valuations, while they are slightly higher than average, Antony noted that they tend to be elevated when interest rates are low. It’s also less useful to compare periods when interest rates were higher to the current environment.
Antony’s primary focus continues to be small- cap technology, and the sector makes up 50 to 60 per cent of the portfolio.
Optical stocks helped drive the portfolio’s strong per- formance in 2016, thanks to an impressive run in names like Oclaro Inc., the fund’s biggest holding last year.
Optical communications networks tend to see major upgrades roughly every seven years, but Antony believes it’s getting late in that cycle.
One of his favourite names at the moment is Hudson Technologies Inc. ( HDSN/ Nasdaq), a supplier of new and recycled refrigerants used in cooling systems.
Antony noted that HCFC refrigerants are being phased out starting in 2020, just as CFC refrigerants were phased out in 1995.
“When these phase- outs occur, the price for refrigerant steadily increases as the dominant price- setting in- dustry supplier of new refrigerants looks to maximize the value of its existing inventory, and as industry production phases down, which limits supply,” he said.
The portfolio manager also noted that with industry production of new supply winding down until 2020, aftermarket or recycled refrigerant suppliers such as Hudson become more important.
“Hudson stands to benefit from both rising prices and from higher volumes, as recycled refrigerants gain market share from new refrigerants,” he said. “We believe profit expectations are likely to be revised upwards materially in the future.”
Antony also noted that Hudson is under the radar because it isn’t followed by most brokers, and the company just raised cash, so it’s poised to make one or more acquisitions in the near future.
Another highlighted holdi ng is Cray Inc. ( CRAY/ Nasdaq), which supplies some of the largest and most powerful supercomputers in the world.
It has a dominant market share in the high end of this space, and although Cray recently suffered some technical setbacks with Intel Corp.’s new Knights Landing chip, Antony believes the stock is pricing in sufficient negativity that risk-reward is skewed to the upside.
“Should the issues persist, we believe the company’s strong intellectual property make it an acquisition target by a larger peer,” he said, highlighting Hewlett Packard Enterprise Co.
Acknowledging the stock is volatile, Antony views Cray as a good trading opportunity, but not necessarily a buyand-hold investment.
A BIG FACTOR DRIVING SMALL CAPS WAS THE STRONG DOLLAR