Small & Mid caps and tech: the dislike continues

The last few weeks have been turbulent for the financial markets. The resurgence of banking risk in the wake of the Silicon Valley Bank bankruptcy (in California, USA) has stopped flows into small and mid caps. This has also highlighted the pressure points, particularly in real estate and technology stocks, which are traditionally two market segments that are more sensitive to rising interest rates. Some analysts have already predicted a new financial crisis. This is unlikely, from our point of view. But it is clear that the high interest rate and high inflation environment is challenging the business models of many companies (especially the financial sector, which is facing a major profitability challenge). Not all sectors can boast as much pricing power as luxury goods. Brands like LVMH, Hermès, Ferragamo (which will sooner or later be the subject of a takeover bid) or Moncler are able to increase their prices almost every year. The flows will logically recycle to these assets. On the other hand, many assets suffer from a dislike that is often partly exaggerated. These are the cases of small & mid caps and tech.

Small and mid caps.

The underperformance of this market segment can be explained by a combination of factors: a strong domestic bias of companies (with a majority of their activity exposed to the European market), the fear of the liquidity crisis (which encourages investors to fall back on the most liquid stocks possible), thematic rotation (healthcare and energy were at the heart of investors' attention in 2022 and this is less the case now) and the search for stocks with strong pricing power (some small & mid caps have it, when they are at the top of the range and well diversified internationally, but it is clearly not the majority). As a result, many of these stocks are now heavily discounted. Investing in small and mid caps means taking a long-term approach. It usually means finding good growth stories at the beginning of their life, poorly or not at all valued, whose potential will be expressed gradually. Let's take the example of Teleperformance. The group was created in 1978. It only entered the Paris CAC 40 index in 2020. In the meantime, the company has become the world leader in customer experience. In addition to the development and growth potential of the small and mid caps, there is also a high level of M&A activity. For example, in 2022 alone (which was not a good year), there were 32 public offers for the shares of companies listed in France, compared with 43 in 2021. A large proportion of the transactions were initiated by the company itself (in this case we speak of a public share buyback offer) or by the company's reference shareholder (in total 29 transactions). In this case, the median premium offered to shareholders is 30.5% compared to the last stock market price before the announcement. Sometimes, it goes well beyond that (100% premium for Tivoly, which is the leader in electroportable accessories). On the other hand, it is always advisable to avoid companies in this market segment that use ultra-dilutive financing, such as convertible bonds (this is typical of the biotechnology sector, for example). These financings are real traps for small investors (sharp drop in share price, impossibility to exit if liquidity is low).

Tech

When it comes to tech, the choice of investments is limitless. There are good and bad surprises (for example, Richard Branson's satellite launching company Virgin Orbit filed for bankruptcy protection in the US due to lack of access to sufficient funding and was forced to cut 85% of its workforce). However, there are some sectors that are doing well in terms of fundamentals in tech, such as cloud companies (ServiceNow, Crowdstrike, Snowflake, Qualys to name just a few well-known names or the company Softwareone that went public on the Zurich stock exchange in 2019 etc.). In recent months, investors have strongly disengaged from this niche - often wrongly. Companies in the sector are generally flush with cash. It is clear that rising interest rates have weighed on their valuation multiples. However, the levels reached allow them to earn a good return on this cash. Moreover, since they have a lot of cash, they do not need to call on banks (which is not the case, on the other hand, of their unlisted private equity competitors). Moreover, these companies still have high growth rates and they provide their clients with tools to do more with less. Four other arguments can be added to explain the sector's interest: valuations have already fallen sharply in 2022 (sometimes reaching historic lows), they have substantial free cash flow (negative WCR, low capex needs), they are companies at the heart of the adoption of generative intelligence (chatgpt type) and they have massively reduced their cost base last year, which will logically lead to a strong increase in profitability this year.

Unless there is a massive macroeconomic downturn - which is not our central scenario - it is hard to see how there could not be a more favorable flow adjustment for these business segments, which have suffered a lot since the beginning of the year (already in 2022) and even more so since the beginning of the banking stress. For asset managers (who are still important market players), the spectre of the crisis seems to be far behind us.