Polar Capital UK Value Opportunities Team

The UK’s small and mid-cap indices have borne the brunt of investors’ unwillingness to hold exposure to a seemingly low-growth domestic economy, impacted by Brexit, the Covid pandemic and the current interest rate environment. However, we believe this negativity is now excessive and that a blanket, macro-driven disregard overlooks stability on the ground among select corporates, as well as updated UK growth measures, and risks ignoring attractively priced opportunities further down the market-cap scale.

In terms of valuation, the FTSE 250 is currently the cheapest it has been versus the MSCI World Index for 10 years. UK small caps are trading at a significantly lower relative valuation to the wider UK market than they did in the financial crisis¹ and the MSCI UK Small Cap Index is on a P/E of 15x against 20x for the MSCI World Small Cap Index².

Mind the valuation gap

However, despite these attractive comparators we do not believe valuation alone is a sufficient catalyst to unleash upside and we suspect it takes a breakdown in headline, underlying issues to close the UK valuation gap.

First, while services inflation in particular has been stickier in the UK, it has started to fall, meaning the UK’s inflation trajectory now looks a lot closer to the rest of the world and is losing its status as an outlier.

Second, labour availability is improving, driven by net migration, older people coming back to the workforce and evidence of some on long-term sick leave returning after Covid. As such, we are confident this improved trajectory for service inflation should continue. Third, the UK economy also appears to be stabilising. The IMF now expects the UK economy to avoid recession in 2023 and has upgraded its growth expectations for the year from 0.4% to 0.5%^3,4. We think the narrative has changed and is still not reflected in valuations, giving scope for a material rerating.

Most importantly, many smaller companies are in good shape, with strong balance sheets and resilient competitive positions within their industries. Increased M&A activity this year targeting UK small caps demonstrates corporate buyers are recognising this and see value at this end of the market.

As we take a step back, we think the significant headwinds of the past two years are unlikely to repeat. The UK’s interest rate trajectory has been a factor that has dwarfed virtually all other drivers, but another c525bps hiking path over the next two years (in line with the rise over the past two) looks extremely unlikely. Any outsized drop in inflation beyond market consensus should lead to falling interest rate expectations and positive small and mid-cap performance.

Melchior European Opportunities Team

European small and mid-cap stocks have faced a perfect storm over the past two years. The stock universe has been the lightning rod for the multitude of concerns that have weighed on European equities over this time, notably the inflationary spike of 2022-23 and the most rapid tightening in monetary policy for a generation which, together with the shocks of war and the energy crisis, raised recessionary fears across the region. Small and mid-cap companies are generally perceived to be more indebted with a higher weight of floating debt and therefore more vulnerable to rising rates. While this may be true, it is not universally the case. The Melchior European Opportunities Fund has an average net debt/EBITDA of 0.8x (ex-financials), just over half that of the MSCI Europe ex-Financials Index (1.5x), with almost 30% of the portfolio holding net cash.

This backdrop has seen European small and mid-caps fall dramatically out of favour with investors, with the MSCI Europe SMID Cap Index underperforming the MSCI Europe Index by over 22% from its relative peak in September 2021 to the recent trough in October 2023. In relative terms, this is greater than the 21% relative peak to trough decline during the global financial crisis (GFC) and dwarfs the underperformance seen in other periods of market turbulence (for instance, the 7.6% relative fall during the crash at the onset of the Covid pandemic). The result is that European small and mid-caps have derated significantly and now trade at their largest discount to European large caps in the past 20 years; greater than in the depths of the GFC.

While valuation metrics suggest an attractive entry point for medium-term investors, valuation alone is rarely a reliable gauge for timing a market turn. What will turn the tide? Looking back, the downturn began as inflation accelerated in late 2021 and rate expectations started to shift higher. Reviewing the past quarter century, one can see that until now there have been five cyclical inflation cycles and, in each case, the peak in inflation coincided within a few months with a trough in the relative performance of European small and mid-caps.

The exception has been the current cycle, where the underperformance has continued for a year after peak inflation in 2022. We believe this is due to monetary policy continuing to tighten and rate expectations rising over the subsequent 12 months. With European CPI now falling below 3% and growing evidence that we have reached peak rates, the sands may now be shifting. History would suggest this is a more productive environment for European small and mid-caps at a time when much of our investment universe is on sale.

Polar Capital European Forager Team

Market volatility, brought on by the war in Ukraine and knock-on effects on company earnings, has held back European small caps in particular in recent years. High levels of inflation and the prospect of a looming recessionary environment have sent equity investors into large-cap indices meaning companies lower down the cap scale, which have historically traded at a premium to their larger peers, have touched a near 20-year relative discount in 2023⁵.

While European markets attempted a rally earlier this year, led by quality growth names, particularly among luxury brands, as hope of a spending boost from China’s reopening lifted the likes of LVMH and L’Oréal, there has been reluctance to look beyond large caps in the face of stubborn inflation and deteriorating financial and macroeconomic conditions, in spite of good long-term growth dynamics, well-managed balance sheets and undemanding valuations among smaller companies.

However, we still see positive catalysts for change ahead, chief among which is a fall in eurozone inflation to 4.3% year-on-year in September, from 5.2% in August. Inflation in Europe has stayed higher than the market originally anticipated but is now on a downward trajectory. The European gas spot price is now below levels last seen before the onset of Russia’s invasion of Ukraine and electricity prices have fallen as well. While uncertainty remains as to how long the more stubborn elements of inflation such as wage growth may linger, and whether macro-economic conditions may deteriorate even further, it is our view that ultimately the easing of inflation will lead to easing financial conditions and a better economic backdrop.

Nevertheless, we believe the current environment presents an attractive opportunity to buy attractively valued, high quality smaller companies with resilient business models and defensive earnings that can weather the storm, or even more cyclically exposed high-quality businesses with strong balance sheets trading at valuations already discounting a very gloomy scenario.

This is not lost among European companies’ share buyback programmes, which have risen to multi-year highs⁶. As in the UK, lowly valued firms with solid characteristics could well be takeover targets for US buyers holding a strong dollar and, even if not, companies are using cash to retire stock at depressed valuations themselves.

In general, the strategy tends to invest in a large and comparatively under-researched small-cap universe, as the European smaller companies landscape has many niche market leaders and national champions for those who wish to look. The competitive landscape for these companies is ever-changing; there is a constant buzz of corporate activity and numerous structural trends and themes at play. The high valuation dispersion we see, with a significant disconnect between the valuations of modestly growing, high quality but lesser-known smaller companies and their larger, more liquid peers creates a rich environment in which to forage for ideas. We remain positive on the outlook for such companies in light of what we hopefully see as a much more supportive environment leading into 2024.

Polar Capital Japan Value Team

It has been our view for some time that the most significant growth driver for Japanese equities will be the steady adoption of structural corporate reforms. These have intensified in 2023, primarily through the Tokyo Stock Exchange’s (TSE) call in January for firms trading below book value to show how they plan to rectify the situation through capital improvement initiatives.

Given Japanese companies currently sit on a cash pile equal to 17% of the market cap of the TOPIX Index versus 4.5% for S&P 500 constituents⁷, increased investor engagement and adherence to the TSE reforms will likely lead to bigger buyback programmes and more committed dividend policies.

However, even with valuations rising alongside equity prices over the past year on the back of renewed faith in the reform rollout, the Japanese market is still attractive on a historical basis and when compared to its developed market peers. While the US trades on 19.1x forward earnings and the MSCI World Index sits on 16.9x, the MSCI Japan Index is currently on 14.5x⁸. This difference is greater still further down the cap scale, with the MSCI Japan Small Cap Index on 14x⁹.

While the quick money responded to the TSE’s pointed finger and Covid reopening positivity by allocating to Japanese large and mid-caps, flows into small caps have seen less fervour. This is where we see the greatest opportunity as smaller businesses tend to be the worst offenders in terms of wallowing book values, allowing for greater recovery potential. Another factor is the lack of analyst coverage among the market minnows. Taking the whole Index into consideration, almost 80% of TOPIX-listed stocks are covered by fewer than 20 analysts, compared to just over 40% for the FTSE All-Share and under 20% for the S&P 500¹⁰. This coverage drops off as firms get smaller, presenting significant mispricing opportunities at the foot of the cap scale.

Should foreign investors decide to increase allocations consistently, they are likely to be joined by domestic corporates buying back at increasing levels, a central bank and Government Pension Investment Fund who show no signs of reducing their Japanese equity exposure and retail investors taking advantage of an improved Nippon Individual Savings Account (NISA) system. The result is a likely tailwind for shares in general, particularly those further down the cap scale as confidence in reform follow-through grows and interest moves beyond the biggest index names.

As such, we continue to look for value among mid-cap and smaller names exhibiting the characteristics set to benefit from the TSE’s reforms and more robust domestic demand. The scope for long-term change here reaffirms to us that Japanese equities now represent some of the most attractive opportunities for some time.

Polar Capital Healthcare Discovery Team

The narrative in the healthcare sector has most recently been dominated by developments in weight-loss drugs among large-cap pharmaceutical firms. In August, Danish company Novo Nordisk published positive clinical trial results for its weight-loss drug Wegovy, providing a significant catalyst not just for its own stock but for other companies with similar assets in late-stage development for obesity, notably Eli Lilly. The market’s excitement around these few potential beneficiaries was underlined by the flight of capital away from companies providing products that currently help treat obesity, such as weight-related technology and equipment used in bariatric surgery and sleep apnoea, and small-cap healthcare stocks.

The result is small-cap healthcare now sits in the 15th percentile in terms of performance, against the broader Russell 2000 Index. With valuations depressed, the sector has dropped below the one standard deviation line, suggesting room for a recovery in the near term.

Moreover, as the initial exuberance around the weight-loss theme retreats, we believe it is increasingly clear that the market has quickly applied a simplistic binary lens, especially among medical device firms, creating mispriced high-quality opportunities for those investors with a more discerning eye. We continue to assess opportunities where smaller companies have potentially been unfairly or rashly dismissed in a rush to take part in the weight-loss theme. More broadly, the sector’s price-to-sales ratio has retraced back to levels last seen in 2016, presenting potentially valuable buying opportunities for active investors looking beyond the current narrative.

We remain constructive on the sector and find support in the fact it displays low levels of economic sensitivity and is currently seeing an above average level of M&A. As such, these low valuations are piquing the interest of firms within the sector itself, with dislocations presenting takeover opportunities.

As the market digests the long-term trajectory for weight-loss beneficiaries and pragmatism prevails, we believe interest will turn back to businesses away from the current crowded trade and attention will turn to high-quality firms currently being ignored.