Investing in out-of-favour quality companies during periods of trough earnings and trough multiples can present a compelling opportunity for investors, particularly when these companies have demonstrated resilience through challenging economic conditions. This strategy hinges on the principle that these are in fact high-quality businesses and not ‘value traps’ in secular decline.  Temporarily undervalued companies still possess the inherent strength to recover and thrive, offering substantial upside potential if conditions improve, or maybe if they just don’t get worse. In this week’s video Greg Dean offers a compelling view that a subset of the global small companies universe might be in this sweet spot. 

The Case for Quality Companies

Quality companies are characterised by strong balance sheets, robust profit margins, and sustainable competitive advantages. These attributes enable them to weather economic downturns better than their lower-quality counterparts. The problem is that the strengths of the most widely recognised ones, US large (mega) cap tech stocks are just that - very, very widely recognised. That means they now carry significant valuation risk if the tide changes (regulation), they lose a bit of their lustre or just start growing at a strong pace (rather than at a meteoric pace like Nvidia). On the other hand  companies like Royal Unibrew and Euronext were trading at depressed valuations due to temporary earnings declines, but have started to show significant resilience and recovery potential. Royal Unibrew, for example, capitalised on market dislocations by acquiring distressed competitors, thereby strengthening its market position and future earnings potential. Its latest earrings indicate that this is starting to pay-off. 

 Trough Earnings and Trough Multiples

Trough earnings occur when a company's profits are at a cyclical low, often due to external economic pressures. Trough multiples, such as low price-to-earnings (P/E) ratios, reflect the market's scepticism about the company's near-term prospects. However, for high-quality companies, these periods can be temporary. As the market eventually recognizes the company's enduring strengths and earnings recovery, the stock price can rebound significantly.

Resilience in Tough Economic Environments

The recent economic environment, marked by high inflation and rising interest rates, has tested many companies. However, quality companies have shown remarkable resilience. For example, during the recent inflationary period, many small-cap companies managed to maintain or even improve their earnings, despite the broader economic challenges. This resilience is often due to their strong balance sheets, prudent capital allocation, and ability to adapt to changing market conditions. We think small-cap companies, in particular, now offer a unique investment opportunity. Historically, small caps have outperformed large caps over longer holding periods, especially following recessions. The current market conditions, with small caps trading at historically cheap valuations and exhibiting strong fundamentals, make them particularly attractive. Investors can benefit from the size premium, where smaller companies grow faster and offer higher returns compared to their larger counterparts.

Strategic Portfolio Allocation

Considering the significant investments currently held in large, expensive U.S. quality companies due to their market cap and index weighting, we believe it's timely to rebalance some of these gains towards smaller, underappreciated quality companies. This strategy may take a few years to really pay off but it could bolster returns substantially over the next decade, much like U.S. large-cap tech stocks have done in the past. Investors likely have a window of a few years to build a more substantial position. The resilience and positive signs from the last earnings season suggest that starting now could be advantageous. It's important to focus on identifying smaller companies with strong competitive advantages, robust profit margins, and low leverage, which are qualities not typically associated with all, or even most, small companies, especially in the Russell 2000 index. This selection criteria may also present an opportunity for effective active management.