By Cliona O’Dowd
Recession and geopolitical risks have driven flows into large US stocks, and investors are shunning small caps in the process, WAM Global says.
But falling interest rates should provide the catalyst to broaden returns, it believes.
Following the greatest concentration in the top 10 stocks in the S&P 500 on record, small caps are primed to outperform, narrowing the valuation gap, WAM Global lead portfolio manager Catriona Burns told shareholders on Wednesday.
“The main factor with that small discount has just been huge uncertainty around recession risk and geopolitical risk, and it’s driven money into more liquid large caps,” Ms Burns said.
“As interest rates (move down), we may go into recession, we may not. If we do, that’s the natural part of the cycle but typically, even if small caps fall into a recession, they rally hardest as you come out the other side. So I think as interest rates come down, we’re going to get the catalyst to broaden out returns.”
With small caps already at such a discount, Ms Burns said it was a good starting point for them to start to outperform, bringing the valuation gap back to more historic norms.
The MSCI World SMID Cap Index is currently trading at a 12 per cent discount to the MSCI World Index, but this presents opportunities in the global small to mid-cap sector, Ms Burns said.
The small and mid-cap index has outperformed its large-cap peer in recent weeks.
The investment portfolio of WAM Global, one of Wilson Asset Management’s listed investment companies, rose 15.4 per cent in the 2024 financial year, beating the MSCI World SMID Cap Index’s 9.7 per cent. The portfolio is “significantly underweight” on the so-called Magnificent Seven of US tech stocks, and does not expect any benefit from the rally in these stocks in the second half of the year.
Pointing to the shift in tech large caps from “capital light, high-margin software businesses, to more capital intensive” businesses, portfolio manager Nick Healy questioned the returns outlook in this segment of the market.
“The capex on Microsoft, Google, Meta and Amazon is just increasing really significantly, and that capex will come with depreciation. So there’s a potential issue around both the margins of these businesses over the next few years, as well as the returns on capital, because they are just deploying a lot more capital going into the future,” he said.
“If we combine Google, Microsoft and Amazon’s capex, next year we expect it to be around $200bn. In 2019, so the year before Covid, it was close to $50bn.
“That’s just a significant increase in the capital intensity of these businesses. And when prices go up, expectations are higher, so you need to keep delivering that earnings growth.”
WAM Global will pay a fully franked final dividend of 6c per share, bringing the full-year payout to 12c per share, fully franked.
WAM chairman Geoff Wilson earlier this week blasted federal Treasurer Jim Chalmers for making “pathetic and disappointing” comments about the Reserve Bank’s efforts to tame inflation.
Speaking to The Australian on Tuesday, Mr Wilson said the Treasurer’s move to declare the RBA was “smashing the economy” with higher rates was “appalling behaviour”, and that the central bank’s job was made harder by the federal government’s stimulatory budgets.
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