By Anna Pugh, analyst on the Artemis UK Smaller Companies strategy
You may not be familiar with the term ‘asymmetry of outcomes’. But you are likely to be well acquainted with one high-profile example of a trade where the majority of risk was weighted to the downside.
In March 2007, a note circulated around every trading floor in New York and London highlighting a potential issue with adjustable-rate mortgages.
These products, which accounted for 80% of recent subprime originations, offered a low fixed rate for two or three years, before resetting to a payment 30% to 50% higher for the remaining term.
Back then, the average subprime borrower’s mortgage payments consumed roughly 40% of their gross income at the teaser rate, leaving a limited buffer to pay the higher payments once rates reset.
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Yet as the author of a recent blogpost on Groundbreaker noted, the market looked at the reset wall and kept buying. Why?
“Because every participant believed the exit would arrive before the reset,” it said.
“Home prices would keep appreciating and the borrower would refinance into a fresh teaser before the old one expired.” This assumption of perpetual house price appreciation (which averaged about 8% a year between 2000 and 2006, relative to 3% a year in the prior decade and a longer term average of 5%) pushed the balance of risks to the downside.
Unfortunately, the point of the blog is not as a history lesson, but to highlight the similarities between the great adjustable-rate mortgage reset and the financing wall behind the AI data centre build-out.
“How does OpenAI,” it asked, “a company with some $40bn of run-rate revenue, sign $1.4trn of compute commitments?”
“The same way a household with $60,000 of income signed a $600,000 mortgage: because the terms at signing do not require the payment yet, and because everyone at the table – borrower, lender, and the market – believes the growth will arrive before the payment does.”
This is a crowded trade that will be tested as the backlog of contracted compute is converted from 2027.
Asymmetry of outcomes
No one knows how this will play out. But the current environment creates an asymmetry of outcomes – valuations that assume perfect delivery of ambitious growth expectations, with significant downside potential if growth in revenue and cashflow disappoint. You could be right about the direction of travel and still fail to make money on your investment.
I think investors should be looking for companies that have demonstrable track records of cash generation with a preference for low customer concentration and capital intensity, and robust balance sheets that can self-fund future growth.
In our own portfolios this has resulted in the average holding valued on a free cashflow yield of 8%, forecast to have no net debt and to grow its earnings per share at 10%.
Importantly, not only do these characteristics provide a margin of safety, they also offer investors time, increasing the chance of delivering attractive returns over the long term.
What do I mean by this?
Bad news reflected in the price
When valuations are this low, most negative scenarios are already reflected in the price.
Yet what is not reflected in the price is any type of good news. When a lack of optimism (often about the short term) is unfairly applied to a company’s longer-term prospects, any hint of positivity can lead to a sudden lurch to the upside.
You saw it with defence stocks before Russia’s invasion of Ukraine; more recently, housebuilders surged on the news that Andy Burnham planned to resurrect the Help to Buy scheme. (We had holdings in these areas – not because we anticipated these tailwinds. We didn’t. But because we saw a mispriced opportunity where any surprises were more likely to be on the positive side.)
Validating the value approach
The bluntest validation of this approach often arrives in the form of M&A activity.
In the past five full calendar years, our portfolio holdings have been taken over at a rate of nearly five a year, for an average premium of 47.4%.
This trend has accelerated across the market in recent months. Analysis by Panmure Liberum shows 5.9% of the FTSE 250 and 8.2% of the FTSE Small Cap by market capitalisation have been bid for this year (to 3 September).
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I suspect there will soon be a broader recognition of the asymmetry of outcomes across the UK small-cap market. After a prolonged period of underperformance – the second longest and most severe since 1955 – smaller companies have been on a run of outperformance over their larger peers stretching back to March.
Meanwhile the data continues to trend positively. Consumer confidence – the single biggest driver of small-cap performance – reached a two-year high in August.
Risks remain, not just for small caps
Admittedly, some risks remain. Higher oil prices, inflation and interest rates pose a threat to the disposable income of UK consumers to which the portfolio is overweight.
Meanwhile, the Prime Minister and the upcoming Budget add another layer of uncertainty, as rising gilt yields restrict his headroom to deliver growth initiatives within the fiscal rules.
Yet to my mind this bad news looks already priced into UK small caps – and then some. When steadily growing, cash-generative companies with little debt are this cheap, not an awful lot needs to go right for investors to make a respectable return.
Whereas for the highly valued companies on either side of those AI data centre contracts, returns depend on a narrow range of outcomes, with downside risks amplified by leveraged balance sheets. It seems a lot less attractive to invest where so much has to go right to only justify the current valuation.
