UK smaller companies and China could prove fertile ground for bargain hunters

And as the growth vs value debate rumbles on – investors could be better served seeking quality

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With the MSCI World down 13%, year to date, it could be a moment to look at whether selective opportunities are appearing. There has been some stabilisation in markets over recent weeks and the thin trading over the summer may provide time for reflection.

David Coombs, head of multi-asset investments at Rathbones, says he has become slightly more positive in recent weeks: “A lot of the Federal Reserve’s work is done and rates may not rise as high as expected, […] the global economy has experienced a massive shock and it is trying to get itself back into equilibrium. If you look a year or two out – and as long as there are no more Covid variants – the economy might start to stabilise, even if the next 12 months are quite wobbly.”

His view is that there are still too many imponderables in the obvious recovery sectors such as hotels or leisure.

Investors should instead be looking at areas where the long-term growth trajectory appears to be intact, but where valuations have been hit hardest.

Bad news priced in

With this in mind, it is worth a trawl of the weaker sectors in the recent market volatility.

Over one year, the obvious laggards are China/greater China, UK smaller companies and emerging markets. Asia Pacific and Japan have also been tepid, whereas some of the laggards in recent years – UK equity income, Europe – have significantly caught up and do not appear to offer the obvious value they did a year ago.

The performance of Chinese stock markets has been dented for well-documented reasons: the pursuit of a zero-Covid policy, regulatory intervention in some sectors, the de-listing of certain stocks from US exchanges.

However, in the very short term, there appears to have been a shift in investor sentiment: the Financial Times reported that offshore investors using Hong Kong’s Stock Connect trading scheme bought a net RMB 28bn ($4.2bn) of mainland Chinese equities in the week commencing 30 May.

Amundi, in its latest Global Investment View, has made more bullish noises on China: “Most of the bad news is priced in: an economic rebound, coupled with more benign regulation, should pave the way for a rebound in H2.”

The CSI 300 has gained 7% from its low of 3,909 on 6 May. There are other signs that the sector may be turning.

From all-time wide discounts to net asset value, the Baillie Gifford China Growth trust has seen its discount halve (from 10% to 5%) over the past two weeks. The JP Morgan China Growth & Income trust has seen a similar, if less dramatic, move.

If investors believe in the long-term growth of China, this may be a moment to re-examine the sector.

Quality over quantity

UK smaller companies should also be a happy hunting ground for investors. Admittedly, the sector saw an astonishing run from April 2020 to March 2021, but it has been significantly knocked back, largely on concerns over the UK economy.

This may be well-founded, but many smaller companies managers report that the operating performance of the companies they hold remains strong.

There appear to be some attractive discounts on offer, particularly among those smaller companies trusts with a quality bias: the Abrdn UK Smaller Companies growth trust, for example, has seen its discount narrow a little, but it remains at almost 11%, against a long-term average of 6.6%. Montanaro UK Smaller Companies remains at a discount of almost 15% compared to a long-term average of 2.5%.

In its most recent ‘Factor Views’, JP Morgan Asset Management said the quality factor looked “particularly interesting” – pointing out that it is nearly as cheap relative to its own history as value, an inflationary environment should favour quality companies, and those companies should also be less challenge at a time of slowing economic growth.

In a recent update, Charles Montanaro, chairman and fund manager at Montanaro, said: “The first quarter of 2022 was almost as bad as the Covid bear market, Brexit and the EU crisis before it.

“Looking at quality compared to the market, it has fallen almost 20% since 2020. This is a significant rotation out of quality […]. But when you have such a strong negative quarter, the next few periods tend to be considerably better […] valuation is now becoming more interesting and is not significantly different to the lows of Covid in March 2020.”

Emerging markets are another weak spot, though this is largely because China became such a dominant part of the index that its falls dented broader emerging markets. Brazil’s strength, on the other hand, barely registered.

While the prevailing view is that emerging markets tend to do badly when US interest rates are rising and the Dollar is strong, others have pointed out that emerging markets are already further through their rate rising cycle (Brazilian rates are now at over 12%, for example) and may be close to cutting rates.

Emerging market equities look cheap on most measures, but investors may continue to be deterred by the broader risk aversion in markets.

While few believe the worst is over, some value is emerging. This sell-off has been unusual in that some of the assets that have sold off dramatically still appear to have healthy future growth ahead.

Canny investors will be re-examining the last 12 months’ most unfashionable areas to see whether any bargains have emerged.

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