An entry point for sustainable SMID caps?

Policies aiming to drive investment in the sustainability transition and adapt to the post-pandemic business environment are generating opportunities for small- and mid-cap firms (SMID caps), which our Natural Capital strategy focuses on.

Valuation opportunity

Over the last 20 years, SMID caps have delivered an annualised return of 6.6%, which is greater than the 4.9% associated with larger companies. What is key to note is that the levels of risk are not significantly different. The MSCI World SMID cap index shows a 360-day volatility of 20%, compared with 19% for the MSCI World. Consequently, SMID caps tend to have a better Sharpe ratio when considered over a longer period.

The relative valuation of SMID caps to large companies has reached attractive levels, increasing their appeal. Historically, SMID caps have tended to be priced at a premium to large-cap stocks, given their attractive growth and returns profiles. This historical premium on forward price-to-earnings multiples stands at approximately 15%. But for the first time in over a decade, SMID caps are currently priced on par with large-cap stocks.

In our view, the outlook for the sectors in which these companies feature heavily is looking brighter, too. One of the headwinds that has been impeding SMID caps is likely to reverse. The response to the pandemic, coupled with a prolonged period of low interest rates, had the effect of boosting large tech companies and accelerating the digitalisation trend. Remote working, for example, was a key development over this period which greatly benefitted tech firms, but layoffs across the sector and declining PC sales indicate that this trend has weakened. Relative to large caps, the information-technology space is 8% smaller in the SMID-cap market, while the industrial sector is 8% larger.

About 50% of the underperformance of SMID caps versus large caps over the last four years can be explained by this sectorial bias. We believe that this headwind is now reversing.

Big trends create opportunity for smaller companies

In this post-pandemic world, governments in key regions are focusing on building resource-efficient, resilient, and competitive economies through a series of legislative initiatives set to heavily influence the broader investment environment for the next decade. These include:

• Strategic independence in key industries, such as semiconductors and advanced digital technologies
• Fighting biodiversity loss, through measures to limit global deforestation
• Decarbonisation to deliver on net-zero commitments by 2050
• Electrification of energy systems
• Preservation of the middle-class. International coordination on tax matters is rapidly increasing and is seen as a way to fight inequalities

Simultaneously, policymakers aim to integrate sustainability into economic strategy, given the vital role of nature in sustained productivity and growth. Recent laws and initiatives which contain provisions for the protection and restoration of natural capital are evidence of this:

• US
  • The Infrastructure Investment and Jobs Act (2021) provides for USD 1.2 trillion in infrastructure spending and represents the largest investment in the resilience of physical and natural systems in US history, including USD 50 billion to protect against droughts, heat, floods, and wildfires  
  • Inflation Reduction Act (2022) includes more than USD 20 billion to support climate-smart agriculture practices, USD 5 bn in grants to support forest conservation, and USD 2.6 bn in grants to conserve and restore coastal habitats
• Europe
  • The Green Deal (2020) represents around USD 1 tn in spending that will in part target the restoration of Europe’s forests, soils, wetlands, and peatlands
• China
  • The implementation of the 14th five-year plan has lagged somewhat due to the zero-covid policy but is on track to be fully implemented. Authorities have called for increased carbon sequestration by ecosystems

These new thematic priorities will likely drive new investment in sectors where SMID caps feature prominently, such as industrials, materials, and utilities. Industrials has the largest weighting in the SMID cap market, accounting for 18.9% of the index. Materials has a weighting of 8.6%, while utilities accounts for 4.5%. This market is therefore well exposed to the new investment flows associated with these legislative achievements.

Natural Capital poised to benefit

The LOIM Natural Capital strategy is also well-placed to benefit from these trends, in our view. It is a SMID-focused, quality-growth strategy which favours industrials and materials.

Industrials firms account for more than a quarter of the portfolio, while companies in the materials and utilities sectors stand at approximately 14% and 9%, respectively. These exposures stand as clear overweights relative to the benchmark’s sector exposures. The strategy is most heavily exposed to SMIDs in the US and Europe, where the transformative policies described above are coming into effect.

The overweights are also firmly aligned with the thematic focus of the strategy. Figure 1 shows how the portfolio’s holdings are highly concentrated in companies that are driving, and are poised to benefit from, four economic revolutions: the circular bio-economy, resource efficiency, zero waste and the outcome-oriented economy. Through active investment, the strategy is targeting SMID caps driving the natural capital theme.

FIG 1. Thematic breakdown: LOIM Natural Capital vs global SMID caps   

Source: LOIM. For illustrative purpose only. Holdings and/or allocations are subject to change.
Portfolio: LO Funds-Natural Capital Reference Index: MSCI World SMID Cap USD ND

Current valuations are presenting an attractive entry point for investment in SMIDs, in our view. Our Natural Capital strategy offers exposure to quality-growth SMIDs in sectors and countries that are well-positioned to benefit from policy-driven capital flows, with a high degree of thematic purity.

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