10 May 2019

Over the last year and a half, a paradigm shift has been seen on the markets: for the first time in several years, small caps have underperformed large caps.

So let’s try to explain this phenomenon a little better. What are the reasons for this shift?

There are two main reasons: one is high valuations and the other is the greater component of automatic and passive instruments in exchanges on stock markets.
These select stocks on the basis of momentum and are characterised by speed of purchase and sale. In order to achieve their objective, they focus on indices, and the market liquidity guaranteed by large caps fits better with their investment choices. Price variations are therefore influenced by the logic of this enormous quantity of flows, particularly during phases of upward movement when the large caps, the only possible target for these instruments, tend to outperform the rest of the market.

So what are the portfolio choices and outlook for future performance?

As already partially mentioned above, the most significant aspect of the current scenario is represented by liquidity flows currently favouring large caps. This has been confirmed by the disproportionately high valuations that small caps reached both at global and national level: in Italy, the PIR bubble in fact contributed to sometimes unreasonable multiple expansion.
During this phase, the lack of the “high tide” of purchase flows supporting the small cap world makes selection even more difficult. Now more than ever, mistakes cannot be made, also because in the case of small caps, the stocks are often characterised by low liquidity, and in the event of sale on the market due to disappointing performance, losses may be greater.

What changes for active managers like Kairos, that adopt rigorous stock picking, giving preference to more financially stable companies, with higher valuations and better growth prospects?

The period before stocks reach maturity increases. Whilst previously, thanks to liquidity and the possibility of Stock Market multiple expansion, small caps allowed returns within 12 months, it is now necessary to consider longer time frames before their hidden value is expressed (1-2 years). More generally, however, whilst financial stability is a qualifying characteristic, what is even more important for small caps is the technological break-up profile, i.e. the potential that they may generate thanks to the specific business model or product innovation.

What are your main current portfolio strategies?

The portfolio is composed of both large caps and small caps. The area of dividends and continuity of steady results even with low growth is developed via large caps. Meanwhile, growth is reserved for small caps. It is true that globally, and also on the Italian stock exchange, it is increasingly difficult to identify small companies with growth still unexpressed in stock-market valuations.

However, in Italy, concentrating on the many examples of excellence in industrial areas and made-in-Italy manufacturing, it is possible to pick out attractive stocks characterised by strategic product-innovation projects and international objectives.

Interview with Massimo Trabattoni, Head of Italian Equity.