US small-cap stocks stand to benefit strongly from disillusionment over so-called ‘unicorn’ stocks, as large-scale investors will look to allocate to growth stocks in the face of rising valuations.
Speaking to Citywire Selector, Hatton said unicorns – largely tech companies valued at $1 billion or more before coming to market – had garnered massive attention over the past two years.
However, the market veteran said small-caps were well-positioned to benefit due to the lack of growth in wider markets. This, he said, was already evidenced by high levels of takeover activity in the sector over the past year.
‘After the downturn in 2008, some money was pulled out of publicly-traded small-cap equities and put into privately-traded companies which had been doing well. That was from pension funds and endowments, who have reduced their equity allocations from 60% to 37% over the last 10 years, reducing the demand for US equities.
‘The unicorn bubble is now starting to burst, so people are starting to look at public companies, and it is clear how much cheaper they are relative to the private companies. This should be a help for public companies, particularly those demonstrating strong growth in this low-growth environment.’
Buy-outs in focus
His comments were supported by Jane White, co-founder and president at Granahan, who said there have been eight buy-outs in the small-cap universe, which shows appetite for investment here.
‘Last quarter we had five technology buy-outs, two healthcare, and we also had a bank get bought out. Large technology and medical firms generate strong cash flow, and they are looking for organic growth, but it is a more effective use of their cash to buy small innovative companies, as it reduces time to market for new products.’
White said she expects strategic purchasing to continue, especially given the disparity between private and public valuations continuing to be so high.
‘Last year, private companies were valued at more than twice the average public company based on EV/Revenues, due in large part to private equity and venture firms driving up valuations through their continued capital raising.
‘I think what it does is it prevents companies from coming public because the private valuations are just too high versus the public valuations. This is another driver of the M&A cycle, because it is just cheaper to buy companies that are already public.’
The largest allocation in the fund at present is healthcare, which makes up 41.9% of the fund compared to a 37.7% index allocation. IT accounts for 15.3% against a 20.1% benchmark weighting.
The Vanguard US Discoveries fund returned 51.5% in US dollar terms over the three years to the end of July 2016. This compares to a 35.7% rise by its Citywire-assigned benchmark, the Russell Microcap Growth TR, over the same timeframe.