Small Cap equities: Volatility creates opportunity

Over the last few weeks, most companies within our European Small Cap strategy have reported their third quarter results and have shared their thoughts and expectations on Q4. As always, investors go through these statements in detail to get a glimpse into the future and try to draw conclusions, if – and how – prospects of the companies and industries they invest in have changed.

At the same time, shorter-term market participants trade the headlines that these earnings releases provide, causing sharp moves up and down in these stocks. It seems to us that the risk tolerance of these participants is lower than it used to be, causing more excessive share price reactions on the day, as they adjust their positions on changing share prices.

For industrial and consumer-facing companies, the key issue during this earnings season was the interplay between raw material cost inflation, component shortages and logistical challenges on the one hand, and pricing power and customer demand on the other. A lot of companies lumped these input challenges together and called them supply chain challenges. This has led to some confusion – some issues are transitory in nature, while others are potentially the start of an inflationary cycle that could last for many quarters.

Signify – A case study

We could have chosen a number of strategy holdings to make the same point. Signify is a world leader in LED lighting and LED lighting solutions. As some of you will know, we’ve been shareholders of Signify for a long time, and even though we reduced its weight in our strategy significantly during Q1 and Q2, we remain admirers of Signify’s long-term strategy and its business.

This is partly based on its excellent supply-chain management. Signify was one of the first companies worldwide to call out the supply chain issues in their Q1 report, and hence, we take their comments seriously.

In our discussion with management, Signify’s CEO explained the main components of the headwinds they face and how the company copes with this. They need to protect margins in the short term, but maintain good supplier and customer relations in the long term.

Firstly, the company notes that raw material prices like steel and copper have increased and the company passes this on to their clients without much resistance – this helps revenue growth and is margin neutral.

Another issue is that certain components needed to make their products are in short supply despite long-term contracts with suppliers. Consequently, the company needs to purchase these components at very elevated prices in the spot market. As this is a temporary and exceptional situation, Signify doesn’t pass these costs on to their clients and takes a temporary margin hit. However, this should normalise over the coming quarters.

And then, there’s logistics – which involves shipping components and finished product in containers from Malaysia and Vietnam to Long Beach and Rotterdam – and partly the intercontinental shipments (by truck) from factories to the distributors. Most market observers think that the global shipping rates will remain elevated for some time, but we believe this will eventually prove to be transitory.

The shipping of product within continents on the other hand will likely remain an inflationary cost, given the structural lack of truck drivers. Consequently, the company is trying to further localise or nearshore supply chains on a continental basis (Asia, EMEA and the Americas) and is adding transportation charges to their customers. ​​​​​​​

Lastly, because the supply chain issues are impacting other industries like construction and general industry, projects have been delayed (but not cancelled). This has resulted in the company missing out on some sales this quarter, but its backlog has increased significantly, which should drive additional sales in the coming quarters as this pent-up demand gets delivered.

​​​​​​​After analysing all this, we concluded that the price increases that a company like Signify can achieve should be more than enough to offset the real underlying cost increases that the business is facing when stripping out the transitory elements. The company also noted that the overall supply chain and logistic issues are actually getting better rather than worse. Given our analysis, we decided to increase our position in Signify.

Like other investors, we too have noted an increase in the ‘shoot first ask questions later’ attitude of the market and the ‘headline trading’ mentality during this earnings season. We don’t have a strong view, if this is good or bad, but given our focus to drive 3-year rolling relative returns, we do want to take advantage of the recent situation, and the recent earnings season surely presented us with some opportunities.

We continue to believe that underlying demand in most sectors remains strong. We think we have chosen companies that have the pricing power to pass on the ‘real’ inflationary components of their cost base, and hence we use the short-term fear of others to add to our core holdings.