Portfolio manager Jonathan Coleman discusses why a return to normalcy following the COVID-19 crisis could support small- and mid-cap equities and lead to a broadening of the market.

Key takeaways:

  • We believe progress toward a COVID‑19 vaccine could set the stage for a return to more normal levels of economic activity in 2021 and increased breadth in the markets.
  • We remain concerned about a disconnect between stock performance and fundamentals in the small- and mid-cap markets. We see this disconnect as unsustainable, and we believe investors will focus more on fundamentals as the economy starts to normalise.
  • In our view, investors should focus on companies with strong competitive positioning and sustainable growth potential over the next five to 10 years.

As we look ahead to 2021, we have reasons for optimism, both for the economy and for disciplined growth investing. We have been encouraged by positive clinical trial results for several COVID‑19 vaccines and therapies, and we expect multiple vaccines to obtain broad US Food & Drug Administration approval within the next several months. While it will take time for a vaccine to be widely distributed, we believe the market will react favourably to this milestone as the first step toward a return to normalcy. Additionally, the US Federal Reserve has signaled that it will likely keep interest rates at or near zero for the foreseeable future, and this could provide further support for the economy and asset prices.

Return to normalcy may lead to a renewed focus on stock fundamentals

One of the most noteworthy market trends of 2020 has been the disconnect between stock performance and company fundamentals in the small- and mid-cap markets. Among small caps, we have seen the stocks of money-losing companies outperform those of money makers by a ratio of two to one. We saw a similar dynamic in the mid-cap market, where a few very expensive companies have driven most of the market gains this year. Several factors contributed to this disconnect, including historically low interest rates. Investors also sought opportunities in companies with virtual business models that they believed might benefit from the pandemic — even when these companies were not yet profitable. At the same time, investors avoided stocks they believed might be susceptible to near-term earnings impacts because of COVID-19 without considering their long-term growth potential. Lastly, the resurgence of individual investors “day trading” on low-cost investment platforms such as Robinhood exacerbated momentum-driven, rather than fundamentals-driven, moves in certain areas of the equity markets.

We have argued such a disconnect is unsustainable. In the third quarter we saw signs this dynamic may be shifting, as profitable, moderately valued companies performed better on a relative basis even if they still lagged the broader market. In our view, this improved performance reflected a renewed focus on fundamentals as investors’ attention periodically shifted away from the pandemic.

We will be looking for a continued market broadening in 2021, especially if COVID‑19 fears ease. As investors contemplate a return to normal economic activity, we expect we will see an even greater focus on fundamentals and on a wider range of companies with sustainable revenue and earnings growth potential. In our view, this broadening will work to the advantage of reasonably valued, profitable companies in both the small- and mid-cap markets.

Maintaining a long-term view

While the past year has been challenging, it is worth considering that it is a relatively short period of time for investors with longer time horizons. Rather than pursuing short-term market rotations or trends, we think investors should focus on investing for the long term in companies with sustainable growth potential. These include companies with strong and durable competitive advantages, high returns on invested capital and strong free cash flows.

It is also important to consider what the economy may look like on the other side of this period. For example, we believe many consumers may now appreciate the convenience of online shopping. They may also have fewer brick-and-mortar stores to return to following this challenging period for retailers. As a result, we believe we may continue to see e-commerce grow as a share of total consumer spending.

Above all, we believe that companies innovating to adapt to this environment and position themselves for the future will likely be able to endure this stressful period and demonstrate the resiliency of their business models. In our view, this resiliency will ultimately be rewarded by investors, even if it is not reflected in near-term stock prices. We are confident that 2021 will provide abundant opportunities to benefit from innovation and long-term economic trends.

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