The only constant is change – and the global market is certainly proof of that. As we assess our outlook for the rest of the year, we see several potential changes that could impact international small- and all-cap funds. Here are the five trends we anticipate having the biggest effect – and the ways the Invesco International and Global Growth team is poised to respond.
1. Dry powder could be helpful in a correction
First, there is always the possibility of a market correction, in which case we believe our team would be well-positioned, with double-digit small-cap exposure in our all-cap Invesco European Growth Class, which had 36.94% small-cap exposure at the end of the second quarter.
2. Volatility could reveal opportunities
There is also the potential for volatility to pick up from very low levels. This could be beneficial, as it would increase our opportunity set if high-quality companies were to be negatively impacted by market volatility and come down in price. It could also potentially aid some of our holdings.
3. Higher interest rates could also come into play
We believe we’d be well-positioned in this circumstance, as our small-cap holdings, on average, have net cash – meaning companies could not only earn more money on their interest balances, but could also be competitively advantaged as more-leveraged peers feel stress.
In addition, higher interest rates could be positive for our retail bank holdings. In Invesco European Growth Class, as of June 30, 2017, we owned Israel Discount Bank1. This bank could benefit from faster re-pricing of assets than of deposits.
4. Reporting standards will change for operating leases
Another way we expect the investing environment to change is through the increased attention paid to operating leases. The new International Financial Reporting Standard, IFRS 16, will take effect in 2019. Operating leases don’t typically attract a lot of attention, but they are basically off-balance-sheet debt. The sell side rarely makes any mention of them in reports, but our team has always looked very closely at this element, treating it as debt. With large store portfolios and related leases, the retail sector will be most affected by this change. As of June 30, 2017, we owned only one retailer in Invesco European Growth Class.
5. Fewer analysts may be following small caps
Finally, we anticipate decreased analyst coverage for small caps in the future. One of the key drivers for this is the Markets in Financial Instruments Directive (MiFID) II standard in Europe, which will take effect at the beginning of 2018. Essentially, this directive will unbundle research and trading commissions, accelerating analyst attrition on the sell side – and most likely, causing less attention to be paid to small caps.
Our team has greatly de-emphasized sell-side research, and we have a number of holdings that have zero analyst coverage. Having already addressed the issue of decreased analyst coverage, we consider this scenario a positive for our fund as compared to our peers.
And one item we see as a constant: Takeovers
Despite our focus on areas of potential change in the investing climate, it’s important to consider one thing we don’t expect to change – takeovers. We feel that takeovers will continue to be a positive tailwind for small caps. Not only is private equity still flush with large fund-raisings, but trade buyers are quite active in mergers and acquisitions. We believe this trend may benefit us. We focus on earnings, quality and valuation to seek attractively valued small caps for our investors, and those characteristics should continue to make these companies good takeover targets as well, in our view.