Is it too early for investors to buy the dive?

Is it time to buy the dip? You may think it’s too early to ask that question – and I would be inclined to agree – but that has not deterred investors from asking it.

Given the pullback in U.S. markets (the S&P 500 has fallen about 18 percent year-to-date, and the technology-focused Nasdaq even steeper 30 percent), the urge to either “buy the dive” or change strategy may be understandable.

Yet very sensible people warn that this is just the first phase of the bear market, while further tightening threatens. Now that the foam has been blown by the valuations, the next risk is that the company’s earnings will fall short of analysts’ expectations – particularly worrying for cyclical stocks as consumers and businesses tighten their wallets – leading to a further leg down.

Nevertheless, I was fascinated to read that small-caps and value stocks in the US have already proven popular with investors.

Here in the UK there is not much “dip” to buy due to the quaint sectoral composition of the FTSE 100 (very little technology but lots of big oil, big miners and banks). Total returns including dividends have only fallen by about 2 percent year-to-date, though the dreaded “earnings recession” could change all of that.

That’s a different story for British small-caps. Total returns on the Numis small business index have plunged 18 percent over the same period, and even steeper 26 percent on the Numis Aim index.

Stock market academics Paul Marsh and Scott Evans at the London Business School, which compiles the Numis indices, note that small-caps have historically done poorly in interest rate-tightening cycles and recessions. But in the long run, they tend to do better.

Although Professor Marsh diligently avoids getting into forecasts, he himself wonders if this sale in small caps has been exaggerated.

Tempted? Aside from my regular monthly investments in my stocks and shares, Isa, the only dip I intend to buy now is one that you will earn with crudités.

But as inflation rises, I become more eager to use some of the cash reserves I have built up, and like many private investors, I am willing to take a long-term perspective. Could it be time to put some select UK small cap shows on my watch list?

I have to admit I have a nostalgic love for the low end of the UK market. I covered lots of small-cap and Aim-traded companies on Investors’ Chronicle 15 years ago; the attraction of getting into the next big thing at the bottom had a special appeal to our stockpicking readers.

Deteriorating economic conditions will be more challenging for this sector, but at the inventory level, some companies may prove to be stronger than others.

Choosing individual stocks, however, is high-octane investments. You have to be prepared to do tons of research, and even then you need a well-diversified portfolio – you will depend on a few hoped-for winners to compensate for the inevitable catastrophic losses.

Risky, yes – but without a doubt a much more fun way to lose your money than investing in crypto! There is a dwindling amount of professional research, but investors can get their heads around the company’s business model by attending general meetings and meeting management teams, where they have a great chance of actually getting to ask a question.

In addition, some Aim-traded companies benefit from inheritance tax exemptions if held for more than two years, which increases their appeal to older readers.

Given the pitfalls, this is an area where it makes more sense to outsource the tension to a specialized fund manager.

One manager who confidently predicts a return to a stock pick market is Katie Potts of the Herald Investment Trust, which specializes in small-cap technology and media stocks.

“There are few periods in the financial cycle where fund managers can predict the company’s profits better than themselves [the companies themselves] can, ”she says. “We see a lot of different management teams and can quickly see the significance of changes across the board, whether it’s payroll costs or who’s smart enough to have contracts with prices linked to RPI and who is not.”

One of the trust’s biggest sectors is software – which Potts claims is more defensive than it may first appear due to recurring revenue from companies with leases and maintenance contracts. But the tightening labor market could be an opportunity for growth: “There is an even greater incentive to automate – and it requires technology.”

When looking at factors to avoid, small businesses with high debt levels look particularly vulnerable in a recessionary environment where interest rates are rising.

Gervais Williams, an experienced small-cap manager at Premier Miton, says investors need to be wary of smaller companies that are negative about cash flow.

“We’re going to see the strong overtake the weak,” he predicts. However, this also provides opportunities for smaller businesses that generate excess cash, which could gain market share or retrieve the aftermath debt-free from administrators.

Another major concern is how well consumer-facing companies are positioned to hold on to current profit margins. In his meetings with management teams, Williams relentlessly asks them about customer service surveys: “Those who do not know the answers stand out”.

John Lee

You too can become an Isa millionaire

And then there’s the “Lord Lee strategy” – taking an ultra-long view of select small-caps (and dividend earnings while you wait) in the hopes that they’ll eventually be taken over for a significant prize.

At present, £ 120 million of the Herald Investment Trust’s portfolio is under the hammer (including healthcare maker EMIS Group and FTSE 250 publisher Euromoney), and Potts says private equity money drives a good chunk of it.

“The valuation is coming down to a level where traders and private equity appear to be very aggressively on the hunt,” she adds.

One last lesson from my Investors’ Chronicle days. Small businesses tend to have wider bid / offer spreads, and some can be relatively illiquid – we used the term “lobster pots” as it can be easy to get your money in, but much harder to get them out again.

You may not be ready to make some great deals, but if you are sitting on cash, it will be harder to be patient as inflation continues to rise.

So far this year, my investments have had a very domestic theme. I have paid to extend the lease on my apartment (another column will follow later) as well as expenses for the maintenance of the home, replacement of all kinds of things now, which will probably fall out within a few years, at which time the price of repair or replacement of it will have increased.

My husband’s best investment idea? Bought six months of wine when Waitrose had its last 25 percent discount. Predictably, buying this “dip” turned out to be a fake economy, albeit a very enjoyable one.

Claer Barrett is FT’s consumer editor: [email protected]; Twitter @Claerb; Instagram @Claerb

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