Why investments must be on right side of the digital divide

Portfolio manager explains why it's a stock-picker's market and why nimble firms will last the course

Why investments must be on right side of the digital divide

Forget growth versus value, the key to uncovering potential opportunity in the small-cap space is identifying whether the company is on the right side of the digital divide.

Greg Wendt, equity portfolio manager at Capital Group, believes that in the today’s environment, it’s a stock picker’s market. The pandemic has accelerated demand for certain e-commerce, video content, social media and cloud businesses, but many of the disruptive growth companies that led the market in the last expansion have continued to lead.

He said: “I think it is a bit artificial to describe what we have seen as growth vs. value. We have seen business accelerate for companies on the right side of the digital divide, and those on the wrong side have largely fallen behind.”

The most successful companies anticipate such shifts, Wendt added. “In many respects small companies are better able to do so because their size can allow them to be nimble and quickly adapt to changing circumstances and consumer preferences.”

Understanding the potential of a small-cap firm ($6 billion or less) requires money managers to really getting under the bonnet of the business and, crucially, understanding the vision of its leader.

Wendt recalled how, nearly a decade ago, Netflix reached an early crossroads. The company, which began its life renting DVDs through the mail, decided to split its video streaming business from its DVD rental business, a decision that was hammered by the market.

The company’s shares plummeted, reducing its market capitalization to the point that it became a small-cap company. The split was cancelled and the firm regrouped, growing into the streaming giant it is today with a market cap of more than US$200 billion.

Wendt, who has 32 years of investing industry experience, said: “CEO Reed Hastings had a vision he was driving for. The way he put it, the name of the company is Netflix, not Discs in the Mail’. Smaller companies are often willed to life by dreamers and a key to successful investing in small companies is understanding their dreams, what their potential might be and maintaining patience as the business hits bumps along the road.”

The small-cap space is not without risk, of course. For every Tesla, there’s a failure and a dream unrealized. This means they tend to be far more volatile than their large-cap counterparts. For example, during the first quarter of 2020, the MSCI ACWI Small Cap Index, a broad measure of the global universe of small companies, slid more than 30%, compared with a decline of about 21.4% for the MSCI ACWI Index, a broad measure of the global large-cap universe. But in the second quarter, small caps rebounded strongly, soaring 24.8% compared with a gain of 19.2% for large companies.

Patience, therefore, is a virtue.

“Whenever I make an investment, step one is to make sure I understand why I'm buying a stock and how I think it will be successful,” Wendt said. “And as long as that thesis doesn't change, I will tend to stick with the investment for years. If the thesis changes, or if a stock goes up too fast, I'll sell it. But otherwise I'm pretty stubborn. I try to be patient with growth companies.

“At Capital Group, we have the luxury of truly thinking long term. Portfolio manager compensation is largely based on an eight-year time frame, which is unique in our industry and allows us to be patient investors. This long-term perspective enables us to look ahead to 2030 and invest in some of these small-cap dreamers that could eventually lead the next wave of global innovation.”