Small and mid-caps may rebound in 2019

Graphic By TMR 

2018 was not a good year for the global equity investors due to the volatility. 

As of Dec 12, there were a total of five countries that posted more than 10% losses year-to-date (YTD) in ringgit terms, while only three out of 15 countries under our coverage delivered positive returns.

Malaysia’s equity market, as represented by the benchmark FTSE Bursa Malaysia (FBM) KLCI, marked more than 7% YTD losses, while the local small- to mid-cap sector, as represented by the FBM Small Cap (SC) Index, delivered more than 30% of YTD losses.

The risk-off sentiment has been one of the main factors behind the significant sell-off in the small- to mid-cap space.

Malaysia’s economic growth has slowed substantially in 2018 due to lower external demand amid the continuing trade disputes between the US and China, as well as the commodity specific supply shock which has affected the local economic growth since the second quarter of 2018.

Moving into 2019, we believe the private sector would be the key driver of economic growth as public expenditure is likely to be constrained by the more than one trillion ringgit outstanding government debt.

The China-US trade dispute could continue to weigh on the external demand for Malaysia’s exports.

The healthy consumer sentiment and business confidence are likely to translate into stronger growth in private consumption and business investment next year. Robust global demand for electrical and electronic products (which accounts for more than 20% of the local manufacturing sector) is likely to lend support to the Malaysia’s manufacturing sector in 2019.

Given the expectation of moderating economic growth for the country in 2019, we do not expect broad based growth in the local stock market.

Hence, we believe an active management strategy with decent stock picking skill is crucial in 2019.

By investing into an actively managed fund, the fund manager would overweight sectors with better prospect and underweight certain industry with lacklustre earnings growth, which might eventually result in the outperformance of the fund.

For investors who have been investing in passive fund such as the index-linked funds, you might want to reconsider the strategy moving into 2019 as there’s unexciting earnings growth ahead for the benchmark index due to the challenging prospect for sectors like plantations, telcommunications and industrials, which in total account for more than 30% in the index.

In terms of valuation and earnings prospect, in the short to mid-term, Malaysian equities might not fall under the radar of the global fund managers as there are many more equities market trading at a huge discount with more decent earnings prospects, such as China equities.

We might also see lesser support for index stocks due to the absence of foreign investors.

After registering superior returns in 2017 (+15.9%), the local small-cap sector not only reversed all the gains made in 2017, but posted more than 30% YTD losses as of Dec 11.

However, we believe the performance of the local small-cap sector space was sentiment driven instead of fundamentals.

In term of valuations, the local small-cap sector is now trading at undemanding level of close to -1 standard deviation.

The spread between the FBM KLCI and FBM SC is at levels not seen in more than five years, suggesting an attractive valuation for the Malaysia’s small-cap sector in comparison with the benchmark.

Apart from the fundamental drivers such as the incentives and measures proposed by the government to improve the overall operating environment, and to increase the competitiveness of the small and medium enterprises (SMEs), we want to highlight the calendar year performance of the small-cap sector over the past two decades.

Malaysia’s small-cap sector tend to deliver strong performance following a year of double- digit losses.

Hence, after recording more than 30% losses in 2018 so far, and cheap valuation as government moves to boost the SMEs sector, we believe the local small-to-mid cap companies are likely to outperform the broad market in 2019.

In 2018, the ringgit depreciated more than 3% against the US dollar due to the new political landscape in Malaysia and rise in government debt.

Moving into 2019, we believe the ringgit is likely to trade higher against the greenback mainly due to a less hawkish US Federal Reserve, stabilising crude oil price and increase in foreign direct investment into Malaysia.

In short, we are generally positive in the more private sector driven economy over the mid- to long-term, given the government effort in pushing for reforms.