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Fund manager Felix Gode is optimistic about the midmarket and small caps in Germany. With his Alpha Star dividend fund, he focuses on small caps with leading positions in their markets. In this guest article, Gode analyzes the situation on the German stock market and presents two stocks from his portfolio.
Catch-up potential for German small caps
The situation on the stock markets has been quite interesting in the first weeks of 2023. Many investors are puzzling over how it is that German blue chips in particular are proving so robust. By way of comparison, since the beginning of the year, Germany’s leading index, the DAX, has risen by 12%, while the U.S. Dow Jones has not even risen by 1%. The broader S&P 500 index is also clearly behind the DAX, with a gain of only 5%. Last but not least, German blue chips have also clearly outperformed small caps recently. Normally, it is the case that the DAX follows the pace set by the US indices. Not so at the moment. So what is the reason for this untypical price behavior?
Short squeeze at DAX companies
Over the past year, we have seen severe dislocations on stock markets around the globe. The reasons for this are obvious. The Ukraine war, inflation, along with rising interest rates, rising prices and shortages in commodities and inputs such as chips. A cocktail that suggested bad things to come. The stock markets have reflected precisely these fears and have gone down in the past year on a scale we have not seen for a long time.
Investors bet on a sharp recession as a result of the multiple challenges, and many market participants also bet precisely on this by taking large short positions on German companies. Cyclical companies in particular were the target. There are plenty of these in the DAX. We now know what has happened on the economic side since then. We are a long way from a sharp recession. At least up to this point. Rather, German companies have coped enormously well with the difficulties, and so the German economy as a whole has also performed valiantly.
The stock markets have been anticipating this development since October, resulting in an unprecedented recovery rally. In addition to the better-than-expected economy, another contributing factor was that it became clear that the rise in interest rates would come to an end in the foreseeable future. This realization, in turn, has been forcing investors to rethink their bets on falling prices for some time now and to stock up again. Since cyclical large caps have been the overwhelming target for short bets, prices here have been rising particularly strongly since October 2022. Small caps outside the indices have therefore lagged behind in terms of returns since the beginning of the year.
DAX stocks still the best choice?
So to a large extent, we are dealing with technical effects. Nevertheless, it remains questionable how the economy will develop in the coming months. Who is to say that interest rates will not rise even further? Perhaps the expected recession will also follow with a slight delay later in the year? The scenario is at least within the realm of possibility.
Therefore, small caps are the right choice in my view. Not only has a catch-up potential been created, small companies also have quite different advantages. After all, small and medium-sized companies are much more often active in dynamically growing areas than broadly positioned large corporations, and these areas are even largely independent of the economic cycle. These are referred to as structural growth markets.
Companies with leading positions in such markets can look calmly to what lies ahead. Whether interest rates rise or fall; the recession comes or not: these companies will be able to continue to increase their profits regardless. That doesn’t necessarily mean that the share prices of these stocks can escape all market turmoil. But it does at least mean that they can hold their own operationally, even when the environment becomes more difficult. This gives such shares the potential to make up for any price setbacks very quickly.
Two strong small caps
Two such examples are the Austrian Frequentis AG and the Berlin software company IVU AG. We are invested in both companies in our Alpha Star dividend fund.
As a result of the Ukraine war, large sums are being invested globally in improving defense. In the course of this, communication systems are also being renewed and brought up to the latest state of the art. Just recently, Frequentis AG was able to announce an order from the German Federal Armed Forces for IT equipment for the national air defense. In the US, Frequentis has only strengthened itself through acquisitions in 2021 and is in a good position to land one or two large orders. In terms of sales, the world market leader for control center solutions should therefore do well in the coming years. The increasing software share has a positive effect on profits, so that we expect gradual margin increases over time. Frequentis’ business is also not dependent on the economic cycle, which is another aspect that should not be underestimated regarding 2023.
IVU AG is also a global market leader: Here, the focus is on software solutions for transport companies, especially rail transport. IVU’s solutions can be used to optimize personnel and vehicle deployment management, as well as operational processes, which saves transport companies money by increasing efficiency. Last but not least, IVU’s solutions also support the energy transition, which will not succeed without an increased expansion of public transport. Due to an increasing share of recurring revenues from cloud solutions, IVU’s profits are becoming more and more stable, making the business more predictable.
Conclusion: Both companies have been looking at constantly rising revenues and profits for many years. The strong market position makes this possible and gives both companies plenty of scope to reinvest profits and thus open up new growth opportunities. Their good market position is thus consolidated year after year. Whatever the stock markets have in store for investors in the coming months: after the anomaly of the past months, with strong blue chips, small caps are expected to catch up. Those who additionally focus on companies in structural growth areas that are market leaders and highly profitable will be well positioned for all eventualities.
Note: This is a guest article by Felix Gode. The opinions of guest authors do not necessarily reflect those of the editors. As a matter of principle, the editor assumes no responsibility, liability or guarantee for contributions by guest authors. This also applies to the charts, graphics, tables, images and all forward-looking statements used by the guest author. This also applies in particular if readers make financial transactions of any kind as a result of these contributions. Investments in the capital markets are associated with a high level of risk. Investors can lose all of their capital – and more. Remember to do your own due diligence! The content of this website is intended exclusively for readers who are permanent residents of Germany. The German disclaimer applies (see below).
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