Small-cap stocks have experienced a renaissance over the last 12 months, with the Small Ordinaries Index returning 26.55% to the end of October. Investors have their sights on a continued small-cap recovery, as the economic storm clouds that have plagued the index finally appear to have cleared after several years of large-cap outperformance.
According to consensus estimates, economists suggest that the recent slowdown bottomed in the second quarter of 2024. This is a good environment for active stockpickers, with the median small-cap manager outperforming in every economic recovery over the last 20 years (with an average return of 37% versus the ASX 100's 20% in these nine instances (see below).
Active managers have historically outperformed in economic recoveries. (Source: Firetrail)
And yet, despite the stellar run in small-cap stocks over the last 12 months, the ASX Small Ordinaries Index remains cheap. That's according to Firetrail's small-cap team, who believe the index is currently offering up the "cheapest growth in the world".
For those not in the know, the Firetrail Australian Small Companies Fund has had a truly stellar 12 months, with the Fund returning 41.67% to the end of October. That's an outperformance of 15.02% after fees over the benchmark - which certainly should not be taken lightly. That said, like many small-cap-focused funds, this outperformance comes after a difficult few years.
Today, the Firetrail team launched its second active ETF, which allows investors to access its Small Companies Fund under the ticker ASX: FSML.
In this wire, I'll take you through the areas the team is finding attractive right now, as well as their favourite stock picks.
Note: These quotes were taken from a media roundtable on Monday 18 November 2024.
Two major themes driving small caps
The return to pre-COVID normality
As portfolio manager Matthew Fist explained, the market has now finally returned to pre-COVID conditions. He recalled JB Hi-Fi CEO Terry Smart's quotes from the company's recent result, where Smart rang the bell on the end of COVID conditions, arguing that the operating environment is the most "normal" it's been since 2019.
"We did see a huge increase in sales associated with government stimulus, consumer savings through that COVID period that then continued far longer than anyone thought it would as consumers ran down their balance sheets and excess savings," Fist said.
"Now, we're really back to a period of normality. What we're seeing out there when we go and speak to CEOs, at shop fronts where we speak to managers, is that high-quality businesses are taking market share from weaker competitors."
This means businesses that are losing market share are struggling to control their costs, as are those that are heavily reliant on wholesale channels. High quality businesses, on the other hand, have focused on structural growth, and have invested through the cycle rather than paying out super profits to shareholders.
Fist points to Beacon Lighting (ASX: BLX) and Kmart, owned by Wesfarmers (ASX: WES), as examples.
China stimulus and its impact on Australian miners and explorers
While Fist notes that it is "amazing" how well commodity prices have held up given the double-digit declines in housing sales in China over the past three years, he believes that the Chinese government's clear messaging is supportive of the outlook for commodities.
"If the stimulus measures that have been announced just in the last month or so aren't effective in seeing a return to house price growth and consumer confidence, then we will see additional stimulus measures," Fist said.
"We believe that would be very supportive for the outlook for a number of different commodities."
This includes the likes of copper, uranium and gold - but the outlook for lithium, nickel and cobalt isn't so bright, he added.
China has developed its own supply chain for raw materials, Fist explained, noting that in a recent trip to China, on visiting a lithium mine (see image below), this truly came to light.
Lithium mine in China - with spectacular sweeping views. (Source: Firetrail)
"[The mine I visited is] on top of a mountain... the strip ratio or the amount of material that you need to mine to get to that lithium given it's on the top of the mountain is zero," he said.
"If we look at a typical Australian mine, that strip ratio would be about 6:1. So, you need to remove six tonnes of earth before you can dig a tonne of lithium, in very simple terms."
While Fist is positive on the demand outlook for lithium, he argues that China's domestic investment in its supply chain, as well as supply growth coming out of Africa and Indonesia, will likely depress lithium prices moving forward.
"We're not going to see the same super normal price spikes and very sharp cycles that we saw previously because there's a wall of supply waiting to come back into the market if prices tick up a little bit," Fist said.
"Australia is becoming an increasingly uncompetitive market in which to invest in resources projects. Many Chinese companies are very nervous about investing in Australia because of the environmental red tape, ESG concerns and just how long it takes to bring mines into production here and the cost associated with it."
Despite that, the team is still finding quality bottom-up opportunities within the materials and mining sector, with Fist pointing to Wildcat Resources (ASX: WC8), Whitehaven Coal (ASX: WHC), AIC Mines (ASX: A1M), Firefly Metals (ASX: FFM), Sandfire Resources (ASX: SFR), Genesis Minerals (ASX: GMD), Amplitude Energy (ASX: AEL) and NexGen Energy (ASX: NXG) as examples of companies the team is liking.
While the Fund doesn't hold any silver or rare earths exposure, for now, they are incredibly bullish on uranium.
"Uranium definitely has the most compelling supply-demand dynamic that I've seen," he said.
"The reasons for that are very simple - the nuclear reactors of the world are burning around 20% more uranium than is being produced every year and it takes a good five to six years to bring a uranium asset online."
Fist dispelled the naysayers, arguing that the current run-up in uranium equities is supported, unlike its lithium peers, in that once you turn on a nuclear reactor, you don't turn it off - so demand is very easy to forecast (it goes up about 1-2% per annum in line with the reactions that are turning on).
"We have high confidence that there's going to be a deficit market in that commodity. Again, the trick is finding high-quality investment-grade companies in the small-cap part of the market to express that view and there's one in our portfolio at the moment, NextGen Energy."
In addition, Victoria's gas conundrum in which many of its gas fields are approaching the end of their mine lives, will have flow-on effects for the entire east coast of Australia.
"There's no miracle coming to save those assets. They will need to be decommissioned and they're declining at double-digit rates," Fist said.
"Gas sets the marginal demand for electricity and at the same time as we're seeing supply go down, we're seeing demand go up from gas power generation as renewables enter the system.
"We will need to, at some point in the future, import LNG into Victoria, which is quite crazy for a country like Australia to be sitting here saying that... As a consequence, we expect the gas price to be higher for an extended period of time and we have that expressed in the portfolio through a couple of different companies, the largest one of which is Amplitude Energy (formerly Cooper Energy)."
Key holdings within the technology, consumer discretionary, and healthcare sectors
Firetrail equity analyst Carta Ryan pointed to Qoria (ASX: QOR), formerly Family Zone, as another of the team's key holdings.
"They're an EdTech safety company. So, in schools in the US, filtering is actually legislated. In order to get funding from the government in the US, you have to have filtering or what we call firewalls in place in their cyber at their schools," she explained.
"Qoria provides filtering and monitoring technology... Teachers are struggling to control what their students are looking at, and also bullying and cyber safety are huge issues not only in the US but globally as well. Qoria is a market leader in that segment - they've got a 13% market share in the US, and just under 40% in the UK. They're quite large in Australia as well, with a 20% market share."
She also noted that the company could be a takeover target, with the five other big players in the EdTech sector all owned by private equity. Additionally, the company could acquire a smaller player to improve its offering.
Meanwhile, portfolio manager Eleanor Swanson pointed to Premier Investments (ASX: PMV) as the Fund's largest consumer discretionary holding and one of its three highest conviction positions - the others being Integral Diagnostics (ASX: IDX) and Genesis Minerals (ASX: GMD).
"Everyone would be aware that Solomon Lew is currently doing a strategic review of the assets in that portfolio. The first one he's knocked off is selling the apparel business, which is the lowest growth part of the business - Just Jeans, Portmans and so on - and combining that with Myer (ASX: MYR)," Swanson said.
"Premier shareholders will own the majority of Myer's equity, so you will be playing in the potential synergies of bringing those two companies together."
This could include the closure of some Just Jeans and Portmans stores and instead having sections for these brands in the Myer store network. Myer is also the fifth-largest e-commerce platform in Australia - which could open up cross-selling synergies at better gross margins, Swanson said.
"In addition, we are also strong believers in the potential of the Peter Alexander and Smiggle brands. We found out recently that they're operating at 30% EBIT margins, which is by far and away the highest EBIT margin of any retailer in Australia. And it's up there with the best in the world," she added.
"As a retailer, that gives you a big buffer if you're going through a tough macro [environment] and if you've got that much margin to play with, you're in a lot better position than a lot of your peers."
She also believes that there's "very little in the share price" for Peter Alexander and Smiggle succeeding offshore - adding that, with this in mind, Premier is a low-risk way to play the consumer discretionary sector.
While position sizes are small across the Fund's two biotech holdings, at around 2% or less weights, Swanson noted that the team is backing Neuren Pharmaceuticals (ASX: NEU) and PYC Therapeutics (ASX: PYC).
"Off the back of Trump announcing Robert Francis Kennedy Jr. (RFK) as his appointment in the US, we are actually seeing biotechs in Australia trade down. I think people are concerned... But we believe that Neuren and PYC Therapeutics will be insulated from what's happening because they're focused on rare disease indications," Swanson said.
"It would be very risky for a politician to try and cut funding to rare diseases. The FDA has done a huge amount of work in actually creating a regulatory framework to incentivize pharmaceutical companies to invest in rare diseases... So, I highly doubt RFK would go after this sector of the market."
Still on healthcare, Swanson noted that while investors are still waiting on approval, a merger between Capitol Health (ASX: CAJ) and Integral Diagnostics (ASX: IDX) could see the combined company become the third-largest player in the imaging space.
"We think the market's under-appreciating the synergies from bringing those two businesses together, but also its growth potential, because IDX has got a really great teleradiology platform," Swanson said.
This allows them to leverage their workforce across Australia, helping with resourcing, she said.
"They're also starting to roll out AI tools across their networks. So, currently, IDX does about 5% of their imaging scans with AI tools. They think they can get that to 10-15% over the next few years."
That would allow radiologists to get through more scans, and focus on higher modality or more complex scans that generate more revenue for a radiography practice.
"You've got structural growth for more imaging volumes as populations age and the health systems get more proactive. But then you've got these other growth levers in AI, teleradiology and then merger synergies as well," Swanson said.
Where the market has gotten too hot
While the team still believes there is opportunity in hot stocks like Life360 (ASX: 360) - despite the CEO selldown, Genesis Minerals (ASX: GMD), Regis Healthcare (ASX: REG), Generation Development (ASX: GDG), Integral Diagnostics (ASX: IDX), and Qoria (ASX: QOR), Fist believes that Netwealth (ASX: NWL) and HUB24 (ASX: HUB) are currently the "CBA's of the small-cap index".
"[They are] fantastic businesses. Those platform businesses have very high incremental drop through revenue to EBITDA and cashflows are growing very strongly and will continue to do so," Fist said.
"Great management teams, but when you look at the composition or the breakdown of the total shareholder return over the last 12 months, it's almost entirely been PE re-rating as opposed to EPS growth."
Fist cannot get his head around the multiples that the market is willing to pay for these businesses - even on the most optimistic DCF assumptions.
"We have very strict valuation discipline. And so for us, other companies look more interesting from a small-cap index perspective right now... We just don't see value in HUB24 and Netwealth," he added.
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Ally Selby is the deputy managing editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your Money, Sky Business and Sky News.
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Ally Selby is the deputy managing editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian...
Ally Selby is the deputy managing editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian...
