TOL - 12th Apr, 2023
2 big buys (and why the worst could be over for small-cap investors)
Prime Value's Mike Younger and Yarra Capital Management's Katie Hudson share the opportunities they have identified within small caps.
It hasn't been easy being a small-cap investor over the past 12-18 months. Since December 2021, the ASX Small Ordinaries has nosedived around 18%, while the S&P/ASX 200 (which tracks the country's listed large-cap companies) has posted modest gains over the same time period.
So, where to from here?
Well, having rebounded from a fresh low in March, it could be argued that small caps have reached their nadir, offering far more compelling value than their large-cap peers. Given the recent pause in interest rates, it's also worth noting that small caps typically bounce harder when the cycle turns.
To explore these themes and more, Livewire’s Chris Conway was joined by Yarra Capital Management's Katie Hudson and Prime Value's Mike Younger to discuss whether the worst is over for small caps, where they are finding pockets of value, and which stock they got wrong over the past 12 months.
Plus, for a little bit of fun, we also asked them each to pick one small-cap stock they would go all-in on – but only if they had to, of course.
Note: This episode was filmed on Wednesday 5th of April 2023. You can watch the video, listen to a podcast, or read an edited transcript below.
Edited Transcript
Chris Conway: Hello and welcome to Livewire's Buy Hold Sell. My name is Chris Conway. Today we are very lucky to be joining you from Melbourne, my hometown, as we don't often get to hear from fundies from here. So buckle up because today we'll be bringing you a deep dive into the small-cap market. You'll learn whether the worst is over for small-cap investors as well as some of our fundie's favourite stocks. To do that, we're joined by Mike Younger from Prime Value and Katie Hudson from Yarra Capital Management.
Katie Hudson: We think the worst is over, certainly from an interest rate perspective. We do a lot of work understanding what's going on with inflation and all the data points we're collecting suggest inflation is on the way down. Freight rates have normalised, supply chains are starting to normalise, hard and soft commodity prices have certainly come down and all of that means that we think interest rates are certainly done for now. We'll still see the effect of that flowing through the economy of course.
It's been a tough 12 months for small-cap investors. Is the worst over or are there still risks on the horizon? Katie, we'll start with you.
Is the worst over for small caps? Katie and Mike certainly think so
The one area we are mindful of, where we think we may not be done in terms of the worst being over, is with credit and credit flows starting to flow out. We really want to be careful of companies that rely on capital recycling as part of their business model because we think there's still work to go on that front.
Chris Conway: Mike, what about you? Do you think the worst is over or there's still some risks out there?
Mike Younger: It's possible that the worst is over. I think from an earnings perspective, there are still risks out there. We really haven't seen the effect of the interest rate increases fully flowing through to households just yet. And you've got the fixed rate mortgage cliff, which in the June quarter and the September quarter have got their greatest rollovers happening. So we think that is still yet to manifest in company earnings. But from a price perspective, you've got the Small Ordinaries index down about 20% from its peak at the end of December 2021. And large caps are up a little bit since that time. So price has moved ahead of earnings in small caps. And when we drill down into it, the industrials are actually trading below where they were pre-COVID, which is almost the only asset class where we've seen that phenomenon happen.
We know that small caps rebound harder than large caps do. We also know that markets move up before the economic data bottoms and so that's why I say it's possible.
Chris Conway: Mike, you touched on it there, we'll explore it a little bit deeper. How much value are you seeing in the small-cap space right now?
Mike Younger: Well, the index PE is probably about in line with long-term averages, around 17 times or thereabouts. So that seems okay. The issue is earnings risks are still there, but the great thing about small caps is that you do have lots of pockets of opportunity. And so when we look at our portfolio around a third of the stocks that we own trade on a PE of less than 13 times. So there are opportunities out there.
Katie Hudson: I think Mike's right that it certainly, in terms of where the multiple is, looks interesting.
What's even more interesting is relative to large caps, small caps have had a big risk-off environment. Relative to large caps, they are trading at 20-year lows.
So that relative valuation opportunity certainly speaks to compelling opportunities in the small-cap space at the moment. We are finding a lot of opportunities, particularly in the growth part of the market with risk-off last year and growth selling off. We're certainly finding a lot of opportunities there.
Portfolio duds from the last 12 months
Chris Conway: Let's talk about some clangers. Katie, what was one position in the portfolio that you got wrong over the last 12 months and what did you learn from it?
Katie Hudson: So our worst-performing stock last year was Megaport (ASX: MP1). We had an underweight to the technology part of the market. We had a big underweight to the unprofitable technology part of the market, so we certainly got the sector call right, but owning Megaport proved to be certainly quite challenging. We thought it would prove to be more resilient and certainly, the revenue has - their revenue is very resilient and their competitive position has remained intact.
What we got wrong there were execution issues, particularly about the growth strategy, and that led to some management changes. And I think the key insight there is where you've got a company that's unprofitable and still burning cash, you need a big margin of safety around valuation.
Chris Conway: And Mike, what about you, was there a clanger for the portfolio over the last 12 months?
Mike Younger: For us, Smartgroup Corporation (ASX: SIQ) was one that we got wrong. We liked it for its strong cash generation and defensive earnings stream, and we thought we'd actually get kickers coming out of new vehicle supply normalising and also an efficiency program they're running that's designed to add 15% to 20% to earnings. But what we got wrong there was the timing of that supply chain unwind, which we're still waiting on. And over that time as well, you've had inflation pop up and the impact that inflation's had on their business specifically has been more than we expected it to be. And so that's eaten into profits and eaten into some of these benefits from the efficiency program.
Sectors that are currently looking attractive
Chris Conway: Mike, stay with you. Which sectors look particularly attractive right now?
Mike Younger: We like the travel sector for its strong earnings momentum. We like profitable tech where you've got defensive and predictable earnings growth. And we also liked aged care, which is a bit bombed out at the moment, but we think that there's a catalyst there with government stimulus likely to step up and that should see these companies generating returns on capital that get some way back to where they used to be.
Chris Conway: Katie, what about you? Which sectors look attractive right now?
Katie Hudson: So when we think about the investment horizons, it's probably three or four years. And against that backdrop, we think we're going to be in a low-growth environment. So it's going to be really interesting, I think, to focus on companies that can generate cash, that compound earnings growth and that can take market share. So with a lot of those companies selling off last year, we think there's a lot of opportunity in that growth part of the market. To Mike's point, technology, some of the financials, and we're finding a lot of opportunity there.
Sectors to avoid
Chris Conway: And the other side of that, Katie, which sectors are you avoiding right now?
Katie Hudson: So there's an alarming number of sectors where they're still over-earning and we are really trying to avoid those parts of the market. We think there needs to be an earning step down before we'd be interested. So to call some of those out, retail had a great COVID, they still need to normalise their earnings and come back. Agriculture has had a good few years, conditions have been great, and commodity prices have been great as well. So we think that needs to come back. Health insurance, the banking sector with net interest margins quite elevated. Energy's probably another one to call out. So there's a number of sectors where they're over-earning and which we would continue to avoid, at least in the near term until those earnings reset.
Chris Conway: And Mike, what about you? Some sectors that you are avoiding at the moment?
Mike Younger: Similar to Katie, retail is one we're avoiding. We think they are over-earning and, notwithstanding they might look cheap, there are consumer headwinds that are popping up right now. On a similar theme to that, the auto dealers. We think that car prices and gross margins are still too high, they'll come down. And then the long-term future of that industry is a little bit in question in our mind, just around the effect that the shift towards the agency model has. And then REITs are the other area where again, they have been reset low in share price terms, but you've got a highly geared sector. The cost of funding continues to increase and we haven't yet really seen any valuation rebasing happen.
Two big buys within small caps
Chris Conway: Mike, the million-dollar question, if you had to go all in on one stock, one small cap, what would it be and why?
News Corporation (ASX: NWS)
Mike Younger: Well of course we'd never do this, Chris, but if we had to, it would be News Corp (ASX: NWS). It's a company that has a number of great businesses under the hood. You've got realestate.com.au, which is the world's most profitable real estate portal Move, which is the second-largest real estate portal in the US, and Dow Jones, which includes Wall Street Journal and Barron's Group. And the old school media business that we see as being under pressure, the old newspaper business, that's really only 10% of earnings - actually a bit less than that now.
And so from a valuation standpoint, when we look at where the peers are trading, News Corps is on about a 30% discount on a sum of the parts basis. But the interesting bit is when we strip out realestate.com.au which is traded on a daily basis, we have a clear valuation priced every day there. Stripping that out, the rest of the business, which is two-thirds of group earnings, trades at about a 75% discount to its peer group. And so we think that the risk-reward there is extremely favourable for investors.
Chris Conway: And Katie, what about you? One small cap that you would go all in on?
Sandfire Resources (ASX: SFR)
Katie Hudson: So I'm going to go a bit different. So we have a resources research capability as part of our team. We've added a lot of value in that part of the market. I know some small-cap investors don't cover it, so that's one that I thought I'd call out. Copper is a commodity we're really positive about over the longer term. It should be a beneficiary of the energy transition. And unlike some commodities like lithium, it is trading much closer to its marginal cost of supply. It's difficult to access supply, so that should support the commodity price over time. And with OZ Minerals now under takeover, it's hard to find really good exposure. So we think Sandfire Resources (ASX: SFR) will be a winner there. They've got two really good mines. They've got good long life with those mines. They're a quality cost producer. They've recapitalized the balance sheet and are having board and management renewal, which we think will be positive as well. So copper and Sandfire.
Chris Conway: Well, that's all we have time for today. If you enjoy that episode of Buy Hold Sell as much as I did, make sure to give it a like. Don't forget to subscribe to our YouTube channel because we're adding great new content every week.
If you had to go all in on one stock, what would it be and why?
Katie picked Sandfire Resources and Mike named News Corp, but what about you? If you had to put all your eggs in one basket, what stock would you choose? Let us know in the comments section below.
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Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
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Livewire Markets
Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
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Livewire Markets
Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
Expertise
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