2 winning stocks (and how rising costs impact those micro caps in your portfolio)

Rising costs have become a major theme to come out of the August reporting season, with both inflation and the soaring cost of capital weighing on companies' balance sheets. 

So which stocks can continue to survive and even thrive in this environment? 

Well, micro-cap managers like 1851 Capital's Chris Stott and Yarra Capital Management's Joel Fleming say they are searching for companies with pricing power - those that are beneficiaries of an inflationary environment, as well as those that are continuing to gain market share and grow their customer base despite the increasingly challenging economic environment. 

So in this episode, Livewire's Chris Conway sits down with Stott and Fleming for their outlook on the future path of interest rates, as well as whether the capital needed by many micro and small caps has dried up. 

Plus, they also name two stocks that can pass on these rising costs, as well as two that will likely continue to suffer. 

Note: This episode of Buy Hold Sell was filmed on Wednesday, 14th September 2022. You can watch the video, listen to the 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. No doubt you've seen rising prices across the board out there, whether it be the $10 lettuces at the supermarket, the ridiculous prices we are paying at the pump, or indeed your energy bills. And with interest rates on the rise, borrowing costs are going up as well.

Today we're here to talk about what the rising cost of capital means for micro caps, and I'm joined by Chris Stott from 1851 Capital and Joel Fleming from Yarra Capital Management. Welcome, gents.

We'll start with the big picture. The market is split on just how high interest rates will go, and there's even some conversation that we might see rate cuts in the back half of 2023. What is the outlook for interest rates? Chris, we'll start with you.

Chris Stott: I think it's certainly an interesting point in time for interest rates. A few months ago we were feeling interest rates could be cut in the early stages of 2023. That's certainly been pushed out, and our expectation is we might see interest rate cuts here in Australia in the later stages of the next calendar year. The bond market's still telling us that rates are going to go up in the short term. Inflation feels like it has peaked, but we have yet to see it. And that will be retrospectively coming through. But certainly, that feels like it's going to be a big catalyst for the equity market to push higher into 2023.

The outlook on interest rates

Chris Conway: And Joel, what about you? What's your outlook on interest rates?

Joel Fleming: Yeah, look, I think they've still got some way to go. Inflation needs to be kept under control. It's appearing. It's a bit stickier than what we would've liked, and I wouldn't be surprised to see interest rates run a little bit harder and a little bit faster than what people currently expect.

Chris Conway: How are you positioning your portfolio with all that in mind?

Joel Fleming: The great thing about microcaps is it touches the full spectrum of the economy. So we have the luxury of investing across the spectrum. Interesting niches, how the world is changing. We've always got optionality there. So we're not managing to an index. And so with that in mind, we're always looking at stocks that we feel the market is undervaluing, have a great growth profile. Maybe they're doing something better, they're growing their customer base, they're creating the market share, and there are always opportunities like that in the micro-cap space.

Chris Conway: And Chris, now for you, how are you positioning your portfolio?

Chris Stott: Very much echo Joel's thoughts there, but looking for companies with pricing power through this environment and beneficiaries of an inflationary environment. So companies like PSC Insurance (ASX: PSI) are one that we own in our portfolio at 1851 Capital that's benefiting from a rapid rise in insurance premiums across various lines at the moment. We suspect that will continue.

So companies that have got strong balance sheets, of course. I think people are underestimating the higher interest costs that are coming through for companies with high levels of debt over the next couple of years. As Joel said, rates will go up a lot higher than we think in the shorter term, potentially. But it's not a time to be overly defensive. Certainly, we're starting to sift amongst some of those consumer discretionary names that will benefit from lower interest rates as we go forward.

Rising costs were a major theme from this reporting season 

Chris Conway: We've just come through August reporting season. What did management teams tell you and were rising costs a major factor?

Chris Stott: Costs were a huge issue. Access to labour was another issue. The common feedback was "we can't get enough people", and wages are going up at a rapid rate, anywhere from 5% to 10% plus, depending on which sector you're in. These were the common themes that really came out of reporting season. The better companies will certainly get through this little next period over the next couple of years in terms of their ability to maintain margins through this rapidly rising cost environment.

Chris Conway: Joel, what about you? What did management teams tell you through the season?

Joel Fleming: One of the interesting things we found is a lot of companies saying, "We've not ever found it easier to push through prices." That's interesting, but at some point, that must stop. And in a lot of cases, it was just the early signs of that inflation starting to creep through. I think this second half of the year is going to be a lot more interesting. At the end of the day, good companies, good culture, they're able to attract people, they want to work hard. And in cycles like this, you can really differentiate yourself and your business model.

Has capital dried up?

Chris Conway: A lot of micro caps and small caps survive on raising capital. Do you think this is now dried up?

Joel Fleming: For good businesses, capital is always available to fund. If you go back six or nine months ago, we were looking at five to 10 deals a day because of the fear of missing out. People want to put money to work. They were not thinking about allocating that capital to a business that's really moving its strategy forward. I think in an environment like this, it's actually positive because good businesses get rewarded. They can continue to go on. Businesses under pressure struggle with their balance sheet because they can't compete as hard and that creates a real opportunity for businesses to grow into these tougher times.

Chris Conway: Chris, what about you? Have the taps been turned off?

Chris Stott: It's absolutely been turned off, and the IPO market looks as though it's going to be one of the quietest years for many, many years in Australia, and particularly in that small and micro-cap space. As Joel said, the better companies that are already listed, secondary raisings are there, particularly at times like now where you do get bear market rallies in times of strength. But we're hopeful as we move forward into 2023 that that IPO pipeline will certainly build, and we'll move forward from there.

2 micro caps set to struggle as costs rise

Chris Conway: What is one micro-cap that you think is really going to struggle as costs continue to rise?

Chris Stott: There's a lot of them out there, but I'd really highlight the retail sector as one, and The Reject Shop (ASX: TRS) is one we think that's going to come under a bit of earnings pressure over the next 12 months with the rapid rising logistics cost that they've got to deal with. It's certainly going to potentially crimp their profit. 

That being said, they've got a really strong balance sheet. They've got over $70 million of net cash. They'll get through it fine and with new leadership there. We're keeping a close eye on it. But certainly in the short term and medium term, those rising costs are going to be very, very hard for them to offset given their lack of pricing power with the customer.

Chris Conway: Joel, rising costs, they can be a killer. What's one stock that's on your radar there?

Joel Fleming: We're on a similar thematic to Chris, the retail sector. They are very good retailers, but Universal Store Holdings (ASX: UNI), I just think their demographics going to come under increasing pressure. Managing inventory in these environments is really difficult and I think that the macro headwinds might just get people caught off guard in terms of the impact on that business.

2 winning stocks as rates continue to rise

Chris Conway: What do you think is one micro-cap that can take advantage of the current conditions and really set itself up for the coming years?

Joel Fleming: I really like Smartpay (ASX: SMP). They're a provider of point of sale for merchants and retailers here in Australia and New Zealand. Really interesting low-cost model. In tough times when you're starting a business or you're looking to switch, that resonates. Inflation is really good in terms of higher transaction values. We've had corporate activity in the sector. It's trading really cheap compared to peers, and I think that's really nicely placed in the current market.

Chris Conway: And Chris, with you, what's one stock that you think is setting itself up well for the coming years?

Chris Stott: We've gone with Atturra (ASX: ATA). It's a recently listed IT services business, trades on seven times EBIT. Empired was a recent comparable, another micro-cap that was taken out 16 times, just over a year ago. So it's doing very well in terms of, it's performed well since its listing. It's got $30 million of net cash on the balance sheet. It's been upgrading its earnings since the listing. So very well managed little IT services businesses off the radar. Not many institutions on the register, not well covered by the stock broking community. So that one stands out for us right now.

Chris Conway: Well, that's all we have time for today. We hope you enjoyed this thematic episode of Buy Hold Sell. If you enjoyed it as much as we did, make sure to give it a like, and also subscribe to our YouTube channel because we're adding great new content every week.

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