Is the worst over for small caps?

In short, no. Fund managers believe that while the velocity of the sell-off may be over for now, investors should brace for continued market turbulence over the year ahead. 

Since the beginning of the year, the S&P Small Ordinaries, the benchmark index used by many small-cap investors, has slid nearly 9%, after returning around 14% in 2021. 

And while many of our readers' favourite smalls are bleeding red in 2022 - think notable names such as Zip Co (down 62%), Life360 (down 42%), Megaport (down 31%), Poseidon Nickel (down 23%), and EML Payments (down 22%) - our experts don't believe you should be running for the exit just yet. 

In fact, Hayborough Investment Partners' Ben Rundle and 1851 Capital's Martin Hickson have been picking through the debris of the sell-off in search of a few unloved winners at a discount, and also have a number of inflation-proof small-caps in their back pockets for the months ahead. 

In this episode, Livewire's Ally Selby sits down with Ben and Martin for the small caps they are backing in this new market environment, why they think there is more volatility on the horizon, as well as two stocks they would recommend investors steer clear of in 2022. 

Note: This episode of Buy Hold Sell was shot on Wednesday 16th March 2022. You can watch the video, listen to the podcast or read an edited transcript below.

Edited Transcript

Ally Selby: Hey, how are you doing? And welcome to Livewire's Buy Hold Sell. I'm Ally Selby, and today we are talking about small caps. These fan favourites have been a bit out of love lately with the Small Ords Index down around 11% year-to-date. So is there more pain on the horizon or is the worst over for small caps? Well, to find out, we're joined by Ben Rundle from Hayborough Investment Partners and Martin Hickson from 1851 Capital. Martin, I might start on you. Is the worst over for small caps?

Martin Hickson: Well, we certainly hope so. It's been a very tough couple of months for small-cap investors. 

We've seen a significant contraction in the P/E multiple of the market. It's gone from a P/E of 25 times six months ago to 20 times today. 

So that's obviously impacted share prices across the small-cap index. So we think volatility is here to stay for the rest of the calendar year, but we hope that the worst is behind us.

Ally Selby: What do you think, Ben?

Ben Rundle: It would surprise me if the pace of the sell-off we've seen so far continues. I think that if you look at where interest rates are and, as Martin pointed out, where equity valuations are, I think that's probably about right. If interest rates all of a sudden move a lot quicker, which may or may not be a possibility, then we're going to continue to see volatility. So I certainly don't think it's going to be as good as last year for small caps, but hopefully, the pace of the sell-off is done on for now.

Ally Selby: Do you think we're seeing a repeat of 2018 here?

Ben Rundle: I think there are similarities with 2018, particularly in regards to interest rates. Obviously this time around, we've got a much higher level of inflation plus a war thrown in too. 

In 2018, small caps sold off about 20% or thereabouts. I don't think we've quite seen that sell-off, but it's probably pretty close. But if you look back to 2018, the market was a lot higher 12 months later. 

I don't know how far it will fall or how this resolves, but with regards to a war, by the time that the peace deal's signed, the market's usually a lot higher. Interest rates, I think, have adjusted for now. Inflation's probably the real worry for me. And I think there are certain ways to protect yourself against inflation in the market.

Ally Selby: So is there any lessons from 2018 about the stocks that you should be picking up right now or you don't think so?

Ben Rundle: I think the lesson for 2018 is buy the dip.

Ally Selby: Over to you, Martin, do you think there are any similarities to 2018 now? And are there any lessons that you can take from that period about which stocks you should be buying?

Martin Hickson: I think the big similarity is that gold is continuing to outperform, and that makes sense. We're going into a rising rate environment. The big difference, though, between now and 2018 is obviously inflation, as Ben points out. Back then the Fed obviously pivoted and didn't end up hiking rates. This time we've got inflation running at 8% in the US, so there are going to be rate hikes. The market is currently pricing in seven rate hikes in the US. We think that's on the high side, but they're certainly going up from here. So that is causing volatility and depressing valuations at the moment.

Ally Selby: With rates rising, tech has been really badly hit. Have you been picking over the debris for some bargains?

Martin Hickson: We've been quite negative on the tech sector for 12 months or so now. We remain negative. There have been significant falls in share prices. 

The tech index is back to where it was pre-COVID. However, a lot of them don't have valuation support. They're still trading on revenue multiples. They don't have profits. 

They're reliant on capital markets being open to support their growth. So it's still a sector of the market that we're avoiding at the moment.

Ally Selby: Are you avoiding tech as well?

Ben Rundle: Largely, we are. There are certain pockets of tech which have very strong earnings profiles, but as Martin points out, there is a significant portion of the sector that relies on capital markets. 

So (tech stocks are) going to have to raise money at some point and that'll significantly dilute the equity basis of those businesses. 

I agree with Martin, it's not a sector that we're rushing into any time soon.

Ally Selby: Is there a beaten-down stock that you've been buying more of recently?

Ben Rundle: Well, we're buying Uniti Wireless (ASX: UWL) because it sold off. I thought the result was pretty good. It sold off 20% indiscriminately. And if you look at the business, 90% of it is recurring earnings in nature and they had a significant contracted pipeline which gave you certainty going forward. So to us, that looked okay. We bought more. We talked about it at our monthly last week, and luckily it's got a takeover bid. I don't know whether that eventuates or not, but those sort of businesses that do have a quality earnings base are the ones you want to be in.

Ally Selby: Martin, is there a beaten-down stock that you've been buying at the moment?

Martin Hickson: One that we've been adding to in recent weeks is OFX Group (ASX: OFX). They operate in the foreign exchange space. Trades on a P/E multiple of 20 times in line with the overall market. Has a strong management team. They've made a recent acquisition in North America, so that will provide another avenue for growth for that business. It's cheap. And they had an earnings upgrade today as well, and the share price hasn't re-rated on the back of that. So we still think it's cheap, undiscovered by the market, not a lot of broker coverage. So it's one we continue to like.

Ally Selby: We're entering this new market regime: inflation, rising rates, crazy commodities, and also war, as we mentioned earlier. What kinds of small caps do you think can thrive in this environment?

Martin Hickson: I think commodities will continue to do well. Unfortunately, it's not an area of the market that we are focused on. But looking at the industrial space, it's really those with pricing power. So companies that can put up their prices, those that can offset a lot of the input cost inflation that we're seeing. Companies like PSC Insurance (ASX: PSI), Austbrokers (ASX: AUB), IPH (ASX: IPH) to name a few.

Ally Selby: Is there a pricing power stock that you think you're backing over the year ahead?

Martin Hickson: PSC Insurance is one. They're benefiting from the stronger premium rate cycle that we're currently in. They raised capital a couple of weeks ago, so they've got capital available to deploy into creative acquisition. So that's one that we think we should do well.

Ally Selby: Martin thinks pricing power is really important in this environment. Are there any other features or characteristics of stocks that you think is really important for small caps over the coming few months?

Ben Rundle: Well, as we've spoken about, inflation is the big worry for stocks. And there are essentially three ways in my mind to protect yourself from inflation. Martin points out two of them, being commodities or high-gross margin having pricing power. The other way is to own a fixed-cost asset where all your CapEx has been spent, and obviously, the replacement cost of that asset goes up. The problem within small caps is you're not going to get earnings growth out of that sort of business, so it's not really an area in which we play around in.

I think the best way to do it is in stocks with pricing power. An example in that space, not one that we own or is even in small caps, but maybe one example that people might be familiar with is Xero (ASX: XRO). You could double the prices of what people pay for Xero, and I think they wouldn't lose many customers out of it. That's a great business with pricing power that will do well in an inflationary environment.

Ally Selby: We talked about a lot of the stocks that we're liking in this new market environment. Is there something that you are steering clear of? Is there a stock that comes to mind that you think, "Stay the hell away from that stock?"

Ben Rundle: Maybe one example of a stock that we're avoiding, for the time being, is AMA Group (ASX: AMA), which is a smash repair business. Now they've got fixed-price contracts with insurers on a fixed margin. The problem for that business is the cost of their goods is going to significantly skyrocket in this kind of environment, so their margins are only going to get smaller and smaller. So that's probably an area we're staying away from at the moment.

Ally Selby: Martin, over to you. Is there a stock that you think could be in for some troubled times ahead?

Martin Hickson: One that we held that was disappointing over February was Praemium (ASX: PPS). We've since sold out of that position. They've increased the cost base within that business, at the same time, Netwealth (ASX: NWL), which had launched a takeover proposal, walked away from that approach. Given the recent market volatility, that's also going to put pressure on their flow. So that's one we're avoiding at the moment.

Ally Selby: So it seems the worst isn't over for small-cap investors, but there were plenty of stocks in there today that you could pick up at a bargain. We hope you enjoyed that episode of Buy Hold Sell today. If you did, why not give it a like, and remember to subscribe to our YouTube channel. We're adding new content every week.

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