Macro explanations don't hold water in small caps (and these stocks prove it)

Markets have been drowned out by the macro - be it inflation, rates, geopolitics, the labour market, government and corporate debt, or the myriad of other factors you'll see discussed.  

The corollary is that stock analysis too often boils down to macro conclusions. Even when analysis is done using bottom up fundamental analysis, the outcomes are often tied back to macro. 

There's nothing wrong with this (and often these conclusions can be valid). But what explains the dispersions between stocks within sectors? Filling this gap is the key to achieving alpha through the cycle, especially when volatility is high. 

At the latest Pinnacle Insights LIVE 2023 Australian Equities event, David Wanis, a portfolio manager at Longwave Capital, demonstrated the benefit of looking past the macro to understand company performance. 

As he explains, macro can explain sectors but it doesn't do a very good job of explaining dispersions within sectors. This wire is a summary of that argument (with some stock examples to boot). 

Insights you won't get from macro

"We don't take a top-down view to sector allocations, we think of bottom-up, and in small caps that's really important," says Wanis. 

If sector distributions were tight, then macro explanations hold a lot of water. But when there's a lot of daylight between the earnings forecasts of different companies within the same sector, macro explanations fall apart.  

"The problem with small caps is that the dispersion of how the companies perform far outweighs any of those macro influences."

The sector EPS estimates below show this to be the case. 

"Coming into the back half of last year, a lot investors would've questioned why you'd buy consumer discretionary stocks. Rates are going up, so the common view is that retail will suffer as a result.

"So the performance of Lovisa (ASX: LOV) and Accent (ASX: AX1) relative to the performance of Baby Bunting, BWX and Kogan had nothing to do with what the RBA was doing. It was mostly down to how company managing were executing and delivering earnings growth to their shareholders."

Not convinced? Let's bring a classic defensive play into the fold - healthcare. 

"On the other side you might say 'let's invest in healthcare companies because they're top-down defensive and they have non-discretionary sources of income.'" 

"But if you had invested in Australian Clinical Labs (ASX: ACL), Integral Diagnostics (ASX: IDX) or Healius (ASX: HLS) the performance... is opposite what you were hoping to achieve."

Then there's financials, arguably the most market leveraged sector out there. 

Finally, consumer staples. "The safe part of the market." The same story plays out, as you can see below. 

"That's why we're focused on the companies and not the macro."

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