More rate hikes to come, but Chris Stott believes it may be time to put that dry powder to work

Over the past 13 months, the Reserve Bank of Australia has ratcheted up the cash rate 12 times. While it hasn't been outright calamity, the effects of said rate hikes are well-known: ever-volatile markets, increasing costs for companies (and a subsequent hit to earnings), a cost-of-living crisis and an oncoming fixed-rate mortgage cliff. 

And yet, 1851 Capital's Chris Stott believes investors may need to brace for three or four rate hikes to come over the next 12 months. 

It's a tough pill to swallow, particularly for growth-hungry investors like myself. 

However, as Stott explains, those willing to do the work will discover that there are some stocks currently trading 60-80% off their highs, while the micro-cap end of the market hasn't been this unloved since the Global Financial Crisis. 

In this wire, you'll get a summary of Stott's latest presentation from the Bell Potter VOICES conference, including some of the risks he believes investors should have on their radars, and some of the stocks he is using to generate top-tier outperformance. 

The biggest risk to markets right now

Given small caps suffered their second worst year of performance in the last 20 years in 2022 (other than 2008) and small industrials are trading at one of the largest discounts to large industrials in quite some time, Stott believes there is plenty of value on offer for astute investors in small caps. 

However, he believes that investors should brace for more rate hikes than the market is currently pricing in.

"If inflation stays stubbornly high, you can fast forward the next 12 months and have three or four rate hikes to come - not the two that people are expecting. If that occurs, the market could struggle," Stott says. 

This is because inflation doesn't typically "come down in a hurry," Stott explains. 

"Unfortunately, we've seen the Kiwis officially tip into recession... And also we've seen a rapid slowdown in the consumer," he says. 

We've also seen a raft of profit downgrades, particularly in the retail sector, in the last few months, like Dusk (ASX: DSK) and City Chic (ASX: CCX) to name a few, as consumers struggle to combat higher interest rates. 

"And right now, in the June quarter, we've got fixed home loans transitioning to variable rates," Stott says. 

"The people who took out fixed loans in the COVID pandemic at 2% are now transitioning across to 6% or 7% or even higher variable rates, which is providing another headwind shorter term for the economy." 

However, there is some hope on the horizon. 

"As we move into 2024, the first sniff of any rate cuts or loosening by the RBA is one of the triggers we're looking for a bounce in the market," Stott says. 

There is also one other signal investors can look out for - when companies downgrade their earnings but share prices rally. 

"Expectations are being cut too hard on the downside," Stott explains. 

"So you'll get earnings downgrades, we believe, in the August reporting season in some of these more cyclical sectors, but if you get the AGM season and you get downgrades again and the stocks start to rally, that's a good sign that the lows are in." 

How CEOs are dealing with the crunch

Stott believes the consumer is likely to tighten their purse strings over the next few months, pointing to some of the commentary from the Macquarie conference in May as evidence. 

"The Super Retail CEO is expecting that things are going to get tougher, but the Domain SEO is more positive," Stott says. 

He predicts that house prices will continue to fall on the back of further rate hikes in the next six months, putting further pressure on the consumer. 

"We would say that house prices have bounced more recently. We expect them to come back off in the next six months, as they are really bouncing on low supply," he adds. 

So where to from here?

Stott believes it will likely continue to be tough for investors over the next three to six months. Unfortunately for us investors, he predicts that the reporting season in August will likely disappoint on the earnings front.  

"We think earnings forecasts that are out there as consensus FY24 generally are too high and will need to come down, particularly in the retail space," he says. 

"We're starting to see some really good value. We haven't pulled the trigger on some of those [companies] in the retail space or the REIT space as yet, but REITs are trading at anywhere from 20-40% discount to NTA." 

In addition, some of the retailers are trading 60-80% off their highs, while micro caps "haven't been this unloved since the GFC." 

"That really excites us from a medium to longer-term perspective," Stott adds. 

Putting dry powder to work 

While Stott admits that the portfolio remains defensively positioned with cash levels currently sitting at 12% (compared to its usual 5-7%), he's patiently waiting to put that dry powder to work on capital raisings and distressed opportunities over the next few months. 

The fund recently participated in the Appen (ASX: APX) and Macquarie Technology Group (ASX: MAQ) capital raisings. 

"We think there'll be more of those types of opportunities that come to us over the next six months," he says. 

For instance, SILK Laser (ASX: SLA) recently received a takeover with an implied P/E ratio of 12 times, but Stott and his team were buying it at just six or seven times P/E. Or Duratec (ASX: DUR) which investors could have picked up a year ago on a P/E of four times but has seen re-rated to a P/E of eight times. Still cheap, Stott adds. 

"Companies with cash backings will obviously do well through this period, where they can avoid a distressed capital raising type scenario if things do deteriorate further to the downside," Stott says.  

"But we are dipping our toes more into the micro-cap space than ever in the last three to six months. We've seen great opportunities in that space... Liquidity is difficult, so we do shape our position sizes in the portfolio to really back that in, which is really important." 

How Chris Stott and the team at 1851 Capital are positioned 

In terms of the portfolio itself, Stott and his team are positioning towards locally listed companies that benefit from the electric vehicle (EV) revolution, including IPD Group (ASX: IPG), Eagers Automotive (ASX: APE), SmartGroup (ASX: SIQ) and XRF Scientific (ASX: XRF). 

"IPD Group was a good Bell Potter float from a couple of years ago," Stott says. 

"It floated at $1 versus the $4 share price today. It has been one of the best-performing IPOs we've seen in the last couple of years on the ASX - and really one of the only ones we've seen in more recent times. So that one's a good core portfolio position for us." 

Meanwhile, Eagers Automotive and Smart Group are benefiting from the high demand for EVs in the novated lease space, with McMillan Shakespeare (ASX: MMS) and FleetPartners Group (ASX: FPR) also benefiting to some extent. 

"They are some of the key ways that we're looking to play that EV space in the small-cap universe over years to come," Stott says. 

Top five holdings 

As of the end of May, The 1851 Emerging Company Fund's top five holdings were Capitol Health (ASX: CAJ), PeopleIN (ASX: PPE), SmartGroup (ASX: SIQ), IPH (ASX: IPH) and IPD Group (ASX: IPG) - however, one thematic that has performed well for the portfolio recently has been its exposure to the travel sector. 

"Flight Centre (ASX: FLT), Corporate Travel Management (ASX: CTD) and HelloWorld (ASX: HLO) have been three really strong contributors to the fund over the last six to nine months in particular," Stott says. 

Interestingly, while the consumer may be saving their pennies on retailers, they are splashing their cash on holidays, Stott explains, with demand levels as good as they have been in well over a decade. 

"Even with record airfare prices and capacity coming back into the system from the airlines, it's still not stemming the growth in the travel space," Stott says. 

"We would expect those companies exposed to the travel and leisure space to report some really strong results, in our opinion, over the next three to six months." 

Fun fact: Stott has recently been adding to his position in Flight Centre on the back of recent share price weakness. 

"They're in a terrific position, which is kind of counterintuitive, right? The economy has fallen away, retail spending has slowed, but people are still travelling," Stott says. 

"There's a pent-up demand that will wash through and we expect that to slow in the next year. But I still think we're going to see some of these travel businesses do quite well."