Oberg: It's time to add risk in small caps

The US small-cap index surged over 10% in July, providing encouraging signs for investors looking beyond mega-cap companies for returns. While the recent correction has taken some lustre off the market, the rally shows where investors see value in equities.

Wilson Asset Management's small to mid-cap Lead Portfolio Manager (ASX: WAM, ASX: WMI, ASX: WAX, ASX: WAA), Oscar Oberg, has been following the moves in the US market and says since COVID, the US has led Australia by six to 12 months.

"The US definitely leads Australia, but I think as a small-cap fund manager, when you start getting too focused on the macroeconomic environment, you can get lost. You should always focus on your stock-picking process; you can always find unloved or interesting companies no matter what market you're in."

The valuation case for small caps has existed for a few years now, with Australian small caps trading at a 20% discount to large caps. However, Oberg says that with many smaller companies exposed to the economy, it helps to have a constructive view on the outlook. A kick-up in capital markets activity, such as IPOs and capital raisings, is another catalyst that would breathe life into smaller companies.

Putting cash to work

Oberg wrote earlier this year that the opportunity set in small caps is as good as he has seen since 2020. That view is reflected by portfolio cash levels sitting below long-term averages, between 10% and 12%.

Some of that cash is finding its way into companies that require investors to be comfortable taking a little more risk. But that's where Oberg believes some of the best opportunities exist, especially if you believe that interest rates have peaked and are likely to come down in the year ahead.

Healthcare, Financials, Retail, and New Zealand-based companies are four parts of the market that are catching Oberg's attention. He also explains that companies with high leverage levels that have been suffering for the past few years look interesting, especially if their interest expenses start easing.

Integral Diagnostics (ASX: IDX) is an example of a former market darling that has been sold off that could benefit simply from a lower interest rate environment.

"You've got radiology volumes that are starting to increase again, they've fully cycled all the issues from COVID. You've got wage inflation, which is starting to normalise and has greatly impacted their margins. But if we get a scenario where interest rates fall, suddenly we're pushing through quite significant earnings per share upgrades simply because the interest expense is going down," Oberg says.

Oberg says Healius (ASX: HLS) is another company that has had a difficult few years where he sees multiple catalysts for a turnaround.

"The key catalyst is that they are looking to sell their radiology division. Optically, the balance sheet looks tight; they're at three times leverage. In our view, if they sell the radiology business and get anywhere close to the valuation being reported in the press, suddenly, you take a three-times-leveraged business to one that is net cash."

In addition, Oberg believes that the pathology market has bottomed and is starting to recover. Combine this with the substantial short position, and he sees a few catalysts that could push Healius shares materially higher.

Lessons from 14 years of investing in small caps

Oberg has been investing in small companies for 14 years and says the big lesson he has learned is to stay true to your process. For Wilson Asset Management, the key to small-cap investing is to ensure there is a clear catalyst for the shares to go higher.

"There's a reason you invested in a company, and if those reasons disappear, it's usually a sign that you need to sell the company," Oberg says.

Watch the full interview to hear the thesis behind three substantial holdings across Wilson Asset Management's small-cap portfolios, views on the upcoming reporting season, and why Wilson Asset Management passed on the Guzman Y Gomez IPO.

Note: This interview was recorded on Tuesday the 30th of July

Timecodes

• 0:00 - Introduction
• 0:18 - Is a rally brewing in small caps
• 3:29 - Why is the small-cap market looking exciting?
• 5:03 - Signs of life in capital markets
• 6:13 - How much cash is in the portfolio?
• 6:53 - Positioning in small caps
• 9:04 - The case for taking some risk on Healius and G8 Education
• 11:02 - What Oscar is avoiding in the market
• 12:04 - Reporting season preview
• 13:15 - The thesis behind 3 stocks Wilson Asset Management is backing
• 18:36 - Views on Guzman Y Gomez
• 19:08 - Oscar Oberg’s #1 lesson for small-cap investing

Learn more

Oscar's funds provide access to some of the most exciting undervalued growth opportunities in the Australian market. To find out more, visit the Wilson Asset Management website.