Opportunities emerging in small caps and four stocks we like

There is an old saying on Wall Street that bad certainty is better than uncertainty. In 2022, global asset markets have been faced with fears surrounding the length of an aggressive interest rate tightening cycle, elevated inflation, and the impact on corporate earnings.

As a result, equity markets have experienced a significant drawdown with sentiment measures currently flashing red. The CNN Fear and Greed Index is at 19, categorized as “extreme fear”, the AAII Investor Sentiment bull-bear spread (bullish minus bearish sentiment) is -35.6% which ranks among the most negative in the survey’s history, and the stock market’s “fear gauge”, the CBOE VIX Volatility Index®, has frequently been above 30 this year (as it is now) in bear market territory. 

Consumer confidence recently dropped to near-record lows in Australia. Media stories help feed this fear frenzy, but with so many data points, it’s not hard to see why. Not surprisingly small caps experience significant underperformance, relative to large caps, in the lead-up to an economic contraction and this cycle has proven to be no different. The Small Ordinaries Accumulation Index has underperformed the ASX50 by over 19% this year.

The good news is that bad news is on the way. The bad news will come in the form of slowing growth due to the tightening financial conditions for households, consumers, and businesses. Bottom-up consensus expectations are for around 0% EPS growth for ASX 200 stocks for both June 2023 and June 2024. This is a considerable slowdown from the ~18% growth rate during the FY22 reporting period. 

We would expect further downgrades as we move into 2023. In past cycles, equity markets have bottomed between 3 to 9 months post-peak inflation whilst bear markets since 1903 in the US have bottomed 6 to 9 months before earnings have reached their lows.

The good news is that this slowdown will help reduce inflationary pressures and provide the backdrop for Central Banks to pause the rate hiking cycle. With markets already significantly discounting bad news, the debate will move to “how much” is priced into equity prices and which companies are successfully navigating the headwinds. We consider the best return opportunities are in those companies that operate in structurally growing industries who can deliver earnings growth despite the difficult economic backdrop.

The LSN Emerging Companies Fund has been taking advantage of the sell-off which has occurred in these long-duration assets as a result of rising interest rates. The specialist platform providers (HUB24 (ASX: HUB)/Netwealth (ASX: NWL)) continue to grow as they benefit from market share gains, providing annuity-style revenue, high margins, and strong cash flow. 

The industry tailwinds support a clear trajectory for growth over the long term. Life360 (ASX: 360) is the global leader in family safety services with an addressable market of well over $12b. With a growing subscriber base and strong pricing power, the business is well-positioned to scale into profitability in the period ahead. Elmo Software (ASX: ELO) is the largest domestic HR tech company which has compounded four-year organic annualised recurring revenue of +38%. The company is on the cusp of profitability and has now attracted takeover interest.

And while all cycles are not the same in terms of duration and performance, history tells us that small caps returns are the strongest after major drawdowns, with liquidity and valuations a major driver of this. Valuations in small caps overall are now at levels only seen during previous periods of market turmoil (GFC, Euro Debt crisis) and for those companies that can deliver earnings growth, this will provide investors with a platform for strong returns over the medium to long term.

The impending economic slowdown will provide clarity on when the interest rates cycle will plateau and the impact on corporate earnings. Given the liquidity and forward-looking nature of equity markets, investors will be positioning their portfolios for the post-slowdown recovery. 

While volatility will remain a feature of markets over the short term, the current drawdown is presenting opportunities to invest in high-quality small cap businesses, with long runways for growth at valuations that are rarely seen.  

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