Rotate or stay? Playing the small cap rally’s next phase

Since the market bottomed in late March, the S&P/ASX Small Ordinaries Index has soared over 40%. However, it's evident that the rebound is thus far two-tiered in nature; e-commerce and technology-oriented stocks have done much of the heavy lifting and left nearly everything else in their wake.

The key question for investors now is whether the dichotomy in sector performance presents an opportunity to take profit from the exuberantly expensive 'online' stocks and redeploy it into the laggards... or is it the case that the world really has changed and the COVID-19 winners will keep on winning?

Here, Gary Rollo of Montgomery and Chris Stott from 1851 Capital discuss this thematic and whether its time for investors to make a big portfolio pivot into the small caps which have been behind.

Notes: Watch, read or listen to the discussion below. This episode was filmed on 9 September 2020.

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Edited Transcript

Matthew Kidman: Welcome to Buy Hold Sell brought to you by Livewire Markets. I'm Matthew Kidman, and today we are going to talk about small companies. Since the market hit a bottom late March, the Small Ordinaries are up 41%. The poor old ASX 200, it's lagging behind. It's only up 24%. And to talk about the small companies and the latest reporting season, I've got Chris Stott from 1851 Capital and Gary Rollo from Montgomery Investment Management.

Small caps survive and thrive

Matthew Kidman: Gary, smalls, they've been the only place to be. What did you find out from the reporting season that we've just had? Was it as bad as what we thought it would be or are there a lot of gems out there that we still should be looking at?

Gary Rollo: Thanks, Matthew. Well, look, going into reporting season, everyone expected the worst. Every press you picked up, it was all about how bad it was going to be. But actually, it turned out to be pretty good. Corporate cost structures in really good shape, balance sheets even better. And some of those e-commerce stocks that were on a tear going into COVID actually had their growth accelerating in the months of July and August. So for us, reporting season was better than expected and there's still a lot of opportunity out there.

Matthew Kidman: Well, we'll get back to those e-commerce stocks. Chris, did you feel the same way? It was a funny one because at the end of it, all the companies said, "Well, we're not going to give you a forecast because we're a bit nervous out there." How did you read the whole reporting season?

Chris Stott: Reporting season was definitely ahead of expectations, Matthew. As Gary mentioned, expectations going in were incredibly low, and that's understandable given the pandemic that we're going through at the moment. But generally, companies came out ahead of expectations outside of those unaffected sectors, which I call that to be our travel and hospitality is the obvious ones. But generally, companies came in ahead of where they thought they'd be in that mid to late March period, where they were in the process of cutting costs, getting their balance sheets in shape.

Chris Stott: So generally, as a whole, results were very, very strong. And in fact, in some cases the quality companies really stood out in terms of the ones that showed good operating leverage through that period, as well as really strong cash flow results, which led to reduced levels of debt for a lot of companies.

Time to rotate away from the winners?

Matthew Kidman:
Yeah. Now, Gary opened the door for us about some of these e-commerce stocks. Some of them were unstoppable, and they were in different areas, was there? There was Kogan, there was NEXTDC with the data centres, there's Temple & Webster, there are PointsBet. They really performed well. Now, do we stay there? That's the question. Was there enough in it for these big multiple companies to keep on running?

Chris Stott: Look, our view is that some of those companies have certainly run their course for now. You've seen incredible growth numbers come out of some of these companies like Kogan and Temple & Webster to name a few. And you'd expect that momentum will continue in the very, very short-term. But in a valuation sense, when you look at some of these companies, they've had incredible increases in their share prices. Kogan up from $3 to over $20 at the time of filming. So for us, really good businesses, longer-term, but shorter term, the valuation argument, we struggle to get there at the moment for some of these companies.

Matthew Kidman: Gary, Chris is a bit old-fashioned. He thinks valuations matter. Some of these businesses, not only were they growing their top line, but their margins just went berserk in that period. So some of those names we mentioned, do you still want to be there? You want growth, don't you, with zero interest rates?

Gary Rollo: Absolutely. Look, these business models are the quality business models for the world that we live in today. And I think we're kidding ourselves if we think that valuation regimes for growth stocks are going to change too much over the foreseeable future, because we're living in a low growth world. And these companies, they have growth and they're going to look a lot better against that backdrop and that valuation regime shift that we've seen. Whilst it might look toppy and there's definitely going to be volatility around it, if you think they're going to get demonstrably cheaper anytime soon, you could be waiting for a while. So some of these names need to be part of your portfolio and let their stories play out.

Matthew Kidman: Well, come on, give us a few.

Gary Rollo: Well, we like the look of some of the data centre companies, so that's been a core holding for us over the course of the pandemic, and we still hold some of those names. Macquarie Telecom is a great example of a company that's got its destiny in its own hands powered by some of the really strong investment themes that are going on out there today, like corporates digitising their corporate infrastructure, moving to the cloud. That's a company that is in our portfolio and is a great team to play.

Rotation thematic: Intrastate tourism

Matthew Kidman: Okay, Chris, you don't want to be there. Where do you want to be? What did you get out of reporting season? Where do you want to move to? Where do you want to shift your portfolio?

Chris Stott: One key thematic we're playing to in our portfolio at the moment is a high propensity of people for interstate travel over the next six to 12 months. With the borders closed international and some of the state borders, we know they'll re-open eventually, but companies like Super Retail Group, we think have still got a little bit further to go here, given their businesses: Boating Camping Fishing, Supercheap Auto brand, Rebel, and Macpac really positioned well, we think, over the next six to 12 months with the consumers' high propensity to travel intrastate.

Matthew Kidman: The retailer theme's not exhausted? They've been spending hard on that.

Chris Stott: Look, we don't think so. It's a consensus trade in terms of the retail's run its course, the stimulus is about to run out, you're going to see the earnings slope. There's no question the like for likes will slow. They've had an incredible period, but I think some of the higher quality businesses like Super Retail that are exposed to that really good thematic over the next six to 12 months, and I'd throw the AP Eagers and ARB in there as well, we think are really well-positioned to take advantage of that over the next year in particular.

Recent stock moves: Correction or a bear market?

Matthew Kidman: Okay. It's been a ripping run, as we said at the top of the show. Green Day said, "Wake me up when September comes." Is that the case this time? Have we just hit a wall or is it just a speed bump for the moment?

Chris Stott: We believe it's a speed bump. The tech sector certainly does look like it needs to correct a little bit from here. So I think it's a really healthy correction that we're seeing at the moment, particularly with that tech sector and the NASDAQ index in particular. So I think you'll see further weakness in that tech space the very, very short-term, but we are bullish on the market, we think the overall trajectory is up from here. So we are quite positively disposed to outlook.

Matthew Kidman: Gary, it's been hotter than a stove. You can barely touch it. But last week and into this week, there's been a big pullback. Is that natural? Is it good for the market to take a deep breath? Or are there more problems out there?

Gary Rollo: Well, look, performance in the market has been concentrated in a select few sectors because when COVID hit, there were very few places that you could go to protect capital and then grow wealth. As economies open up, as vaccines arrive, there will be more opportunities to make investments that make more sense. So it's natural that capital will be taken out of those places that have done well and put to work in other opportunities. And that's what we've been doing with our portfolio, taking the top off these winners and putting it to work in sectors that through no fault of their own have been damaged by COVID. And we just so happen to have some cracking stocks in small caps that play into that. I mean, as Chris mentioned, domestic tourism, there are lots of ways to play that. There's also the travel stocks too. We think that some of the business models in there have actually stood the test of COVID quite well and are well-positioned for recovery whenever that does come.

Why the small cap rally is set to broaden

Matthew Kidman: So in any good bull market, the narrowness that leads us out, it bleeds into the other stocks and we get a broader rally amongst all sectors or a lot of sectors. Do you see that coming?

Gary Rollo: That's how we see it. I mentioned earlier that if we think that the valuation for equities is going to demonstrably change, I think that's a difficult conversation to believe in. The reality is we're in a low growth world and you need to make your return where you can find it. And as return opportunities open up and those sector areas that will open up in the economy, that's where the money will get put to work, and that's where the returns will be made.

Matthew Kidman: Righto, Chris, I'll put the same question to you. Everyone's worried about government stimulus coming off and the economy really going to do a deep dive recession next year, March, somewhere around there. But do you think it works the other way? Do you think the stock performance goes much more broad than what we've had so far?

Chris Stott: Look, we believe so, Matthew. Clearly the two key events for us between now and Christmas, firstly, the U.S. election result, that's really critical for the direction of markets over the medium-term. Quite a close race, we believe, between Trump and Biden at the moment, so we'll see how that plays out. And secondly, we're getting a lot of news flow around vaccine trial results over the next six months in particular. So that really could help lead the direction of equity markets into FY21 and 22 and beyond. So there are two key events, shorter-term, that we're keeping a close eye on.

The importance of operating leverage

Chris Stott: But what excites us the most is at the moment is generally companies back in March were quite concerned about the outlook, and rightfully so. First instinct is to take cost out of the business. So generally, a lot of cost had been taken out of companies. They've delivered their balance sheets and revenue lines have been a little bit, or in some cases, a lot stronger, like those retail companies, than what they thought they'd be in March. So you're starting to see a huge operating leverage come through for some of these companies in particular in that retail space. So what that excites us about the outlook going forward is a lot of the companies that we've met with over reporting season believe they can keep those costs out of the business over the next one to two years. So we think that there's a high propensity for the quality businesses to really shine and exhibit that operating leverage through margin expansion.

Matthew Kidman: So there it is. Go small, stand tall. The bull market's only just begun, and we can't build a pen big enough to hold these two bulls.

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