Small caps are in a bear market: Here's what to do now

Remember in early 2021 when investment experts were talking about a "Goldilocks" scenario for markets - that is, when global economies were going from strength to strength, earnings seemed to be going through the roof, and stocks pushed investors' portfolios to lust-worthy heights? 

Well now, Goldilocks has well and truly been discovered by the three bears, with major indices around the world crashing in a risk-off market. 

While the Aussie large-cap index is in correction territory, the S&P/ASX Small Ords Index has suffered far worse, having fallen more than 25% year to date. Anything more than a 20% fall from a peak is considered a bear market. 

So how are the professionals navigating this difficult environment for small caps? Glad you asked. 

Livewire's Ally Selby was joined by Medallion Financial's Michael Wayne and Hayborough Investment Partners' Ben Rundle for their top tips on how to do exactly that. 

They share whether they have been buying the dip or selling the bounce in recent months, how much cash they are holding right now in portfolios, the signals they are watching, and six stocks for when markets rebound. 

Note: This episode was filmed on Wednesday 12th October 2022. You can watch the video, listen to the podcast, or read an edited transcript below.

Edited Transcript 

Ally Selby: Hello and welcome to Livewire Markets' Buy Hold Sell, I'm Ally Selby. And if you think 2022 has been bad for large caps, let's take a moment of silence for the small end of town. The Small Odds Index has fallen around 26% year to date, meaning it is well and truly in a bear market. So, to figure out how the pros are navigating this market environment, we're joined by Michael Wayne from Medallion Financial and Ben Rundle from Hayborough Investment Partners. 

As I mentioned there, it's been a really volatile year for small-cap investors. Michael, I might start with you. Have you been buying the dip lately or selling the bounce?

To buy the dip or sell the bounce

Michael Wayne: Neither really, at the moment. By this stage in the decline, we've already culled those businesses that we don't want to be in, and we're just holding onto those quality names that we're happy to see things through. We're not confident enough to start piling money into the market. We're happy to sort of sit on the sidelines. We do have a sense that this has further to play out, so we're being pretty cautious at the moment before rushing in and buying stocks.

Ally Selby: How about you, Ben? Are you waiting as well?

Ben Rundle: Yeah, well our cash balance is pretty high at the moment. We've been in inflow mode, so more money's coming to the fund. We're sort of deploying that as we see fit, but we're certainly not rushing out there and going berserk at this point.

Findings from 2022's bear market in small caps

Ally Selby: You actually told Livewire Markets that you're keeping a bear markets journal at the moment. I was wondering if you could share some of the findings from that.

Ben Rundle: I was hoping that wouldn't see the light of day. I mentioned it to James Marlay that I was doing that. So each bear market, I like to keep a diary of what's going on - just things that I'm seeing on a day-to-day basis - because I think that you can learn from history. And I also think that you can learn from the psychology of markets. And if we go back to the selloff we had during COVID-19 - I think it was March 23rd, the day the market bounced, I mean there was just no reason to buy. We had Victoria and New South Wales closing schools. Centrelink had lines that were a hundred metres long. I said to myself, it's starting to feel very scary. A lot of people feel that the depression is coming and it's hard to disagree with that.

There's not one person I spoke to who was bullish. And on the day when everything just seemed like the world was ending, that was the bottom for markets. And I think that tells you that at the bottom there's no signal. There's no one saying "Now's the time." 

I mean, the bounce that we had in June, we had Seth Klarman, Jamie Dimon, and James Gorman from Morgan Stanley all in the papers saying that markets are getting worse and then we bounced 10 or 15% pretty quickly. So yeah, there's no real answer to it but I just feel by doing that and trying to keep a journal of it, hopefully, it improves each time as you go through it.

Ally Selby: Sentiment indicators are looking pretty bad at the moment. Do you feel like we've seen peak fear yet or is there still more fear to be seen?

Ben Rundle: That's a good question. I don't really know. I think it's all dependent on what happens with the Fed. They've been pretty adamant about the fact that they want to increase rates as quickly as possible, so that's driving the market. Until they stop doing that, it's hard to really see an equity rally. So, that's sort of the key indicator that we're looking for at the moment.

Ally Selby: Michael, have you and the team been looking out for any indicators to change strategy?

Michael Wayne: Absolutely. We've seen a lot of short interest come into the market, reaching peak levels that we haven't really seen since the crisis of COVID-19 and the GFC before that. So, we'll be monitoring to see if some of that short interest comes off. Things like corporate earnings. 

Goldman Sachs put out a good chart, a couple of weeks ago now, which suggests that prices start falling often before earnings start falling, which is what we've seen. 

But then also prices tend to bottom before those earnings bottom, so we're just waiting for that point when corporate earnings start to come off the boil a little bit. 

When people start to get very pessimistic before then starting to maybe look to try and take advantage of that peak pessimism - which I don't think is necessarily set in with the realisation that corporate earnings, given all that's going on, are likely to come off now a lot quicker than many people are anticipating. 

But back to Ben's point, I think the key takeaway is when you first start to ease that cash into the market, it's going to be painful. It's going to feel like it's the wrong thing to do, it's going to feel scary. But history suggests that's often what you have to do, to really take that leap of faith because there's no clear signal that this is going to be the bottom.

Ally Selby: Have you made any strategy changes to combat those challenges?

Michael Wayne: Like a lot of fund managers, we probably got drawn into that high growth, high PE space too much and we probably had overexposure to that. So, what we've tended to focus on is those companies with short-duration cash flows and short-duration earnings. That is the businesses that are earning money in the here and the now, rather than focusing on those companies that have long-duration cash flows, and long-duration earnings, those being the companies that might have a good story today but aren't expected to see the fruits of that good story play out for a few years to come. So, we're still happy to hold growth names, but they've got to be high-quality growth and businesses that are growing and earning money today.

Ally Selby: Okay, over to you. Have you made any strategy changes to combat the challenges we've seen this year?

Ben Rundle: Not so many strategy changes, but you tend to find that your portfolio composition changes around a little bit. So, some of the lower quality names that you think well, okay, maybe they're not lower quality, maybe the earnings are just being pushed out as to Michael's point. You start to cycle out of those and focus on good quality businesses that maybe you haven't been able to own in previous cycles because they've been too ritzy in regards to their valuation. These are the sort of markets where you can pick up really high-quality companies and do so at a reasonable price.

Ben Rundle's cash allocation and top stocks for when markets pivot

Ally Selby: You mentioned earlier that you're sitting on a little bit more cash than usual. How much cash are you actually sitting on?

Ben Rundle: We're between 25% and 30% at the moment, which is pretty high for us. We're not in a rush. We've been putting some to work, but it's sort of been building up with the inflows we're getting into our fund as well.

Ally Selby: Where have you actually been putting that money to work? Which sectors do you feel will lead a recovery, if we see one, in the next few months?

Ben Rundle: I think the ones that have been the most beaten up. If we do see a recovery, it's probably likely to be a very fast one and then you tend to see the high beta names. So, the platform providers, HUB (ASX: HUB), Netwealth (ASX: NWL), and Praemium (ASX: PPS) probably run pretty quickly because they'll start to get inflows into their businesses. So, it's those companies that will do well in a good market environment - and that at least have an earnings base to them at this point in time.

Michael Wayne's cash allocation and top stocks for when markets pivot 

Ally Selby: How much cash are you holding at the moment, Michael?

Michael Wayne: Probably between 15% to 20%. We've got a lot of clients who have cash holstered and ready to go, but we're pumping the brakes on that for now. Some clients, even if they are nervous and they want to smooth out that volatility, might even look at some inverse leveraged ETFs, for instance. You can get that on the NASDAQ or the ASX, and that just gives you a bit of downside protection. Obviously, if the markets rally sharply, it's going to do some damage, but it's the price you pay for that insurance. And it's not for everyone, but it's definitely conversations we've had with a few people.

Ally Selby: Which sectors do you feel will lead the recovery?

Michael Wayne: Yeah, like Ben says probably the ones that have been beaten up a lot.

Ally Selby: The long-duration stocks? 

Michael Wayne: Potentially, but I think a lot of quality growth will probably rally quickest, and things that have come back a long way, like Seek (ASX: SEK), REA Group (ASX: REA), Megaport (ASX: MP1). We own those three companies for instance, and we think that those businesses, although they've come back a long way, once the horizon clears up a little bit, they're the quality names that people will feel more comfortable jumping in, and you'll see them rally quickly. 

My fear with some of those higher PE, higher growth names is with the extreme valuations people might glance over those initially because there's no need to chase poor quality at this stage in the cycle. I think people can pick up very high-quality names, which have come back 30% to 40% instead. So, there's probably an argument to suggest that there's no point in trying to chase that high risk at this point because there are a lot more bargains on the table than were there a year ago.

Ally Selby: Well, that's all we have time for today. I hope you enjoyed that episode of Buy Hold Sell. If you did, why not give it a like? Remember to subscribe to our YouTube channel, we're adding so much great content every week.

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