Small caps are looking cheap. These are the stocks Ben Griffiths likes

Imagine launching a new investment firm in the midst of the dot.com crash. Add to that a specialist focus on small and emerging companies – a notoriously volatile area to invest. It sounds like a tough call, and yet, that’s exactly what managing director and senior portfolio manager Ben Griffiths and Brian Eley found themselves doing 20 years ago in founding the Eley Griffiths Group.

It’s testament to the idea that quality stock selection is more important than market timing – though an eye to point of cycle can certainly help with the bottom line.

While there are a range of concerns about the market, Griffiths thinks the worst may be behind us and that now could be a great time to get back in the market, especially in small caps.

“The small cap PE ratio is at about an 8-9% discount to the big cap equivalent so they’re trading at cheaper prices than the big caps. 

Yet, the big cap industrials will struggle to post any earnings growth in FY24, whereas the small cap part of the market will probably do between 10-15% earnings growth,” says Griffiths.

In this episode of Views from the Top, Griffiths shares his views on the market cycle, why small caps are looking good and which companies he likes. He also discusses the upcoming mid-cap strategy and two companies Eley Griffths Group favours in this space and his key insight from years of investing.

Topics discussed:

• 0:37 - The challenges of launching in the dot.com bear market
• 1:46 - Investing in different market cycles
• 4:30 - Where we are in the market cycle
• 8:22 - Opportunities in small-caps
• 10:31 - Views on resources and commodities
• 12:50 - The upcoming mid-cap strategy
• 16:33 - Ben's view from the top

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Edited transcript:

Hello and welcome to Views From the Top. I'm Sara Allen, and today I'm joined by Ben Griffiths. Ben is the co-founder, managing director and senior portfolio manager for the Eley Griffiths Group. Eley Griffiths Group is celebrating its 20th anniversary this year, which is no small feat when you think about the market cycles we've been through in that time. Today we're going to discuss how to invest through different market cycles, where we are in the cycle, and where Ben sees the opportunities in small and mid-cap companies. 

To begin with, can you discuss some of the challenges you faced launching Eley Griffiths in the third year of the dot.com bear rally?

It was every bit a harrowing time. Some of the real world ructions were extraordinary. You had SARS, you had the second Gulf War, you had the Iranian earthquake that killed a large number of people. There was a lot of tumult in the world and financial markets weren't spared either. There was chaos.

I recall when Brian Eley and I struck out and said, "let's set this thing up", there were a lot of doubting thomases who said, "it's a bad time to start, markets are going lower and its destined to trade into much lower levels". 

I remember thinking at the time that it was a lesson that there's never a good time or never a bad time to launch forward with a business. You do it when it's right, when you're confident and you think you can do a good job. So, on the basis of that logic, we set forth. 

In your 20 years with Eley Griffiths group, you've seen a lot of market cycles. What do you see as the factors for success investing during different market cycles?

Every cycle is different, however they do boil down to a couple of common elements. One is a discussion about valuation and the other a discussion about sentiment. 

In every situation, a cycle will peak on a valuation that's overstretched to the upside with ebullient and exuberant sentiment. 

Equally, a cycle will bottom in times of despair, when valuations contract and when investor sentiment is very negative - you have very poor animal spirits. 

If I can just share an example, I think the global financial crisis in 2009 is a great example where markets had had a very buoyant time up until December 2007, and then they began to unravel into a very pronounced downleg or economic contraction. And I recall wondering at that stage of the cycle, when will we know the cycle lowers in? When will you know that?

Of the two things I just referenced, we held on to the fact that valuations had contracted. I took a call from a private investor who rang up and was inquiring about three stocks we held in large quantity and he wanted to buy them. 

I said, "I'm sorry sir, we deal through stockbrokers. We don't deal directly with corporates, but can I ask what's your fixation with these three businesses and why are you calling me today?" He said, "Well, I can tell you one simple thing. Valuations on the listed market are now cheaper than valuations in the real world."

Of course, that absolutely rarely happens. Listed market valuations tend to be higher than the outside world or unlisted valuations. So you had the complete reverse of the valuation methodology where stocks were trading cheaper than real world businesses.

That for me was a bell ringing moment that valuations had reached rock bottom. It's time to start thinking about buying. And at the same time talking to people, you couldn't find a person in Pitt Street Mall or Hunter Street for that matter that would say, "yeah, I'm buying stocks. It's time to get the portfolio filled". 

So you had the extremities and that's what you get in cycles and markets. Markets are based around cycles, the yin and the yang. And so we need to make sure that, at the appropriate times, we've either got a bit of cash to take advantage of a cycle low or we're responding to valuations and we start pruning the portfolio when valuations are toppy and sentiment has run wild. And that's what you often get at the top.

Where are we in the cycle right now?

I thought you might ask that. When you look at the cycle, you can look at it in a couple of perspectives. You look at the real world economic cycle, which would suggest that we are on the cusp of a recession. That's certainly what the commentators would have you believe. I'll discuss that a bit more in a second. 

If you look at in terms of the market cycle, there are two different things. 

There's the economic cycle that plays and there's the market cycle, which is always pre-empting and presaging activity. 

It looks ahead and the market cycle goes through four stages as attributed to John Templeton. 

It goes through pessimism, scepticism, optimism, and euphoria. With a market cycle hat on, I think they aren't at the sceptical or the scepticism stage of the market.

I think we're pessimistic. 

I think there's more sceptics around about the impact that higher rates are going to have on investment and consumption and so on. We're not yet optimistic and we're a long way from euphoric. So I think in that cycle setting, we're through the bottoming stage and we're trying to get out of a sceptic stage in the market and in the economic setting. 

As I mentioned before, commentators are telling you we're going to soft or hard land at some combination of the two. It's interesting, I had a meeting this morning with Michael Knox who's the economist at Morgan Stockbrokers in Brisbane, and he said, "we're not going to have a recession in the US. The recession didn't happen. And that's simply because the US government has been spending and they've been growing their budget deficits substantially. And that enormous demand stimulant has meant that the US economy will get through without recession".

It's an interesting observation from Michael and it went some way to explaining yield curve activity to me. Yield curves are a great indicator - as yield curves invert, we know we're moving into a recession type footing and that's reason for concern. But yield curves now have started to, it's a terrible word, but they're dis-inverting or they're starting to steepen again. So if we're going into a steepening scenario, and that's been happening since early-mid May, that's almost the professional market saying, "I think the recession concerns have been overplayed". 

I think there's enough ingredients in place to suggest that the US economy won't go into a hard landing. It'll be a very modest landing. GDP will print positively in the fourth quarter of this year and first quarter next year suggesting that we're not going to go into recessed conditions.

The other thing I'm quite heartened about where we are in the cycle right now is people don't pay a lot of attention to the S&P earnings series. Certainly not people in this country, in the US, they're obsessed with quarterly earnings. But I think you'll find that the US market since March this year has been in upgrade mode. We've had Q2 earnings came out well and we've upgraded. Q3 earnings have been upgraded, Q4 and expectations for the whole of 2024 have also been lifted. 

Wall Street is starting to think the same way as Dr Knox, and that is that we may just get through without a recession. So there's a bit of confidence around. 

It feels to me like the worst is perhaps in the rear view mirror. And that markets have got a bit of that sniff right now, either expressed in bond market traders and with yield curves or just the man on the street. 

I saw some recent equity in flow data that suggested monies flowing back into mutual funds, both bond and equities. I think we're off the bottom of the cycle. The economic backdrop is looking slightly more constructive than it did 12 months ago, and that's getting people a little bit excited that maybe we're going a bit higher here.

On the note of optimism, we've had a few fund managers say to us that now is the time for buying small caps. Do you agree with that and where are you seeing some of the opportunities?

I would agree with that. You're probably thinking "he would say that", but I agree with it simply because the small cap PE ratio is at about an 8-9% discount to the big cap equivalent so they’re trading at cheaper prices than the big caps. Yet, the big cap industrials will struggle to post any earnings growth in FY24, whereas the small cap part of the market will probably do between 10-15% earnings growth. You're getting stocks that are kind of on sale, but they're offering far superior growth outcomes for next year. 

I think the fundamental base case is these stocks are cheap, they're priced cheaply for the growth we think they're going to deliver. And the other reason I think small caps look interesting is they've kind of been neglected somewhat. They've been cast aside, there've been chronic underperformers versus mid caps versus big caps since about December 21. They've been panned and they've been shunned and there's that sentiment thing coming back where the interest is not there. 

When you can show me a valuation case, as I mentioned, discount PEs and you can show me there's earnings growth coming through and there's a lot of disinterest from investors, then that tells me that small caps are a good place to be.

Any particular that you like in the moment?

Plenty. 

Can't lift the skirt too high on this show, Sara, but there's a number of stocks we like. There's a number of resource names in the energy space that we like. We're fans of Paladin Energy (ASX: PDN) and we're fans of Karoon Energy (ASX: KAR), so we've been big believers in where the oil prices is going. 

There's a number of good quality industrial names that we like. And as you might expect, Breville Group (ASX: BRG), we've got some Fisher & Paykel Healthcare (ASX: FPH). We have some Ridley (ASX: RIC) and we have some Siteminder (ASX: SDR). There's a number of stocks that aren't necessarily pigeonholed into sectors, but there's a good cross-section, we've seen quite a bit of value develop and we've taken advantage of that over several months.

You mentioned a couple of resources names in there now. I know you've been fairly bullish on resources and commodities in the past. Are you still fairly bullish in these areas going forward? And any particular commodities that you like? 

Constructive rather than bullish. 

I think that the fundamental supply demand ratios for most base metals are unbelievable right now in terms of being undersupplied and demand remains fairly buoyant. You see, in the oil market as well, demand is strong. I think there's average daily demand of over 106 million barrels of oil. Those estimates were what the market was pencilling in for five years time. We're now seeing the demand levels today. We like the outlook for the oil market and, by virtue of that, the gas market as well, and of course the uranium market. We've seen that perform very strongly in a number of stocks. There aren't a lot of stocks in the Australian market to get exposure there, but uranium generally has performed well and those stocks have also come into their own. So certainly materials and energies sector generally, but there are stories within that.

We don't go hunting for sectors. We go hunting for stocks and the outworking is a sectoral representation. 

We've got Genesis Minerals (ASX: GMD), which is a great emerging gold play in WA, and we are very familiar with Raleigh and his team who are doing an extraordinary job. They've had a few headwinds to navigate and we've navigated these with him, but we feel pretty good about the prospects for that group as we do for Capricorn as well. 

Capricorn Metals (ASX: CMM) is another gold stock that we own in the portfolio, but it's not a blanket approach. We've got a very specific portfolio construction methodology. That's how we're thinking about it. We're not getting too far ahead of ourselves. It's a very commodity specific thing. We're aware of the powerhouse that is China and the issues they're having up there. But as much as they've got issues below the surface, there's still plentiful demand for infrastructure projects up in China. 

So we're constructive rather than bullish for now and probably turn bullish at some point as we see China enjoy some stimulus and start to recover more efficiently.

I'm going to turn to the fact that you are in the process of launching a mid-cap strategy. Why do you see this as a natural progression for the firm?

It's a natural progression because we've owned 28 of the 50 stocks that live in that mid-cap space previously. We have all good working knowledge, we've got files on them that just probably need to be updated. But certainly we know the businesses well. 

It's a time honoured observation that mid-cap stocks tend to be among the sweeter performers in the Australian share market. It's a great hunting ground. The space tends to be underserved by managers. 

There aren't a huge number of managers who get down in the weeds in that part of the market, and we've been doing it for years. So it's a natural for us. And my strategist at work, Peter Stoltz, drew my attention to an interesting data point the other day. He said that the mid-cap PE ratio has derated by about 45% from where it was in November 2020 down to around 15.5x. 

This brings you bang in line with the top 50 stocks- you're paying the same sort of rating or the same sort of PE ratio for the top 50. Yet the growth prospects for mid-cap stocks are far, far superior than those that live in the top 50. Normally you pay a 10% premium to the big end and now they're trading at parity at the same PE ratio. So we think they're fundamentally cheap. We think they're fundamentally under-serviced or looked after or managed in a portfolio sense. And we think there's a great opportunity for us to extend our expertise and start building some portfolios around these names. 

Traditionally, as a small cap manager, we've had to release these stocks to the market because they've become a little bit too big for us. We now have the receptacle or the fund to capture those stocks and then nurse them through to their ultimate, which in many cases is top 50, top 20 inclusion. And if we can be on stocks like that, we've done our job. That's our job - to hold and nurture and identify value and good quality businesses. So that's why we're doing it.

Are there any stocks that you've released in the past that you're looking forward to bringing back to the portfolio?

There's a good number and we've got a great team up at Eley Griffiths Group pouring over the sort of members or the stocks that should be a part of the portfolio. 

There's two that we're very fond of and we have a very long history with that. Again, I'm lifting the skirt a bit because we haven't bought them yet for the new fund of course. 

A stock like Carsales.com (ASX: CAR) and a stock like Worley (ASX: WOR) would be two great examples of fully fledged mid-caps who are about the same size, about $9-10bn in market cap. They are two very different businesses. 

One's an online marketplace for motor vehicles and the other clearly is oil and gas and renewable energy construction group. Both those businesses are very well managed. We're familiar with the management teams. They have great earnings perspectivity. In the case of Worley, there's a great order book. There's a lot going on there. 

Carsales is prosecuting a great business that's been in formation for a long time. We owned it when it debuted and first came onto the market. We owned it for a long time and we've since now cast our affections back to it. So there's two names, for instance, that many of the viewers would be across and would be familiar with, and we think they're outstanding names.

What's one thing that you've become privy to recently that you wouldn't have come across had it not been for your experience and your position at the moment - that is, what's your view from the top?

My view from the top is that experience counts for plenty in stock markets and stock market investing. It helps to have participated in a few cycles to know when you see value staring at the face, what you've got to do about it. 

The fact we, as a group, are so well integrated into small and mid-cap land corporately means our insights and our conviction around our positions is strong. 

My view from the top is one of relative confidence with where the economy's heading. I'm sufficiently confident we'll be able to find oversold gems, unloved pets, call them what you like, in the marketplace. We think we'll do a good job of finding them. That's the business we've always been in is finding diamonds in the rough. That's what I think we'll do. I think that's something this team, which is very established and stable, has the ability to parlay experience and put it to work.

Thank you so much for sharing your insights with us today, Ben.

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