Another financial year draws to a close which presents an opportunity to look forward to the financial year ahead. We believe FY19 will involve more of the same, and some noteworthy changes. In this wire, we discuss our top 5 considerations for smaller companies’ investors who are aiming for out-performance in FY19 and beyond.

Smaller companies’ earnings upgrade cycle coming? Will earnings matter?

Australian economic growth is consensually expected to be higher in FY19 versus FY18, which provides a solid backdrop for corporate earnings growth. In our experience, smaller companies are generally more leveraged to the local Australian economy than larger companies.

This reflects a greater domestic focus as they build their business models from an earlier stage in the business development cycle, and often a more opportunistic management mindset as they aim to establish their market share from a low base.

As such, strengthening domestic economic growth is expected to be particularly supportive of an earnings upgrade cycle for ASX listed smaller companies in FY19.

Having said this, one of the smaller companies themes evident in FY18 was that investors generally focused more upon concept and theme based stocks, rather than fundamental earnings driven investment cases. Earnings seemed to matter less than normal as a result. So, it is worth asking whether a smaller companies earnings upgrade cycle will have a significant impact in FY19?

We believe earnings will matter for smaller companies in FY19 for three key reasons:

1. Market inefficiencies tend to resolve themselves over the long-term
2. Investors in concept stocks tend to lose interest when a story starts to lose momentum and these funds then look for a home elsewhere, often in the next strategy which is working at the time;
3. The market always cycles between value and growth, and value investing as a strategy currently appears to be at a cyclical low. This suggests to us that risk is on the upside for a fundamental value-based investment approach in FY19.

The profound impact of the Royal Commission on smaller financial services players

The Australian financial services sector is clearly in shake-up mode as the Banking Royal Commission has highlighted. There are a large number of smaller ASX listed companies operating in financial services that may be impacted, such as platform providers, financial planning, and funds management businesses.  

We believe there are a number of ramifications:

1. Trust has become scarce in the financial services sector which means emerging and innovative customer-centric financial advisory firms have a well-defined growth opportunity ahead of them. An interesting exposure here is through smaller companies such as Easton Investments (ASX:EAS) and Countplus (ASX:CUP) which are both well placed to benefit from the convergence of accounting and wealth services. Accountants are generally seen as trusted advisers who can offer an increasing range of wealth management services to their client base.  
2. Royal Commission recommendations look likely to promote independent and objective advice as the best model for the industry looking forward. This implies to us that conditions are ripe for smaller emerging financial services operators to take significant market share from the larger institutions who are a long way from being independent and objective. Independent platform providers such as Hub24 (ASX:HUB) and NetWealth (ASX:NWL) are positioned well, although both appear to have a significant amount of future success already reflected in their share prices.
3. Larger financial services conglomerates are likely to be forced into redefining their business models in the near term which suggests a pickup in M&A activity is likely, with some players concurrently buying and selling assets, as they focus on a few core competencies rather than being all things to all people. The value of high quality smaller players is likely to benefit from this M&A activity whilst unsustainable business models with minimal value add are likely to find the going a lot tougher.

We believe investors should position themselves accordingly ahead of the Royal Commission interim report due in September and the final report due in February 2019.

Takeover activity is likely to increase. Compelling smaller company opportunities to become scarcer

Corporate Australia en masse remains in a generally healthy state with balance sheet strength remaining a theme for the broader market. Whilst Australian dividend payout ratios remain extremely high by international standards, we believe in an environment of strengthening economic growth, business confidence is also likely to strengthen.

Stronger business confidence tends to leads to more M&A activity. And it is worth remembering that Australia, due to its proximity to Asia, continues to be seen as an attractive investment destination for global companies looking to diversify into the Asia-Pacific region. Many US corporates in particular are currently cashed up by virtue of a buoyant US economy and the recent tax cuts, and are looking for acquisitions in Asia.

As a result, we believe FY19 will be a year of significant takeover activity on the ASX. Smaller companies are obviously more vulnerable to takeover risk so we are expecting to lose a number of our potential investment opportunities in the coming financial year.

Following the takeover of Mantra by Accor Hotels in May, we have seen Sealink (ASX:SLK), one of the few remaining high-quality tourism companies on the ASX, receive a takeover offer. Beaten up stocks also represent potential takeover opportunities, with I-Select (ASX:ISU) currently in play, and cheap defensive stocks such as Konekt (ASX:KKT) looking particularly vulnerable.

New business models vs old business models: the changing of the guard is speeding up

This is a general theme which has been occurring in the US for some time now. New disruptive business models are disrupting the old guard faster than ever, by virtue of faster routes to market and far more efficient new distribution networks.

Australia has arguably remained behind the global curve on this front in recent years as evidenced by the All Ords’ Technology weighting of only 1% versus 24% for the S&P 500.

However, we have observed in our wanderings that more and more Australian technology companies are becoming both innovative and disruptive. Companies that are emerging as leading players in their respective market niches include:

• Gentrack (ASX:GTK),
• Appen (ASX:APX),
• Wisetech Global (ASX:WTC),
• Janison Education (ASX:JAN),
• Xero (ASX:XRO) and
• Altium (ASX:ALU)

It feels to us like there is a “changing of the guard” underway, which bodes well for the coming financial year and beyond, with technology companies making up an increasingly significant portion of their respective indices. Watch this space.

Financial leverage likely to come into focus

The global interest rate cycle is clearly in an upward trajectory at present, led by the US. Whilst the RBA remains on hold at this stage, no country exists in isolation given the interconnected nature of global financial markets, and thus it is worth keeping an eye on global interest rates, and US interest rate developments in particular.

Given the backdrop of a decade of abnormally low interest rates, a significant increase in interest rates looking forward is likely to sort the wheat from the chaff in the world of listed equities.

As the famous expression goes “you only find out who is swimming naked when the tide goes out”. In a rising interest rate market, we believe investors are likely to ascribe higher valuations to companies with strong balance sheets and vice versa. One of the benefits of investing in smaller companies is that generally they have either equity funded their growth or have relatively conservative gearing metrics.

As high quality focused investors, we will continue to focus on companies with net cash surpluses, and believe this balance sheet strength will increasingly be rewarded by investors looking forward.