Outlook 2018: What’s in store for small caps?

An outlook for 2018 is best served with a quick recap of the last six months. After a tepid first half of 2017, the Australian Small Ordinaries index (XSO) rose strongly over the second half of the calendar year, to be up over 18% (at the end of December). While the headline gain is impressive, the reality is that this rally has been fairly narrowly based with a small number of stocks recording strong gains.  This rally has been driven by a frantic search for earnings growth given what continues to be a low growth domestic economy.

In their quest for growth investors have aggressively chased stocks exposed to thematics associated with the Chinese daighou export market, Resource stocks exposed to commodities required by Electric Vehicles and certain tech stocks, such as Wisetech. In this chase for growth, the divergence between growth expectations and the price investors are willing to pay for that growth has widened significantly.   

Chart 1. Small cap investors are paying more for less growth

Source: Blue Ocean Equities

The surge in these certain ‘concept’ stocks has given rise to pockets of over-valuation in the Small cap segment of the market. With the valuations in these ‘concept’ sectors at extreme levels, they have dragged the broader small cap index to over 19 times 2018 earnings, and a below average dividend yield of 3.3%. At the same time more mature companies’ stocks which are more exposed to the domestic economy such as GWA and Sothern Cross have, until recently, lagged the Small Caps’ sector rise. As a result, in our view, many of these stocks are trading at reasonable multiples.

So, what’s in store for 2018?

With interest rates globally still at record lows, and with many major global economies now recording reasonable economic growth, a rebound in inflation is possible in some parts of the world. This could potentially pose significant risk to global share markets, particularly in the US where unemployment is now at 4.1%, a 17-year low. The US tax cuts approved in December could act to stimulate the economy further with the risk of significant short-term interest rate increases over 2018. Should this occur, it would be negative for equities. In this environment, the equity market would be susceptible to a correction – but especially many of the ‘concept’ stocks that have been bid up aggressively and which are trading at expensive multiples.   

In the context of Australia, we would be very cautious on these ‘thematic concept’ stocks, where valuations have been bid up and where multiples look very stretched.  Stocks, such as Blackmores and Wisetech, which trade at a minimum of over 38 times earnings carry significant price risk in our opinion. With the recent run in the small cap index having been very narrowly based we believe this makes the index susceptible to a pullback. We see 2018 as a year for investor caution, particularly in those stocks where valuations have been bid up aggressively.

Chart 2. Small cap performance FY18 to date has been dominated by a narrow band of stocks.

Source: FactSet, IML Date range: 30/06-29/12/2017

Where to find opportunities in 2018

With domestic growth still lacklustre, opportunities next year will come in companies that are able to grow through their own initiatives, for example through cost out or via strategic acquisitions. Tox Free Solutions (TOX) has been a core holding in our portfolios for some time, given our view that the business represents a desirable suite of assets with significant barriers to entry and a difficult to replicate footprint. The company has grown through a series of acquisitions to the point where it is the leader in the liquid and hazardous waste industry in Australia. The Cleanaway bid for the stock in mid-December vindicates our holding in Tox and is affirmation of the company’s long-term strategy. In the current low growth environment, we believe there will be an ongoing pursuit of growth by corporates through strategic takeovers and we expect that further corporate activity will be a feature of the market in 2018.   

Companies that can offer growth through contracted revenues, higher market share, or restructuring will also offer opportunity next year.

Southern Cross Austereo (SXL) is a company that has improved the quality of its business significantly via restructuring in the last few years. SXL is what some would classify as an ‘old world’ Radio company. Having said this the company trades on an attractive 10x earnings and a dividend yield of 7% fully franked. With costs largely fixed, and radio continuing to grow as a medium, this company generates significant cash. We have a high opinion of CEO Grant Blackley, who through a series of non-core divestments has repaired the balance sheet and positioned the company well for any industry consolidation going forward. In our opinion, the stock prices of companies like this should do well in an environment where earnings and cash flow take precedence over ‘concepts’.

One company that ticks all our boxes

We like companies with recurring earnings and sustainable competitive advantage, run by good management, that can grow, trading at a reasonable price. Over time, such companies should perform well. On these measures, Pact Group (PGH) is currently the largest weight in our portfolio and that we believe can do very well in the next 3 to 5 years. Pact is the leading manufacturer of rigid plastics in Australia, with long-term blue chip customers and recurring and defensive orientated revenues. The company is growing and has expanded into contract manufacturing and pallet pooling. The company also operates in Asia which represents an additional growth avenue. Trading on a below market multiple of 16.6x and a solid 4.2% yield, strong franchises such as Pact with valuation support should perform well over the coming years.

Into 2018, investors should look to own quality industrial companies that are capable of generating growth under their own steam and which are able to generate good free cash for their shareholders.

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Disclaimer: While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.