Why Australian small caps are looking promising and three stocks to watch

Just over a month ago, Australian small and mid-caps were looking close to fully valued. A stronger than expected reporting season has changed the game.

In fact, Stephen Wood, co-founder and portfolio manager at Eiger Capital, points out that earnings are going well. He notes that forward PE ratios of around 16 times and the prospect of US rate cuts are also likely to be supportive.

“The economy's stronger than we probably had expected. Earnings revisions are up, Wood says.

"And consequently, those target forward PE ratios that we were talking about, while the stocks haven't dropped, the earnings have actually been pretty strong. We've seen across the board 10 and 15% upward revisions to earnings,” says Wood.

It’s a good time to be hunting for opportunities, and Wood particularly likes what he is seeing in areas that haven’t experienced the full ASX rally.

In this episode of The Pitch, Wood discusses the small-cap environment and shares three stocks he particularly likes in the energy, construction and healthcare sectors.

Note: This interview was recorded on Wednesday 27 March 2024. You can watch the video or read an edited transcript below.

Edited transcript

Where are we in the small-cap cycle and what are the key headwinds and tailwinds you are seeing?

Wood: If you’d asked me this just a month ago as we were rolling into the back of reporting season, I would have said to you things are starting to look fully valued. If you look at the long-term averages for PE ratios in the small-cap market, we’re approaching 21-22 times PEs and that’s starting to look like full value. It wasn’t just small caps, it was mid-caps as well. The ASX was a bit lower and both mids and smalls were at a 10-15% premium, not only to long-term averages but to the ASX200 as well.

However, reporting season was quite a bit stronger in many sectors than many of us were expecting. Retail was quite a big one. In the post-mortem from reporting season, a lot of people are looking back to the Melbourne Cup rate rise which was not great for retailers rolling into Christmas. 

What on earth has happened? Immigration. A lot of people have turned up, they’ve got to fit a house or flat out. The students are all back. The economy is stronger than we expected. Earnings revisions are up and consequently, we’ve seen 10 and 15% upward revisions to earnings. Those forward PE ratios are back around the 16 times mark, which is not too bad.

A month ago before reporting season, it looked fully valued. Earnings are going well and if we do get rate cuts in the US later on this year, that is probably supportive for valuations as well.

Are we now finally seeing the market for small caps?

Reasonably positive. We’ve got a strong economy.

I don’t think we’re necessarily going to get rate rises in Australia, nor do I think we’re going to get rate cuts, but the economy is going very well. Consequently, earnings are looking good and markets are responding accordingly.

Where are you seeing the best opportunities?

We’ve got several ideas at the moment. Some of the sectors like retail and REITs have run pretty hard and we’re stepping through that at the moment. A few places that have been left behind are areas like energy (excluding uranium, which has been strong).

One idea we’ve got in that space is a company called Karoon Energy (ASX: KAR). They made a major acquisition late last year. It’s diluted their share base, for want of a better term. There has been some indecision around the capital raise. The share price has been stuck at under $2 since the raising. 

Before the acquisition, it was $2.35. We’ve seen the oil price go a bit soggy, but oil prices come back. Brent is now around $85 and we think, with its new acquisition, Karoon has a pretty solid year ahead with very strong cash flows. That’s one idea that could go well if we start to get rate cuts in the global economy. 

Another one that is very non-economic dependent is Telix Pharmaceuticals (ASX: TLX). It’s a stock that exploded in the last 15-18 months when its first product hit commercialisation. It has generated some enormous revenue off the back of it. 

The fabulous thing that it has going in the next year is two adjacent products coming up to back up the one they’ve already released – which has generated strong revenue. They’ve got an equivalent product related to kidneys and brain cancer. It looks like it will be approved in the next six months. If that comes through, that’s another stock that hasn’t been caught up in the "oh my goodness, the economy is stronger than we expected".

What are some sectors you are avoiding? Have you sold any positions as a result?

As a general rule, we avoid stocks that have low returns on invested capital. They tend to have lots of capital, low margins and often, limited growth. 

For us, the best group of stocks that encapsulate that are REITs. They own a lot of land, they are very capital intensive and they have limited growth. That sector has done very well in the last three months. That’s a sector we would probably avoid.

The retailers have been epically strong in the last three months, and frankly, we didn’t expect them to be that strong. With some of the earnings valuations in that space, with a few very selected exceptions, that’s an area we think "a lot of the juice has probably been drunk", so we’d let that go as well.

We go looking for something that hasn’t done so well or is not cyclically exposed. The best example we’ve got at the moment is Telix.

You’ve mentioned Telix and Karoon Energy. Do you have any other top stock picks?

Another stock with bipolar views in the small caps space is Johns Lyng Group (ASX: JLG). Johns Lyng got people’s attention with a hiss and a roar in 2018-2019. They are in the construction space but more in terms of restoration work for insurance companies or for body corporates. For example, when something goes wrong in your apartment block. That’s more their style than actually building your house or apartment block or helping with an airport. They caught attention back then because we had massive floods in northern NSW, massive floods in Victoria and we’d just had bushfires. They had an enormous body of catastrophe work and the market noticed.

Over time, people start thinking the catastrophe work is a one-off and re-evaluate and pull back. In the last couple of years, the stock price has gone from $9 to $6 but they’ve been building up their business-as-usual revenue. There is a lot of insurance work that isn’t "Lismore’s been flooded three times this year." There’s a lot of ongoing maintenance, breakages, and minor weather damage which is happening more frequently. That business is building up and up.

Not only that, they have expanded into the US and very recently, they were on a panel with Allstate – one of the biggest insurers in the US. While the market is thinking "catastrophe is not so good," revenue is growing nicely and they’ll top a billion dollars this year. There’s a great opportunity they have in the US and the market has left this one behind.

If we were to pick a stock that could reignite some of the enthusiasm the market could have for it, it would be this one. It’s been left behind. They have a couple of things they can deliver on, particularly expanding the US business, and we think it looks really good value assuming they can pull that off.

Digging deeper to find the best opportunities

Eiger Capital is an active boutique Australian equities investment manager specialising in small companies. For further information, please visit their website or fund profile below.

Managed Fund

Eiger Australian Small Companies Fund

Australian Shares

View