Why small-cap stocks may have a big runway over the next 12 months

It should have been a much tougher 18 months for equity markets. Interest rates are up 450 basis points in the United States, the 2s/10s curve has been inverted for nine months, and inflation is still above target in most major economies. But just because it should have been does not mean it has happened.

As it actually stands, the benchmark MSCI World Index is just 12% off all-time highs and the ASX 200 is inches away from the all-time high set back in February this year. Internationally, most companies have reported another round of resilient earnings. Some US regional banks and some European consumer plays are providing a minor blip to the overarching storyline.

This is all a long way of saying that equities have remained sturdy at a time when they arguably shouldn't be. 

While some analysts believe this means the risk of a big drop has increased, the team at Wilson Asset Management are much more constructive, with WAM Global Lead Portfolio Manager Catriona Burns arguing the next 12 months in markets might be more "exciting". 

In this wire, I'll take you through the key insights from the annual Wilson Asset Management Shareholder Presentation. 

Burns: Take advantage of the discount

While 2022 was a less than stellar year for large-caps, it was the 10th-worst year for small cap stocks globally since records began in 1926. For plenty of investors, that's a reason to pack your bags but Burns sees things differently. 

"We are cautious in terms of the overall market but we look at the companies that we own and we're actually very excited because when we look at the underlying earnings of those companies, we think they're really well positioned going forward," Burns told the audience of shareholders and clients.

The WAM Global fund is now bullish on global small caps with a bias towards select, resilient growth companies.

"We have some exciting opportunities in the healthcare space which tends to be much more resilient. We see opportunities in the data space like exchanges and infrastructure," she added.

The re-rate has also provided an opportunity for small and mid-cap stocks despite the risk of more blow-ups. Traditionally, companies in these areas have traded at a premium but at the moment, they trade at a 10% discount. 

Haupt: Where macro meets stock picking

In the Australian large-caps, the opportunity set is much more nuanced. As Matthew Haupt, WAM Leaders Lead Portfolio Manager pointed out, the ASX is a macro-driven market where economic data points can and often do provide leads for stock selection in the top 200. 

"These companies are really driven by the macro environment and the Australian Dollar is used as a risk-on mechanism," Haupt pointed out. "We do the bottom up stock picking as well but on a daily basis, we adjust the portfolio based off the data we are receiving."

"It's not trading for the sake of trading," he hastens to add.

As for individual sectors, financials and materials (or more colloquially, houses and holes) make up more than 50% of the ASX 200. This naturally takes up most of Haupt's attention.

And while both sectors have a reputation for being good dividend payers, it's not been without its challenges. For the Big Four (and to a lesser extent, Macquarie), the fastest rate rises in decades haven't had the desired effect.

"The environment was set up really well for the Australian banks because interest rate increases are great for banks," Haupt said. "But what we've seen since October is that competition in the sector has given away all those extra returns which we thought they were going to have," he noted.

In addition, the US money markets are showing signs of stress. Stateside investors have been running to these instruments in droves and consequently, the yield on individual instruments can now often change dramatically overnight.

All this points to an UNDERWEIGHT positioning in the Big Banks. For Haupt, ANZ (ASX: ANZ) and Westpac (ASX: WBC) are considered the "trading" banks while NAB (ASX: NAB) and (ASX: CBA) are considered the quality, long-term holds. 

In the broader materials space, the China story is described as "reasonably attractive" by Haupt. Having said this, not all materials companies rank equally when it comes to finding the best opportunities in the Chinese reopening.

"For us, China is so important around BHP (ASX: BHP), Rio Tinto (ASX: RIO), Fortescue (ASX: FMG) and some of the smaller miners like Iluka (ASX: ILU) and South32 (ASX: S32) to a lesser extent," Haupt said. "As long as credit generation keeps coming through, it looks like a reasonable place to invest for the time being."

Of the five names mentioned above, Iluka and BHP are Haupt's preferred picks while Newcrest Mining (ASX: NCM) provides optimal exposure to both the gold and copper prices.

In the energy space, Haupt says Santos (ASX: STO) makes up 5% of the portfolio. In addition, he willingly admits that he is "always" an oil bull due to the constant back-and-forth at the geopolitical level.

Oberg: Lots of companies are undervalued

After a tough 18 months for small-cap investors, WAM Capital Lead Portfolio Manager Oscar Oberg argues that better days are ahead for companies with strong balance sheets and attractive valuations which can perform irrespective of the business cycle. 

"We focus on small-cap industrials that have a catalyst which could lead to a re-rate in the share price," Oberg said. 

And speaking of catalysts, Oberg and the WAM Capital fund have found several of those lately with three portfolio holdings receiving takeover offers in as many weeks. 

"It shows there are a lot of companies that are trading on what we consider to be below fair value. What's more important is that most of our companies have strong balance sheets so we see a positive period for capital management or accretive acquisitions at this point in the cycle," he added.

Oberg's team have also had wins in the agriculture sector. Elders (ASX: ELD) and GrainCorp (ASX: GNC) are among two of the recent holdings which were recently sold. The one name from the space that remains in the fund is Select Harvests (ASX: SHV) and that's in large part due to the underperformance for the price of its primary product (almonds). In the biotech space, Oberg nominates Neuren Pharmaceuticals (ASX: NEU) as one company making waves.

Zinurova: Be patient. Returns take time.

Alternative assets are increasingly becoming part of the "perfect portfolio" conversation as more investors shun (or at least, move away from) the traditional 60/40 portfolio and look to include other diversifiers such as private equity and real estate. 

The one thing that alternative assets don't have that equities and bonds tend to have is correlation. 

"When other asset classes go down or experience a lot of volatility, alternative assets bring strong complementary benefits to portfolios. They continue to deliver strong, predictable returns and protection against rising inflation," Zinurova explained.

In the next 12 months, Zinurova said she will be looking much more at opportunities in the M&A and private equity markets. 

"We'll be looking for more opportunities to provide protection against rising interest rates like private debt," she added.

Other assets the fund is invested in include a stake in Gosford Private Hospital, which has a long-term lease and possesses potential for long-term capital appreciation. 

Geoff's final word on dividends

It's not a Wilson Asset Management presentation without hearing from the man who started it all. Geoff Wilson AO fielded many questions from the audience along with the panel, but it's the one on dividends that sticks out for this humble observer.

"In terms of your return, if we were paying a 4% yield, then you can't have more capital gain. You can't have both." he said. 

Investing is always full of choices but in tough markets like the one that is happening now, choosing to go for one over the other is a real quandary.

You can catch the full presentation here.