Why there's more wheeling and dealing to come in the ASX small caps

Following a tough FY2022, FY2023 was an improvement for small-cap investors. The ASX Small Ordinaries Accumulation Index rose 8.5% over the year. However, small caps once again underperformed large caps with the ASX 200 advancing 14.7%. FY2023 was a welcome reprieve from the macro-driven market of FY2022 where factor positioning drove returns rather than stock-specifics.

Figure 1: The Small Ordinaries Index has underperformed the ASX 200 by over 20% since October 2021…

Figure 2: Small Ords underperformance has been largely driven by the Metals & Mining, Consumer Discretionary, Financials and IT sectors

Three key themes stood out to us over the year and continue to be a key focus:

1. Depressed valuations and a buyers’ strike; opportunity for private equity
2. The (cost) problem that won’t go away
3. Has the consumer finally cracked?

Depressed valuations and a buyers’ strike; opportunity for private equity

Who wants to be listed anyway? Over FY2023, a combination of declining investor interest and liquidity created several bargains. Towards the end of FY2023, private equity capitalised on several instances where the listed market refused to pay fair value for small and micro-cap companies. We expect this to continue, as evidenced by announcements by Costa Group (ASX: CGC) and United Malt Group (ASX: UMG) already in FY2024! Many industrial small companies that are self-funding and primed for growth are trading on single-digit price-to-earnings ratios or below the replacement value of their assets. For private equity with record amounts of ‘dry powder’, acquiring listed assets now makes sense.

Despite the positive short-term returns from takeovers, we question some of the recent valuations that boards and management teams have been willing to accept. 

Overall, the ‘premiums’ to share prices offered for many takeovers we’ve seen do reflect fair value for current year earnings but fail to value the companies’ 3-year outlook or fundamental changes in industry structure. 

Put another way, is a certain 30% premium today worth more than a risky 20% p.a. return compounded over the next 3 years? From a portfolio perspective, the answer depends on our ability to redeploy capital in companies with more upside than the company being taken over.

For some management teams, we understand that being unlisted may be preferable and, over the short term, lucrative. For boards, there is clearly significant pressure to consider offers with attractive headline premiums. Despite the long-term implications of many great companies being removed from our investment universe, the short-term impact is unequivocally positive.

Figure 3: Silk Laser Australia received a bid from Wesfarmers in Q2 2023

Figure 4: Estia Health received a second bid from Bain Capital in Q2 2023

The (cost) problem that won’t go away

Many of the incremental costs borne by companies due to COVID-19 are disappearing as supply chains normalise. At the same time, more persistent underlying cost inflation is taking over. While goods price inflation has decreased, services inflation remains stubbornly high. As a result, many companies with labour costs are seeing 7-9% year-on-year cost inflation which is difficult to offset.

Electricity costs deserve a special mention. Owing to fundamental shortfalls in Southern East Coast gas supply, we expect electricity prices to remain elevated around A$150/MW for the next few years. Many companies and consumers will see sustained price increases of 50-100%! Insurance and finance costs are increasing strongly in line with the cost of capital, as are rental costs

Understandably, against this backdrop, companies with the ability to offset cost pressures by raising prices have outperformed the broader market, and are trading at lofty valuations. Companies with large amounts of debt (or lease liabilities) relative to cash flow have been sold off. Should these headwinds persist, many may need to raise additional equity at discounted valuations. This will present opportunities to selective investors.

Figure 5: While goods inflation has started to taper, services inflation is still rising

Has the consumer finally cracked?

Mortgage holders should hope that RBA Governor Phillip Lowe is an avid small-cap investor and has been closely following recent trading updates from the consumer sector. Many listed and unlisted companies we speak to are experiencing -20% year-on-year declines in sales because of collapsing consumer traffic. Add rising labour costs, energy prices, rent, insurance and finance costs, and it is easy to see how many small-cap companies may see profits go negative. In volume terms, -20% may understate the real volume decline in goods given broad-based inflation over the past 12 months of ~7%!

Finance companies are seeing increases in borrowers unable to meet loan commitments of over 10% month-on-month. Bankruptcies are three times higher than levels two years ago. While these statistics are misleading given the low base caused by COVID stimulus, the trends are clear. By historical measures of financial stress, we haven’t even started yet.

How can we be positive against this backdrop? Australian cyclicals make up just ~15% of the ASX Small Ordinaries Index and even here there are opportunities! For instance, baby boomers with significant net cash balance sheets are enjoying extra income from higher interest rates. 

Travel agent feedback in the last few weeks has highlighted an increase in the number of bookings valued at over A$30,000. Many consumers are booking multiple A$10,000+ trips at the same time! Essential workers in some fields are enjoying record pay increases and targeted government support is causing some consumer finance to report over 50% increases in their number of customers. Many companies in the eye of the storm are trading at 50% discounts to what we believe is fair value on a medium-term outlook.

Figure 6: NAB Consumer Spending Pulse: Expected changes in household spending patterns in the next three months (net balance of consumers). Fewer consumers are expecting to spend on discretionary purchases

Figure 7: Small cap retailers have sold off on the back of slowing consumer spending

FY2024 outlook and positioning

The ASX Small Ordinaries Index is trading on 17.4x 1-year forward earnings which is broadly in line with the 5-year average. However, this number is misleading. It incorporates many loss-making stocks that make up over 12% of the index. Excluding these stocks, the 1-year forward price-to-earnings ratio is 14.5x, which is lower than the ASX 200 (14.9x) despite a much stronger growth outlook.

Consensus is forecasting 11% earnings growth for the next 12 months. Despite forward earnings estimates falling by 17% since June 2022, we expect more downgrades to flow through the market in the coming months. Weakening consumer demand, and rising labour, energy and finance costs will once again be the focus during the August reporting season.

The good news for investors is that for many stocks, this appears to be ‘priced in’. At an index level, the small-cap market represents good value when considering the 3-year growth outlook. We are increasingly optimistic and are seeing many opportunities to buy companies at significant discounts to fair value across all sectors.

Figure 8: At the index level, the weakening consumer outlook looks largely priced in. We believe the market represents good value considering the 3-year growth outlook

The small cap market is more exposed to Australian consumer cyclical and high-growth technology stocks than the ASX 200. In our view, many of these loss-making technology stocks with line of sight to positive free cash flow within 2 years represent compelling value. However, we are proactively managing our risk exposure in this part of the market. ‘Quality’ stocks with perceived earnings certainty are popular among investors. Most appear overvalued.

As always, we are focused on identifying compelling bottom-up stock opportunities across all sectors of the market. This approach ensures excess returns are driven by stock selection rather than a bias towards a particular style or sector. As shown in Figure 9, the Firetrail Australian Small Companies portfolio exhibits better value and stronger earnings growth than the ASX Small Ordinaries Index.

In recent weeks, we have been increasing our exposure to existing defensive and growth holdings. We have also undertaken deep-dive research into several high-quality consumer-exposed companies which are trading at attractive mid-cycle valuations. We anticipate that the first half of FY2024 will provide buying opportunities in many small cap stocks.

Figure 9: Firetrail Australian Small Companies Fund is highly active, exhibiting better value and stronger earnings growth than the ASX Small Ords Index

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