October 01, 2019

October 01, 2019 | Adviser News

What’s happening in Small Caps?

If you look at the Small Caps index return over the last 12 months to the end of August and compare it to what the big end of town has done, you could be forgiven for asking what’s going on. After all, the ASX Small Ordinaries Index return of 0.95% over the period has fallen well short of the ASX 100 return of over 10%.

Well, part of the story appears to have been driven by the macro-economic backdrop. Economic growth expectations in Australia have eased and smaller companies tend to be more sensitive to such changes. The big caps also appear to have received a disproportionate boost from May’s election result.

Dis-engaged investors?

Volatility and uncertainty can also sway investor behaviour, with periods like the final quarter of 2018 prompting a rotation out of smaller companies and back into the bigger – and perceived safer – end of the market. The associated impact on more conceptual names also seemed to be significant (think Lithium stocks, for example) and it is here that investors can sometimes be slower to re-engage.

Of course, a moment in time does not tell the full story and a look at a longer time frame, say 5 years, reveals a much more comparable number. Also, investing in Small Caps has never really been about the index – instead, this is the realm of the active investor, distilling the (often under-researched) whole to uncover individual mispricings and attractive opportunities that can generate long-term wealth.

Finding the balance

Perhaps this is at its most obvious during reporting season, where most recently we saw fairly lacklustre results at the overall index level largely meet expectations. However, at the individual stock level, large share price moves in response to short-term beats and misses showed that there is a lot more going on under the surface. This remains an ongoing challenge – and opportunity – for active Small Cap managers and finding the balance between valuation and confidence in companies delivering to expectation is highly relevant.

A broad observation from the most recent reporting season is that revenue growth remains difficult to generate and that cost growth continues to tick away, as rents and utility bills increase. Wage growth has not been a material factor to date, though these costs seem likely to begin growing from here, creating further pressure on underlying earnings.

Category killers winning in the mall

But while revenue growth is elusive at the overall index level, it is still available if you know where to look. Perhaps a surprising example of this is in the retail space. With consumer sentiment subdued and headline retail sales growth soft, it’s understandable that investors in general have been wary of the sector. But look inside the mall, and there are individual specialist retailers that have definitely been bucking the trend.

For example, Baby Bunting, which is now Australia’s largest one-stop baby shop, saw total sales grow by 21% in the year to June 2019. This was a solid rebound after a challenging period in the prior financial year, when several competitors exited the sector with liquidation sales. Comparable store sales growth, at over 8%, is strong and guidance suggests that the company expects to continue to leverage its ‘category killer’ position.

Fertile hunting ground

City Chic is another great example. The plus-size apparel retailer saw total sales grow 12% and the successful expansion of its online sales base (which now accounts for over 40% of sales) has boosted profitability further. While City Chic is not a constituent of the ASX Small Ordinaries Index, at a market capitalization of nearly $500mn it is by no means a microcap. Relatively large, non-index stocks can be a fertile hunting ground for those that are willing to do the work.

Both companies offer investors structural growth for the next few years and ongoing execution should see delivery of double-digit earnings growth that is less reliant on tax-cuts and broader consumer sentiment. While it may be too early to speak broadly of ‘green shoots’ in the retail sector, individual opportunities appear available to those with the right tools and disciplines to identify them.

Powerful levers

Celeste Funds Management*, a specialist Small Caps’ fund manager, recognises the importance of focusing on companies that can grow revenues and earnings and generate strong free cash flow. Taking a 3-5 year view on individual investments, the experienced investment team also believes that quality companies typically have levers that can help them to offset external headwinds, including a weaker Australian economy.

Celeste looks for levers that help buffer the company in tougher times and leverage earnings and cash flow in good times.  These factors are a combination of strong brand names to aid them to deliver genuine pricing power, good cost control that can be squeezed when times get tough, a strong balance sheet to provide financial flexibility and good cash generation to drive both business reinvestment and dividends for shareholders.  Ultimately, Celeste makes an assessment of the medium term cash flow characteristics of the business and assesses the likely rating the market will pay for this. These are important considerations in understanding the intrinsic worth of the company, and they often uncover a significant opportunity where the value is materially above the current share price.

Weighing up valuations

Finally, how far have valuations impacted on Small Caps’ recent relative performance? Today, Small Caps trade on a similar multiple of forward earnings as their larger cap peers, an improvement from the recent premium, but still above the long-term average relative discount. Worth noting, though, that this index comparison is swayed by the impact of Financials in the Large Cap index - a big sector weight with a relatively low valuation that brings the overall Large Cap index multiple down. Perhaps, given the ability of the smaller cap stocks to access some of the better veins of growth in the market, the relative attraction is larger than at first seems the case.

Notwithstanding this relative view, Small Cap valuations do appear full in absolute terms compared to history. But while the overall index may not appear cheap, individual stock opportunities can still be interesting. Simply put, if a company delivers underlying cash flow growth better than the market and this looks sustainable in the medium term, it is likely to justify a valuation multiple in excess of the market. While it may require more digging around, an active approach supported by the right fundamentals can find significant opportunities in Small Caps regardless of the aggregate index multiple.

*Celeste Funds Management has recently entered into a strategic alliance with Zurich Investments to exclusively distribute the Celeste Australian Small Companies Fund.


Important information: The content of this publication are the opinions of the writer and is intended as general information only which does not take into account the personal investment objectives, financial situation or needs of any person. It is dated September 2019, is given in good faith and is derived from sources believed to be accurate as at this date, which may be subject to change. It should not be considered to be a comprehensive statement on any matter and should not be relied on as such. Past performance is not a reliable indicator of future performance and should be used as a general guide only. Neither Zurich Australia Limited ABN 92 000 010 195 AFSL 232510, nor Zurich Investment Management Limited ABN 56 063 278 400 AFSL 232511 of 5 Blue Street North Sydney NSW 2060, nor any of its related entities, employees or directors (Zurich) give any warranty of reliability or accuracy nor accept any responsibility arising in any way including by reason of negligence for errors and omissions. Zurich recommends investors seek advice from appropriately qualified financial advisers. Zurich and its related entities receive remuneration such as fees, charges and premiums for the financial products which they issue. Details of these payments can be found in the relevant fund Product Disclosure Statement. No part of this document may be reproduced without prior written permission from Zurich.
Past performance is not a reliable indicator of future performance. GINN XYY9MQ.00000.SP.03. CSTT—014933-2019