Quarterly Thought Piece
Sinclair Currie, Principal and Co-Portfolio Manager
The highlight of the past quarter was the February reporting season, during which most companies released their half yearly results. Market expectations were broadly met, indicating to us that most companies have been doing a good job of ensuring the market is fully informed of what their earnings should look like for the full year.
As we have previously observed there was some weakness in business activity during the September quarter. We believe this resulted from prevailing uncertainty around the time of the Federal Election which saw deferred decision making and detracted from economic activity. Fortunately this proved transitory and many companies were able to recover in the December quarter. This provides an encouraging backdrop for the second half of the year however needs to be monitored.
Negative commentary surrounded the retail sector leading into reporting season. The bankruptcy or closure of significant retail chains weighed on perceptions. Despite this negative sentiment surrounding the sector we saw many listed retailers perform well, possibly due to a combination of reduced competition and possibly superior operational performance. More recently significant attention has been paid to Amazon’s intentions for online retailing in Australia. The fear surrounding the as yet unknown impact of Amazon has dented the valuations of many retailers yet there is nothing new about online retail in the year 2017. As much as anything else the innovation (and threat) posed by Amazon appears to be its willingness to pursue market share at the expense of profit. This is a strategy is shared by many of the start-ups we can identify. One has to wonder the extent to which the sustainability of the strategy relies on the ultra-low cost of capital associated with the proliferation of loose monetary policies.
Overall, substantial infrastructure plans on the east coast of Australia, stabilising commodity prices and low interest rates remain supportive of the underlying business environment. On the risk side we highlight that consumer debt levels have the potential to provide future turbulence. Unforeseen credit shocks or moves by consumers to accelerate repayment of debt would likely contain demand growth. Beyond this, we recap three themes which have played out in small caps in the recent past:
Theme 1: After blowing out, valuation dispersions have reduced
Last year we highlighted a growing dispersion of valuation multiples within our sample of smaller companies. Simply put, companies were trading at unsustainable extremes of high and low valuations. This dispersion has subsequently narrowed, evidenced by the below chart which shows fewer companies trading at valuation extremities at current prices.
Chart 1: PER Dispersion 2017 vs 2016
Why had the dispersion in valuations blown out last year? We believe it resulted from investors targeting earnings certainty in order to compensate for i) weak growth outlook and ii) extremely low yields in cash and bond markets. We suspect markets quite logically conflated positive earnings revisions with earnings certainty and earnings growth. What made less sense was the apparent indifference to valuation, the market seemed willing to pay any price for companies delivering positive EPS revisions.
When predicting the future, there is always potential for surprise. Earnings revisions are ultimately nothing more than changes to predictions and while they may provide a more reliable momentum indicator, it is not foolproof or shockproof. The overemphasis on this one factor peaked last year and has unwound since, which has seen some substantial share price moves and normalized the dispersion of valuations.
There are numerous possible explanations for the recent revision in valuations. A simple reason is that some names simply collapsed under their own weight of valuation, which is another way of saying that the underlying assumptions required to justify the valuation became ridiculous.
Secondly, we noticed a slight decrease in the pace of upward revisions to earnings in the companies we cover. A weakened revisions signal possibly detracted from investor appetite for these names. This segues into another feature of the small cap space, the proliferation of companies pursuing Initial Public Offerings (IPO’s) over the last two years. As part of the IPO process companies generally predict earnings for the next one or two years and are often encouraged to leave ‘enough gas in the tank’ to ensure these are comfortably delivered. In the last year we observed a number of maturing IPO’s retrace their early share price gains as their capacity to exceed earnings expectations appeared to diminish.
Theme 2: Small cap outperformance moderated
Small companies have outperformed the top 20 ASX companies over the last two years however this outperformance has narrowed since its peak in August 2016, shown in Chart 2.
Chart 2 – Small Ordinaries vs 20 Leaders, last 24 months (common base)
At the same time we observed a number of large cap investors showing interest in small companies. It appears they sought higher returns outside the heavily concentrated large cap universe. This strategy clearly worked well for a period of time however in the second half of last year bank share prices strengthened and amongst other factors, improved commodity prices saw large resources companies rebound. The small cap sector is less exposed to these sectors and thus has underperformed large during this recovery. The implication for us small cap managers is that the liquidity risk associated with large cap managers reducing their weighting to small caps is significant. We remain cautious of investing in stocks that are over-loved.
Theme 3: Resources vs Industrials
Small resources performance recovered in early 2016 following several years of underperformance. Resources have now outperformed industrials over two years, shown in Chart 3.
Chart 3: Small Resources vs Small Industrials, last 24 months (common base)
Gold and Energy initially drove the turnaround in resources and producers benefited from the depreciation of the Australian dollar. In the energy sector, stronger coal prices were largely driven by supply constraints (in particular within China). More recently, we’ve seen an emerging interest in the base metals: copper, zinc and nickel. We believe improved outlook for the major developed economies will drive demand for key base materials, particularly nickel. We retain a cautious stance towards the more ‘exotic’ resources such as lithium and graphite. In our experience thinly traded commodities trade in short sharp cycles, previous examples being rare earths phosphates, uranium and even tantalum.
In our view investing in small companies continues to be a stock picking exercise. Liquidity is low, earnings are often volatile and in many cases the sustainability of a business model remains unproven. Offsetting these risks are the opportunities to invest in innovative and growing businesses or those which have been unfairly overlooked by the broader market.