Monday, August 24 2020
Playing the long game in small caps
Given all the debate around the “new normal” in a post COVID-19 world, there is increasing divergence in the performance of the perceived winners and losers from the pandemic, according to leading Australian equities investment manager, DNR Capital.
Sam Twidale, Portfolio Manager, DNR Capital Australian Emerging Companies Fund says: “Certainly key structural trends will be accelerated by the crisis. However, we still need to be careful not to over capitalise the one-off benefits many companies are seeing in the short term. For example, the positive impact of unprecedented fiscal stimulus on consumer companies, or the accelerating shift to digital and e-commerce based business models.
“Conversely, with increasing concerns around the spread of COVID-19, companies most severely impacted in the short term have suffered significant share price falls. These include companies with leading industry positions and strong balance sheets which we expect to take a greater share of the market during the eventual recovery.
“We need to look beyond the near-term earnings downgrades arising from COVID-19 in favour of valuations based on long-term cash flows. Although some of these companies suffer from a lack of visibility in the short term, it is this uncertainty that presents attractive opportunities for long-term investors,” adds Twidale.
He says: “Given the current level of uncertainty, our focus continues to be on what we can control, which includes taking a disciplined approach to applying our investment process. This involves building a concentrated portfolio of high-quality companies, which we believe will deliver an attractive return for investors over a long-term horizon (5+ years).
“We look for companies with a strong industry position, disciplined management, a resilient balance sheet, high earnings quality and low environmental, social and governance (ESG) risks.
“We believe a disciplined focus on quality companies has never been more important. For example, strong balance sheets are required to transition through a difficult period for earnings, ensuring companies can invest through the downturn, and take advantage of the recovery when it comes. Disciplined management is required to navigate through an unprecedented period of disruption, allowing companies to allocate capital prudently, and capitalise on potential opportunities when presented. A strong industry position will allow certain companies to thrive as many weaker companies struggle, allowing them to take a greater share of the market during the recovery, enhancing long-term cash flows.”
With earnings for many companies under significant pressure in the short term, it is also important to focus on valuations based off long-term cash flows, rather than being too distracted by the earnings expected over the next 6–12 months (which the market frequently overreacts to) notes Twidale.
He says “Given the temporary nature of many aspects of the pandemic, short-term earnings are not always a true reflection of the long-term earnings power of a business. For this reason, our focus continues to be on understanding the extent to which the pandemic has impacted a company’s long-term cash flows.
“An example of a holding we have been recently adding to in our DNR Capital Australian Emerging Companies Fund is IDP Education, a leading provider of English language testing and student placement services to the university sector.
“Although there is considerable uncertainty in the near‑term around the re‑opening of international borders this is an opportunity to acquire shares in the company well below our long‑term fair value. We are attracted to the company’s high‑ quality attributes, which includes its leading position in English language testing globally, and a long runway for growth in the student placement market as it takes share from smaller competitors.
“The company generates a very high return on invested capital, with an astute management team focused on digitalising the business model and expanding offshore. We believe this will further strengthen the competitive position and quality of IDP Education’s business model,” Twidale says.
“This is the type of opportunity we are looking for in the current market- whereby near-term uncertainty allows us, a long-term investor, to acquire a high-quality company on a discounted valuation.”
Learn more about DNR Capital’s Australian Emerging Companies Fund or email email@example.com to chat to a member of our distribution or client services team.