The outlook for Australian small caps post reporting season

So looking at the opportunities in the Australian small cap sector post the reporting season, I think there’s definitely some reasons to become more positive selectively on parts of the market here. We’ve definitely had quite a significant pullback in many of the small caps. Valuations have pullback. Small caps have underperformed quite materially versus large caps over the last year.

But I think just sort of diving into reporting season in a bit more detail, I think one of the key takeaways for us was definitely the sort of ongoing cost challenges that companies that are having to deal with, and this is something we have been concerned about for some time. We’re now starting to see the impact of tighter monetary policy slowly sort of flowing through revenue growth slowing, but it is the cost pressure as well that’s starting to squeeze margins, in particular, the sort of higher wage growth. We’re seeing skill shortages across many sectors, and this is really a challenge for lots of companies to deal with going forward.

And I think certainly some of the low quality business models are certainly being exposed. This is a challenge for them. So I think it’s really a time to sort of scrutinize business models, make sure that they’ve got that pricing power to protect returns at this point in the cycle. And I think we are starting to see sort of companies that have obviously not been able to generate cash flow, they continue to be exposed as well if they can’t make that inflection and start turning some of those losses into positive cash flows.

What we are seeing as well, I think some of the bad capital allocation decisions being made. When interest rates were very, very low, we saw lots of risk taking by investors, but also lots of risk taking by management teams. And I think the Warren Buffet quote around “When the tide goes out, you start seeing who’s been swimming naked,” is particularly relevant at this point in the cycle because there are many companies that did lots of offshore acquisitions when money was cheap, when investor appetite was there, and some of those are now really unravelling and that can be quite a dangerous combination for investors when they put lots of debt on the balance sheet. So we are seeing quite a few companies run into some challenges. So I think this is really a time where you need to be scrutinizing the strategies of management teams, how they think about capital allocation.

When we start looking at some of the opportunities here and where they’re emerging, where we’re really looking, I think it is really a time to start focusing in on some of these de-rated quality opportunities. I think what we’ve seen is a big valuation adjustment lower for many stocks, but what we’ve been really waiting for with some of these quality stocks is to start seeing the earnings adjustments coming through. Many of these stocks were price perfection, high valuations, optimistic earnings assumptions, but we’re now starting to see the earnings downgrades coming through, and that’s throwing up some opportunities to buy some of these really good quality businesses on debased valuations and more realistic earnings assumptions going forward as well.

One of the opportunities we’ve been adding back into our emerging companies fund is Breville, leading consumer appliance manufacturer, and this is a business where shares have fallen significantly over the last 12 months. We’re now starting to see the earnings downgrowth coming through. And I think the market’s obviously very concerned in the short term around what the impact of higher interest rates will be on consumer spending, but that’s really what presents the opportunity for longer-term investors to really look through some of this short-term uncertainty and focus on the longer-term opportunity in a company like Breville, which is a really high quality business, generates a very high return on invested capital, great long-term growth opportunity to expand internationally.

Another company would be something like PEXA, leading digital property assessment exchange. Again, market very focused on some of the short term issues that company’s facing around the weaker property market, what that’s doing to property transactions. But again, this is a high quality business, generates very high margins, great long-term growth opportunity for that business as well as they expand into the data insights area and also offshore into the UK.

So I think these are the types of opportunities we want to be looking for at this point in the cycle, these high quality businesses, which are getting de-rated on some of these sort of short term concerns, and that’s what really presents the opportunity for longer-term focused investors. And in our emerging company strategy, that’s what we’re really looking for. We’re looking to find these shares and these good quality businesses where valuations are pulled back. That really is what presents the opportunity for investors.