Sam Twidale, Portfolio Manager for the DNR Capital Australian Emerging Companies Fund, recently provided an update on the current market and where he sees opportunities for the small cap sector.
So looking at the opportunities in Australian small caps, we think the time has come to be more positive on the opportunities that we’re seeing. And certainly when we look at the positioning in our Australian Emerging Companies Fund, we did have quite a defensive bias for some time all through last year, at the start of this year. But I think now, the conditions are there to start getting more positive on this sector of the market.
I think if we look at the backdrop here, we have had significant underperformance of small caps over the last 18 months versus large caps. We’ve seen valuations now pulling back. We’ve seen quite a de-rate for a number of high quality businesses. But you still do need to be selective. I think if you look under the surface of the market, there are still some areas of overvaluation, some speculative activity going on. We’ve seen many defensive companies on quite high valuations. I think many people are concerned about slowing growth and the risk of a recession. And that has seen many defensive companies see their valuations really come up to quite excessive levels. So you do need to be careful there.
But I think when we look at the earnings’ downgrades as well, that’s been the last catalyst we’ve been waiting for to turn more positive. And we’re now seeing the downgrades coming through. Just about every day, we’re seeing more companies downgrading earnings. And what this means is you get more confidence to start stepping into some of these opportunities because we’ve seen valuations pull back. We’ve now seen earnings downgraded, and that gives you confidence to buy companies on much more realistic valuations and more conservative earnings expectations. Quite a change from that price for perfection scenario that we saw 18 months ago.
So I think when we look at the opportunities and the sectors of the market where we are seeing great opportunities to buy high quality businesses, it is a bit where that the fear is in the market, where the uncertainty is. I think you’ve got to embrace some of that uncertainty because that’s really what’s throwing up some of the dislocations between price and value. And for us, it is where the concerns are around the economy, especially the consumer discretionary sector. That’s now our largest overweight. It’s a more contrarian positioning, but I think investors will be rewarded taking a longer term view for many stocks in this sector.
Looking through some of the short term risks that we see, and two great opportunities there. Companies we’ve been buying in recent months would be Breville and Lovisa, two really high quality companies. They’re leaders in their industries. They generate high returns. They’re well managed. They’ve got strong balance sheets to get through. A bit of a trickier period in the short term. They’re not out of the woods yet. I think they could still face some challenges in terms of earnings in the short term, but they’ve got the strong balance sheets to get through this more tricky period, and we think they’re going to emerge on the other side of this in a really strong position. So they do, when you see a bit of a setback in the short term, when you get these concerns in the short term, that’s what presents the opportunity for long-term investors to really take advantage of.
An area of the market where we’ve been reducing our exposure, it’s been a source of funding for us, has been the mining space. That’s been a key overweight for us for several years now. But I think conditions have changed there and we’re just not seeing the contrarian opportunities, the mispricings that we saw several years ago. We were buying many of this lithium, rare earth-based metal producers at the bottom of the cycle three years ago when capital was scarce, when supply was being curtailed, when no one believed in decarbonization or the shift towards electric vehicles. Well, that’s all very much consensus now. Everyone believes in electric vehicles, the transition towards renewable energy. And valuations have lifted up. So we’re seeing better opportunities elsewhere in the market.
And I think that’s one thing about our Emerging Companies Fund. Every stocks competes for capital. We’re always looking around. Where are the mispriced opportunities in the market? Where can we deploy capital to find those inefficiencies in the market? And I think at the moment, to summarize our positioning and where we’re seeing the opportunities, it is back in some of these companies that we sold out of several years ago, going back into these de-rated quality opportunities in consumer discretionary, financials, industrials, a bit of tech. So I think when we look at the portfolio now, the quality of it has really lifted. And we’ve got a concentrated portfolio of some great businesses, some really high quality companies where valuations have really pulled back. So I think for investors that are willing to look through some of this on short term uncertainty, it’s really presenting some great opportunities to take advantage of.
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