Hear the latest from Sam Twidale, Portfolio Manager for the DNR Capital Australian Emerging Companies Fund as he gives his insights into the outcomes of the recent reporting season for the Australian small cap sector.
FILMED IN SEPTEMBER 2024. So, quite an eventful month for the small caps. When we look back over the reporting season, started off the month with quite a significant sell-off, concerns around the economy, risk of a hard landing in the US. And then we saw the unwind of the carry trade in Japan. Then the market did then slowly come back as we got sort of more confidence around the outlook for the economy. So, quite a volatile month.
When we look back at the reporting season, very volatile reporting season. It’s quite a significant dispersion in returns across the market. Small caps, still having a tough time. I think with this sort of sluggish environment that we’re in, high rates is having an impact on a lot of companies. And I think when we look back at the reporting season of some of the companies, one of the overriding themes was really the outperformance of quality. And that’s something that we’ve been preparing for for some time in our small cap fund, really drifting up the quality curve. And it feels like it’s a bit of a tide going out moment across small caps. It’s been through a period of fiscal support being removed, monetary support being removed, been through a period of quite a significant fluctuation in inflation, saw a big ramp up in inflation and now that’s coming back down.
And I think the challenge for companies in this kind of environment and the challenge for investors is what is the true sustainable level of profitability going forward? And I think that’s really been the opportunity for bottom up stop picking in this kind of environment as well, really looking at what is the true profitability for some of these companies. And if we look back at the reporting season, it was a bit of a coming home to roost moment for a number of companies. Some companies struggling with a reversion in margins. Some companies struggling with more stretched balance sheets, high interest costs, acquisitions that haven’t delivered on high expectations. Increasing capital expenditures were announced by some companies, or just optimistic growth expectations weren’t really delivered on for some companies. We saw some quite significant share price reactions to the downside for some businesses.
Overall in our emerging companies fund, we had a strong month, outperformed quite materially versus the index. And I think it was really that quality focus that put us in a good position through this period. And if we look at some of the key highlights in terms of companies, Breville was definitely a key outperformer. This is a long held position. We’ve owned it since the inception of the fund. And coming into reporting season, there’s definitely some concerns around the outlook for the consumer in this high interest rate environment, what would be the resilience of the profitability for some of these companies. And Breville really showed that this is a business that has continued to reinvest, that got the profitability that’s been much more resilient than the market was fearing. And arguably, that business is in the strongest position that it’s been in its history from a product and geographic footprint. And that’s because they’ve continued to reinvest back into the business, back into product development, back into expanding that geographic footprint rather than just letting that post-COVID boost in terms of profitability drop through the bottom line. And we think that puts them in a really strong position to maintain above market rates of growth going forward. So, continue to like that business. They’re in a category which is structurally growing, especially that coffee category.
Another area of the market we liked and it was a good example of some winners getting even stronger, cementing their market position was in that platform market. And HUB24, also like Netwealth as well, these companies continue to get stronger and stronger, taking market share from those legacy incumbent platforms. Pretty interesting, we look back over the last five years, companies like HUB and Netwealth used to have a combined share of the market around 4%. Now they’ve got nearly 15% and they continue to take share. So we see a lot of disruption in that space. These companies are really emerging as the winners in that space. The economies of scale are kicking in. They continue to reinvest back into the platform, into customer service and they continue to outperform some of their competitors that aren’t investing to the same extent. So some great examples of some quality businesses which are just getting stronger, really cementing those leading positions that they’ve got.
So I think overall, when we look at small caps, pretty interesting opportunity set at the moment. Big dispersion in quality across the market, and that really came through in reporting season. It was more almost a repeat of the last reporting season we saw in February when quality outperformed then as well. So I think too, what we are really focusing in our emerging companies fund is being very, very selective. There’s large parts of the index we believe you just wouldn’t want to be invested in at this point in the cycle. Still tough out there for a lot of companies, so having that quality focus is key. And some of the opportunities we like continue to be in that consumer financials and tech sectors where we’re seeing those quality businesses that we think offer those attractive longer-term returns for investors.
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