Portfolio Manager for the DNR Capital Australian Emerging Companies Fund, Sam Twidale shares his thoughts on the current market and the importance of staying disciplined on valuation.
So looking at some key observations and outlook for the Australian Small Caps sector, I think one of the key observations is this significant rotation we’ve seen since the start of the year, this big shift away from growth into value. What’s driven this rotation has been the significant dispersion in valuations and quality that we’ve seen in the market. In the last six to 12 months, there’s been quite a significant breakdown in the valuation discipline, a very high gap between cheap and expensive in the market, and there’s been a breakdown in quality discipline as well. Many profitless companies as companies are selling the big addressable market that have been bid up to very high valuations. We’ve seen a lot of this now deflate, and what’s driven this rotation has been a pick-up in inflation and the expectation of high interest rates going forward.
This is something we’ve been concerned about for some time. If we look at the inflation outlook, this has been building. I think at just about all our company meetings that we’ve been having, inflation’s been one of the key issues that corporates are facing. We’re seeing very broad base inflation, a pick up in wages, raw material costs, a lot of freight, and logistical challenges. So how companies deal with inflation is going to be a key challenge going forward, and it does have significant implications for portfolio positioning. I think the types of companies that have been performing well in a more deflationary environment with falling interest rates, are going to be different to those in a more inflationary environment and a pick-up in yield.
This is something we’ve been preparing the portfolio for. I think it does mean that you’ve got to be disciplined on valuations. We’ve been shifting our portfolio over the last 12 months out of some of the more growthy areas of the market where valuations just got too expensive, and we’ve been shifting it into some of the more value areas of the market where we’ve seen a good upside in terms of valuations. That certainly favored some of the more mining and materials, the energy areas of the market, where we still see a very positive outlook.
I think if you look at some of the demand fundamentals driving mining stocks, for example, it’s the most positive it has been for some time. I think we’re still seeing this ongoing shift towards our renewables, towards electric vehicles. That’s very positive for a number of the underlying commodities like nickel, lithium, rare earths, but it’s the supply now which is coming to the forefront in terms of some of the key challenges. Mining companies have underinvested now for the best part of 10 years since the last commodity supercycle. We’ve seen a lot of challenges in terms of environmental permits. We’re getting new minds approved, but this whole situation in Russia and Ukraine, obviously, a very challenging situation there, and it’s compounding a very tight market already. Russia is a key producer of a number of commodities and it’s just tightening this up even further. So we still like some of these good quality mining companies that are generating strong cash flows, strong balance sheets, long mine life, the likes of IGO, Lynas Rare Earths, Iluka. We still think they are attractively priced.
I think also if we look out further as well, there are definitely some risks around the growth outlook. I think the market is starting to get concerned about the stagflationary impact of this energy shock that we’re seeing now, high oil prices, high energy costs feeding through to the high agricultural prices, food prices. So there’s some pressure building on the consumer. That’s one of the reasons we’ve been taking down our consumer discretionary weight and why we still like some of these more defensive companies, these industry leaders where you’ve got attractive valuations, but very resilient earnings. They’re industry leaders, good pricing power, and they can pass through this cost input inflation that we’re seeing.
So I think overall, there is some uncertainty around the outlook. We’ve just gone through a pandemic. Now we’ve got the situation in Russia and Ukraine. I think always important for investors to look through some of the short-term uncertainty, focus on where the long-term opportunities are in the market, focus on good quality businesses, and more importantly, making sure that you’re staying disciplined on valuations because that is an area, I think, that investors haven’t focused enough on over the last 12 months. The valuation discipline has broken down in certain sectors of the market, and that’s why we continue to focus on building a concentrated portfolio, good businesses where we see that valuation upside.
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