Sam Twidale, Portfolio Manager for the DNR Capital Australian Emerging Companies Fund, recently provided an update on the current outlook for the Australian small cap sector.
So it’s been a challenging time in small caps now for quite some time. Actually, if you look at the index over the last four or five years, it’s really sort of just gone sideways, delivered very little return. And over the last sort of two years, we have seen significant under performance versus large caps as well now, about 20%. And I think what the market’s struggling with here, what’s the right valuation to pay for some of these stocks? We’ve just come through a period of quite high valuations and we’ve now seen a very sharp lift in interest rates and the market’s sort of questioning what’s the right valuation you should pay for these stocks in this sort of high interest rate environment. I think there’s uncertainty around earnings as well given the Covid surge that we saw and then the unwind since. And also the lifting interest rates and the impact this will have on the economy in a more certain economic environment too.
What’s the right sustainable level of earnings for a number of companies, especially some of the more cyclical. So I think this is definitely weighing on sentiment. What we’re seeing though, is we are starting to now see a lot of disproportionate share price reactions to negative news. And it is starting to throw up some great opportunities, especially in some of the quality business models. I think there’s a bit of a dilemma in the market. You do have some of these cheap companies with a bit more cyclicality to them that is offering the value. Do you step into these versus the more expensive defensives that have the resilience and earnings, but you’re paying for that in high valuations? Where we think we should be positioning and where we’re starting to pick off opportunities is in these D-rated quality stocks, these outer favour quality businesses where there could be some concerns around earnings in the short term, but where the long-term outlook looks very positive.
And we’re now starting to see the entry points are much lower valuations. And if we look at some of the opportunities here and a couple of companies to call out in our emerging companies fund, firstly would be IPH. This is a company leading intellectual property, a patent attorney firm. This is a company that’s trading as sort of a decade low valuation nearly now. There’s some concerns around short-term activity in their Australian business, but this business has been around for decades, got a great market leadership position in Australia and a growing international business and you now get to buy on an incredibly cheap valuation.
Another company would be in the consumer discretionary sector like Lovisa. In the consumer discretionary that’s a core overweight for the fund. We are starting to see some real value here at emerging because of some of the concerns around the consumer in the short term, great opportunity to buy these high quality businesses at much lower valuations. And that’s the case with Lovisa, leading fast fashion accessories retailer. I remember when we first bought this fund, there’s this company in the fund over five years ago, less than 300 stores they had mainly in Australia. Now this is a business over 800 stores. Big position now growing in the US and we see a great international store rollout opportunity. This is a business that could be over 1000 stores. And I think that’s what the market misses. Lots of focus on short term like for like sales growth, what’s happening with the weaker consumer, but that misses the bigger picture opportunity of ongoing store expansion as it continues to diversify internationally.
And lastly, Credit Corp. That’s a business that has been a bit of a drag on our performance in recent months. Shares have been very weak. This is a leading debt collection services business in Australia with a growing business in the US. They’ve had a trading update recently, shares been really weak on the back of that, highlighting weaker collections in the US but we think that’s sort of more backward looking. And forward looking, they’re seeing some great opportunities to buy debt books at much cheaper valuations. And what’s interesting is that valuation is now trading at sort of a load that you haven’t seen since the global financial crisis. So really cheap valuation for an industry leader in Credit Corp.
So overall, I think when we look at the outlook, there is some uncertainty still in the short term. What we’ve been doing in our emerging companies fund is really looking to buy these out of favour quality businesses where there could be some concerns in the short term, but they’re well managed, they’ve got strong balance sheets and we think they’re very well placed in the longer term. And this is the time that investors with a longer term time horizon should be looking at these companies. And I think as we get some better clarity on the sustainable level of interest rates and the economy, those really deep valuation gaps that we’re seeing between price and fair value will start to converge over time.
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