Sam Twidale, Portfolio Manager for the DNR Capital Australian Emerging Companies Fund sat down to discuss the current market, the impact on valuations and earnings and where he sees the opportunities in the Australian small cap space.
So I think looking at the outlook for Australian small-caps, I think some interesting topics to talk about is what’s happening with valuations, earnings and some of the opportunities that we’re seeing currently. I think firstly on valuations, it’s been a pretty savage drawdown in the market that we’ve seen this year, and small-cap index down over 20%. And we have seen quite a valuation adjustment now, index has fallen from 24 times price to earnings down to about 14 times, 15 times currently. So quite an adjustment. And I think obviously the question investors are asking now, does this offer an attractive entry point? And I think that the headline valuation does hide a fair bit of dispersion under the surface.
And that’s what investors still need to be quite careful of. We’re still seeing a lot of dispersion, we are still surprised at the number of more speculative companies, some of the more growthy businesses that are still trading on very high valuations, many unprofitable companies in the index that investors need to be careful of. Many of these companies are going to have to really adapt to the changing circumstances that we’re in now. Investor appetite to fund loss-making businesses has really dried up. Many of these businesses are going to have to cut costs, shrink their addressable markets. That hurts the terminal value, but ultimately they need to start showing positive cash flow so the investors can really start valuing these businesses, and so that we can step into them.
I think as well, what we are seeing, the markets crowding into some of these more defensive businesses with resilient earning streams. We like to fund these companies, but we don’t want to overpay for them either. So we do need to be careful. So I think overall, when we look at the small-cap index, you still need to be quite selective and really focus on good quality businesses where you have that downside protection from that attractive valuation as well.
And as we start looking forward, I think it’s really now earnings that’s going to get a lot of the attention. We’ve had the valuation adjustment, it’s now really about what’s happening to the earnings cycle. And I think here we are at risk from an earnings downgrade cycle as we start entering tougher economic times, we are seeing a lot of stimulus now being withdrawn, fiscal stimulus and monetary stimulus. And this is going to be a more difficult environment for corporate earnings because they are really coming off a bumper period over the last couple of years. It’s been a very, very strong period for corporate profits, margins in many industries have reached peak levels, and companies have been a beneficiary of all this loose monetary fiscal policy, strong revenue growth, a lot of money in the hands of consumers.
So we’ve seen that positive operating leverage of strong revenue growth, and not much cost pressure either. But that’s now changing, we’re starting to see revenue growth starting to slow, could turn negative in some industries. And we’re now seeing costs increasing; wages, raw material costs. And some companies could be sitting on too much inventory as well. And that risks a real profit crunch. And that’s really what we’re on the look out, where investors and the market has been extrapolating very high levels of profitability in the future.
Generally, we are looking for companies that are good quality businesses, where you have the downside protection of a reasonable valuation and also conservative earnings assumptions. And we’re happy to wait and be patient for those earnings to re-base lower because that will offer some great opportunities to buy these good quality businesses, a much more conservative earnings forecasts.
So I think when we look at the opportunities in the small-cap space, I think you do need to be still quite selective. I mean, we are still focused on putting together a concentrated portfolio of good quality businesses where we see that valuation upside. And I think you do have to look a bit outside the box currently. When we’re looking for defensive businesses with resilient earning streams, we’re looking at companies like Deterra Royalties, for example. This is a businesses that has a royalty stream over one of BHP Mine’s in the Pilbara and a very solid earnings base. Yes, it’s got some downside risk from iron ore prices in the near term, but we think that’s more than factored into the current valuation. Generates very high levels of cash flow, pays an attractive dividend deal as well.
Continue to light the energy space as well, I think that’s a real standout valuation opportunity as well. I think this whole energy transition towards renewables from fossil fuels, this is going to take decades, not years. And I think the market’s been too cautious on some of these traditional fossil fuel producers. I mean, many of these companies are going to have a life for many, many years. And I think the market was far too bearish on some of these businesses, and they’re trading on very, very cheap valuations. They’re now cashed up, they’re generating strong cash flow, and some of these opportunities in oil, gas, coal look attractive to us, and we still like Beach Energy and Whitehaven Coal.
With this sell of as well, we’re looking for these quality businesses that are de-rating, where the markets getting quite cautious on them. It’s always a good opportunity to start looking at companies like Breville, for example, and it’s share price down 40% this year. Significant valuation adjustment lower. Yes, there’s some near term risk still, but I think that’s the time when you want to be looking at some of these companies really taking advantage of that longer term time horizon. Breville’s forward P/E multiple’s fallen by 40 times. This business still has a fantastic opportunity to expand internationally, really a global leader in that kitchen appliance market.
So overall I think, yes, there’s near term risks at the moment. I think you still need to be selective. We still have a fairly high cash weighting that allows us to be opportunistic, take advantage of some of this volatility that we’re seeing. And we just continue to really stay disciplined to our investment process, look for these good quality businesses. But most importantly, make sure that you’re buying them when there is that valuation upside on offer as well.
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