Buy Hold Sell

Small caps roared back to life in 2019 following the liquidity injection provided by the "Fed pivot," with tech stocks leading the way and helping the ASX small industrials to a 17% gain for the year to date. But the question now is whether or not this spectacular run can continue, with value, cyclical and domestic exposure stocks having outperformed post Federal Election.

And with understanding sentiment such an important facet of the "dark arts" of small-cap investing, with sectors able to disconnect from fundamental drivers, the importance of being in the right sector at the right time cannot be overstated.

In the video below, TMS Capital's Ben Clark hosts Eley Griffiths Group's David Allingham and Wilson Asset Management's Oscar Oberg, who let investors know which parts of the small-cap space are offering the best value at the moment, as well as two small-cap picks that currently pass muster.


Transcript:

Ben Clark: Welcome to Buy Hold Sell, I'm Ben Clark, and joining me today we've got Dave Allingham from Eley Griffiths and Oscar Oberg from WAM, and we're going to be talking about small caps with two of the small-caps specialists in the local market. Small caps have roared back to life this year after a pretty challenging end to 2018. So, Dave, starting with yourself, what's driving it? Is it more a market-based risk-on theme, or is there some more happening underneath the hood?

Dave Allingham: Look, that's definitely what's going on, Ben. I think liquidity's the primary driver of asset prices and we saw a big easing in financial conditions late last year with the Fed pivot. We've done that to death now, so we don't need to go back over that. That's the primary driver.

I think if you look within small caps quickly, though, it's been a tech-led industrial rally. The small resources are up 7 or 8% so far this year, the tech stocks are up well north of that giving the industrials a 17% gain for the year, so that's been the defining feature.

Ben Clark: Absolutely. Oscar, anything you can add to that, and where do you think we can go from here, the million-dollar question?

Oscar Oberg: Yeah, look, I agree with Dave, exactly what he said. It's been an environment of low interest rates, particularly after the Fed pivot. From what we see, the technology sector's driven a lot of this increase in the small industrial sector, and it's interesting that eight stocks have actually contributed around 70% of the index's performance this financial year-to-date.

Can it continue? Look, we think it's tough for it to continue from here. It's interesting that the most expensive companies in the ASX are now trading at pricing-earnings multiple of around 38 times earnings. This is at very high levels. It's actually higher than what it was at the time of the tech bubble in the early 2000s, so it's hard to see price earnings multiples rerate from here.

Ben Clark: Yep, okay. And Dave, from here, I was looking back at some numbers. The Small Ords as an index has gone up 16-odd percent this calendar year, but it's actually underperformed the All Ordinaries Accum by 8% over rolling year-to-date, which is a bit unusual. You normally see in a frothier market small caps are sort of outperforming. Do you think they could keep running if the market had a bit of a pullback?

Dave Allingham: Yeah, look, I think Smalls can do okay. I think we're relatively optimistic. I think the defining feature will be a change in leadership. That's what we need to see. I think tech has done a lot of the heavy lifting, and I think whilst that may be maintained, if the current settings are in place, I guess is the goldilocks theory, relatively moderate growth but with low inflation so the tech stocks look good in that environment.

But I think what we need to see is a change in leadership and we've seen that since the election results. Value cyclicals, domestic exposure suddenly outperforming quite materially, and if they can take a bit of leadership, the industrial heartland of Australia, so to speak, then we might see this market continue to sort of tick up.

Ben Clark: Yep, absolutely. And part of the dark art in smalls caps is sentiment. We see that sectors can completely disconnect from the underlying fundamentals, positively or negatively. How do you guys manage that at Eley Griffiths when you're looking at some rules around investing in small caps and trying to look through sentiment?

Dave Allingham: Yeah, sentiment's a big driver, clearly. We try to define ourselves or differentiate ourselves by taking sort of medium-term views on stocks and positions.

One thing Ben Griffiths taught me very early on in my career was it's all about getting the rotation right in the portfolio. You need to have that medium-term view and you need to know which sectors to be in and when.

And so right now, to your point earlier, I think that industrial positioning, under-owned, very depressed sentiment, feels like an opportunity for some minor rerating, given how extended the high P/E versus low P/E differential in the market is at the moment.

Ben Clark: Yep, okay, good comments. And Oscar, anything you can add to that at WAM? Is there anything else that you try to do, some rules you abide by that help you manage sentiment?

Oscar Oberg: Very similar to Dave. I think, as a portfolio manager, it's very important to know where your competitors are in, in terms of the sectors that they're in, and to make sure that if you're in a hot sector, such as the technology sector now, or perhaps mining services was a good example 12 months ago, to understand where that flow of money will go to if these sectors start to come off.

And I agree with Dave, I think we're at that juncture at the moment with the technology sector and now you're starting to see domestic cyclicals look quite interesting.

Ben Clark: Okay, and looking at some individual segments, because we always see in small caps there's some parts running hard, there's other parts are very pessimistic, is there an area that you sort of call out where sentiment really is playing a part, the market's got too ahead of itself or maybe too pessimistic?

Oscar Oberg: On the pessimistic side, I actually think the mining services sector looks interesting again. I think commodity prices in iron ore and coal are supportive. The projects are still going ahead in iron ore in Western Australia. Just been over there. There's still labour shortages and equipment shortages, so a lot of those stocks have been beaten up over the last 12 months. I think they look interesting again.

Ben Clark: Yeah, okay. And Dave, where are you guys looking at the moment, somewhere that you're a bit worried about, somewhere you see an opportunity?

Dave Allingham: Yeah, look, I think we've been positioning very gradually the last six to nine months in the resi market, and I think the market's got way too bearish resi. Obviously, we've had a couple of big wins with the APRA changes announced yesterday, the election result and the no negative gearing concept.

But I think the real catalyst there is just the value. These stocks are very, very cheap and they're pricing in Armageddon for a number of years, Peet & Co (ASX:PPC), Villa World (ASX:VLW), AVJennings (ASX:AVJ) to name a few. I think Oscar's made a good point about mining services. We think that environment's still relatively good.

I think the other part of the market that's been very depressed has been the dealers. So, car dealers that is. So when you look at things like the novated leasing car dealership industry, under the nose on new car sales, but we think we're going to see some stability there later in the year and into 2020 and they'll start to look attractive again.

Ben Clark: Okay, good comments. Okay, so, Oscar, for us, us an individual stock, and maybe you can just talk about some of the filters that you look at when you're scanning the market for small caps, something that makes you do more work on an individual share and something that's passed those filters recently.

Oscar Oberg: Yeah, sure. So the filters we use at Wilson Asset Management, we use three filters. The first filter we need is a price-earnings multiple that's less than the growth rate of the company over the next 12 months. We need a good management team and we need a good positioning of that particular company within its chosen field of expertise. Most importantly, we need a catalyst and need something that's going to change the valuation of the company.

A company that passes those filters at the moment is Johns Lyng Group (ASX:JLG). The ticker's JLG. These guys provide emergency repair to buildings and homes following natural disasters. We bought the stock six months ago, given the tailwinds we saw from the Sydney house storms and also the Townsville floods.

I think most importantly, at the moment, is they're winning quite a lot of work on insurance panels and it's got a very strong balance sheet. It's trading at around 20 times earnings next year for about 30% earnings growth, so we quite like that one at the moment.

Ben Clark: Okay, and Dave, one stock from you, if you could?

Dave Allingham: Yeah, sure.

Ben Clark: What are you guys looking at at the moment?

Dave Allingham: Look, to touch on what Oscar said, I think in small caps, qualitative features of the company, management, their alignment, their strategy, their longevity is just critical, so something that really stands out for us at the moment is AP Eagers (ASX:APE). I read through the annual report on the way back from Brisbane, having seen the company just a couple of days ago. 106 years of history this company. I mean, that's the kind of stuff we just can't get enough of.

It's in a bit of a depressed period at the moment from a new car sales perspective, but they've got a big opportunity to drive earnings from the finance penetration story, as far as the recent changes there, and of course the merger with AHG, so the two largest players in the market coming together to have only still a 10% share, we think the synergies from that transaction, and there's the operational efficiencies the company will get managing the margins of AHG under better management, will see genuinely five years of very solid earnings growth.

So, for any investors with a one to two beyond year sort of outlook, we just think that's a no-brainer, so APE is there.

Ben Clark: Okay, you need to keep your wits about you in the small caps space, and there's some dark art involved in investing, but we've just heard some great tips from the pros.



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