Changing times for smallcaps

UBS Asset Management

The environment for equity investing has become a little more challenging in recent months in the wake of developments such as Brexit and the Trump presidency. Rising longer term interest rates (bond yields) and the risk of higher inflation in developed economies (fiscal policy returning to the fore?) has seen a selloff in both yield-based defensive assets and long duration growth assets. The UBS Small companies investment process is one that preferences quality characteristics of businesses ahead of a simplistic and often myopic 'low PE' valuations. Our fund has a 12 year track record of good performance achieved by focusing on businesses with many of these 'quality' business franchise characteristics. Growth, margin and the capital required to deliver cash earnings are the key quantitative factors of our investment process. Furthermore, a six year cash flow forecast forces us to look beyond the typical short term investment horizon of equity markets that overemphasise 1-year-forward PE valuations.

It was therefore with some trepidation that we confronted the recent change in the investment climate for equities. Most of our fund's (generally longer duration) 'quality' businesses have performed very well in a low interest rate / low growth environment. That is because most of these businesses are not low growth. They are well managed smaller companies benefiting from either disruptive structural change or otherwise longer term trends that provide enduring tailwinds to their growth.

The key focus for us is what one pays for such quality businesses. We are mindful that a quality business is not necessarily the same thing as a quality investment, especially if purchased at the wrong price. The structural growth assets have seen large valuations uplifts in recent

years, helped by falling interest rates (growth is worth more in a low growth / low interest rate environment) and anemic global growth post GFC.

In anticipation of the end of the multi-decade decline in interest rates, we have undertaken some rebalancing of the portfolio. Earlier in the year we purchased positions in some of the better quality resource names such as Fortescue Metals (our fund can buy mid-caps – little else of quality in small caps iron ore), Whitehaven Coal and Worley Parsons (a proxy for oil given scant other sensible alternatives in small cap oils). These stock positions have performed very well and provided our fund with a good relative performance buffer against the large recovery in resources companies.

More recently we have trimmed the size of some of our 'higher PE' long duration growth holdings whilst still retaining solid core positions. An example of this is one of our larger positions, TechnologyOne which reported its annual results this week. It continues to grow at around 15% pa as it has done for more than 10 years (we have owned it for more than five years). With the repositioning of their entire business to a cloud based SaaS product, we believe growth will only accelerate further in the years ahead. This opportunity is difficult to capture in a 'fully valued' one-year's PE of 40x, yet becomes obvious when looking out a little further beyond the one year horizon.

With the recent fund rebalancing we have also bought into positions in some quality 'lower PE' businesses that whilst not necessarily strong structural growers, are nevertheless sound and well run businesses that are priced reasonably. Examples include Super Retail Group (management refocusing on core good businesses), Collins Foods (quality management and a defensive business), Ainsworth Gaming (significant valuation gap to Aristocrat – we expect some operating mean reversion), Automotive Holdings (new CEO likely to exit logistics), Bank of Queensland (midcap – banks will benefit from rising interest rates) and Oz Minerals (the rise in commodity prices now spreading to base metals).

Lastly the fund is now running with cash levels that are at historical highs as we await better buying opportunities and enter a period of rising investment uncertainty.


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