Five key themes for small-cap investors

The smaller end of the stock market delivered a mixed bag during the recent reporting season. But if you sift through the company reports, you’ll find five themes common to those that provided positive reports and/or outlook statements. These are the companies to put on your watchlist.

Overall, the stats suggest the results were on the soft side with the number of small cap industrial companies seeing downward revisions to their broker forward earnings estimates outweighing those that were upgraded (66 stocks revised down versus 21 revised up).

In aggregate, the index-weighted consensus forward earnings per share (EPS) was reduced by 3.8 per cent, according to JP Morgan Research. The most material projected earnings cuts occurred in the consumer staples, consumer discretionary and healthcare sectors, while only utilities saw net upgrades. However, the share price performances for the month of August indicate that market expectations for consumer related companies was already very low – many of these stocks actually bounced post results despite the forward earnings cuts.

Let’s explore five of these growth themes in greater detail.

Technology

The small cap technology sector spans software, hardware and IT service providers. Indeed, the ASX has recently become quite an exciting tech hub thanks to relatively cheaper listing costs and growing local investor interest. Thematically, investors gravitate towards tech stocks for their highly disruptive business models and their relatively long runways for growth (low penetration of large addressable markets).

Driving this structural growth is a number of global mega trends, including large enterprises migrating from on premise servers up into the cloud. This is positive for local data centre operators, such as NextDC, as well as special connection services like those provided by Megaport. Another trend is the evolution of software towards the favoured Software as a Service (SaaS) model – small cap SaaS companies include Technology One, Bravura, Infomedia, Hansen and Nearmap, ecommerce platforms (like Kogan and Temple & Webster) and the emergence of big data and artificial intelligence, Appen is a key small cap player in this space. Additionally, the falling cost of deploying technology has become a key enabler for smaller companies to execute their disruptive business strategies.

With market expectations relatively high, stock price moves in the tech sector during results season were more about hitting or missing near-term earnings. Looking further out than the next earnings print, we saw no evidence of any weakening of these global mega trends during results season so expect the medium-term investment thesis for owning tech to largely hold.

Fintech

Another interesting structural growth theme available to small cap investors is fintechs. Here, innovative companies, known as fintechs, are using technology to disrupt the traditional financial services industry. Key target areas include payments, wealth platforms, e-wallets, digital currencies, foreign exchange, crowd funding and even traditional banking. Armed with a clean sheet of paper and a better technology stack, many of these fintechs are creating a real change. For example, Afterpay’s buy now pay later model has materially disrupted the credit card segment, and driven significant online sales growth for many retailers, particularly in the millennial cohort. In the aftermath of the financial services Royal Commission, the major banks have largely pulled back to focus on their ‘bread and butter’ housing mortgage books, leaving the consumer and small business financing sector wide open for the fintechs – names include: Zip Money, Flexigroup, Money3, Prospa.

Another strong fintech theme playing out in the Australian small cap arena is the structural growth of the independent wealth platforms (Netwealth, HUB 24 and Praemium). Their platform technology is superior to the legacy platforms found within the incumbents, and these fintechs are also rapidly gaining share on the back of the Royal Commission fallout which is driving financial advisers out of the aligned groups and into independent planning networks. Fund flows remain strong, but market focus has been on near-term pricing pressure from increased competition and lower cash profits due to falling interest rates. The longer term structural trends appear intact.

The Asian consumer

Rising wealth within the expanding Asian middle classes, particularly in China and India, presents a strong structural growth theme and a significant market opportunity for a number of small cap companies. Premium Australian products and services are highly sought after in Asia, especially infant formula (Bellamys, Bubs and Clover), vitamins (Blackmores), health and beauty products (BWX and McPherson’s) and education services (IDP Education).

Indeed, technology is also playing an important role here with the dominant e-commerce platforms such as Alibaba’s T-Mall and JD.com (partly owned by Tencent) facilitating strong cross-border transaction growth. Notwithstanding the recent global macro turmoil brought about by unresolved trade wars and disruptions to the grey ‘daigou’ channel, demand for these premium Australian products and services remains exceptionally strong.

Mining services

On the cyclical front, the small cap mining services sector has offered investors exposure to the recovery in global commodity prices and the resurgence in construction activity, particularly in the domestic iron ore and coal industries. All three of the iron ore majors operating in the Pilbara region are embarking upon multi-billion dollar projects to sustain their current rates of production well into the future.

This is underpinning a significant pipeline of work for small cap contractors (such as NRW, Decmil, Monadelphous and Seven Group). The key question for investors here is how long will this current iron ore construction boom last?

Recent commentary from the majors suggests at least two more years of significantly elevated construction activity based on committed projects, with the potential for the cycle to extend further subject to the iron ore price and demand from China. The exceptionally strong rally in the gold price over the last quarter has also increased investor confidence in small cap companies leveraged to gold exploration and production like Perenti, Macmahon, MACA, Imdex and Swick.

Improving household outlook

One cycle small cap investors are increasingly considering playing is the potential recovery in domestic household consumption. FY19 was a really tough year for many consumer discretionary companies – retailers traded through a soft demand backdrop with high household indebtedness, low wages growth, falling house prices, Federal election uncertainty etc. while media businesses saw reduced advertising spend, particularly from their banking and finance (Royal Commission) and retail clients.

Looking forward, investors appear to be wondering if we have perhaps seen the bottom of this consumption cycle with a potential turnaround on the horizon driven by improved consumer confidence on the back of the surprise Federal election outcome, ensuing fiscal and monetary stimulus through tax cuts, RBA rate cuts and APRA loosening credit requirements, and early signs of a stabilisation of house prices.

Encouragingly, outlook commentary from leading retailers, JB HiFi and Super Retail Group, noted ‘green shoots’ in activity. If household consumption improves, this could ultimately drive improved auto sales (A.P. Eagers, ARB Corporation, G.U.D. Holdings, Bapcor and Autosports Group) and residential construction (Adelaide Brighton, CSR, Fletcher Building, GWA and Bingo). It’s very early days but worth watching considering the consensus trade here looks to be underweight.

Many small cap retailers have the benefit of store roll-out programs (like Adairs, Baby Bunting, Lovisa, Nick Scali, Noni B and City Chic Collective), which help drive earnings growth even when underlying conditions are tough. Another key driver for small cap retailers has been strong double-digit online sales growth, partly propelled by the growth in by now pay later offerings and partly attributable to significant investment in technology to support e-commerce transactions. Amazon threat was likely a key catalyst here.