Not since the dark days of 2008 has the spectre of macro-economic trends and global events had so much impact on small cap portfolios. I’m reminded of a quote attributed to Warren Buffett’s mentor Benjamin Graham who is reported to have said “the market is like your mistress, you can’t afford to ignore her completely but…” With this in mind we’re not ignoring our mistress, and we’re well aware that bond proxies and growth stocks will struggle short-term, and that cyclicals, banks and non-gold resources are going to run. But nor are we straying too far from our core business of finding undervalued, growing smaller companies. In this wire we discuss our approach to current market conditions, the sectors and themes we think could outperform, and mention five small-caps that we think look attractive following recent pullbacks.
When determining our investing strategy, we would say that it doesn’t pay to throw yourself in front of a bus. Share prices trend. They over-react. Right now REITs, Utilities and interest rate sensitive stocks are trending down as rates trend up. Value will emerge but more often than not prices overshoot. If you’re nimble you could sell some or all of these stocks but more likely the lesson is to be patient and let the trend exhaust itself before starting to buy these sectors. All of this is a long-winded way of saying a shift in the macro environment influences where we allocate the incremental dollar. No need to throw it at something that is not working.
If rates keep rising, value stocks, cyclicals, banks and larger companies will work. REIT’s, Utilities, growth stocks and smaller companies will struggle. Some of this is just maths; high PE stocks are more sensitive to rises in the cost of capital. Some of this will be driven by the assumption that a rise in interest rates will be accompanied by an increase in global growth which will disproportionately benefit cyclical stocks as their earnings recover.
I’d caution about getting too carried away with sector-based or thematic investing, however, as we’re really talking about 3-6 month trends. Over a more medium term timeframe good old fashioned stock picking will still work. As the Silver Fox, Peter Lynch, said “if you spend 13 minutes a year on economics, you've wasted 10 minutes.”
On the back of recent pullbacks, the market is throwing up heaps of opportunities in the small cap space right now. We like Smart Group, Hansen Technologies, Trilogy International, RCG Group and Webjet among others. The last couple of months has seen carnage in the well-owned mid and small cap industrial space – some of it for stock specific reasons – but also because there has been a retreat of ‘large cap refugees’ out of small caps. A ‘large cap refugee’ is a manager who has tired of delivering low single digit returns for the last 3 years and has come down to play in the small or mid caps sector to ‘enhance’ returns.
We don’t own any of these, but stocks representative of this behaviour include Aconex (down -45% from its peak), TPG (-45%), Mayne Pharma (-22%) and Altium (-21%). All are growth juggernauts with great stories and global addressable markets and they are certainly more exciting than the typical ASX100 stock.
It’s not hard to be enticed by these names until something like APN Outdoor’s spectacular -35% in-one-day implosion reminds the large cap refugees of what small cap volatility looks like. The point of the story is, should banks and resources find favour, as discussed above, then large caps will start to work which could see further selling of small cap growth names; this will be painful short-term but sets up attractive medium-term opportunities.