Four small caps for the 2023 contrarian

Last year was one the worst on record for global stock markets. Yet the MSCI World Index has returned to levels that can hardly be described as cheap, trading at approximately 16 times earnings.

However, the discrepancies are extreme. Small-cap land has been most heavily hit, which is where the opportunities may lie in 2023.

Sheltering in quality

As is usual in bear markets, there is currently a strong desire to own “quality” - resilient stocks that won't outgrow significantly in good years but will remain steady during the bad. Many big broker houses are recommending a quality tilt in their research reports and 2023 equity predictions. However, you don't have to look far to see that the resilience of these companies is already being priced in for most, with many now trading at significant valuation premiums relative to the broader market.

MSCI World Quality Index vs MSCI World Index PE Premium

There is a place for quality companies within a portfolio. A number of them provided a bright spot in what was a rough year for the Forager International Shares Fund, including Keysight (NASDAQ: KEYS) and CDW (NASDAQ: CDW). But we believe the real opportunity for the contrarian investor lies within the sectors that have been punished most harshly during 2022.

Opportunities in distressed spaces

Many of the darling sectors that performed well in 2020 and 2021 have experienced a vast unwind. They are now faced with a tougher outlook due to rising interest rates and a weak housing and consumer market.

Finding the exceptions within these punished sectors - companies that end up being more resilient than expected - is where some great returns could come from.

Pockets of opportunity

Starting with the sports betting sector, Flutter (LON: FLTR) was a huge favourite in 2020 and 2021. It was then hammered in the first half of 2022.

The share price tumbled in solidarity with Draftkings (NASDAQ: DKNG), Flutter’s main competitor in the US. Investors were throwing these two companies in the same bucket, despite their differences. Flutter posted better-than-expected results for several quarters, while in the same period Draftkings posted several profit warnings.

It looked to us like Flutter was winning in a huge and important market, yet the share price was suggesting the opposite.

Businesses experiencing Covid unwind is the next area of focus. In Australia, companies like JB Hi-Fi (ASX: JBH) and Nick Scali (ASX: NCK) have sold off due to investor concerns surrounding the profits and sales these companies were making during the pandemic. Therein lies an opportunity for any business that can buck the trend.

A recent International Fund portfolio addition, Yeti (NASDAQ: YETI), a lifestyle brand that produces premium coolers and drinkware, is a company that could do exactly that. Yeti has grown more than 25% year on year for the better part of a decade and, with its significant international expansion potential, could keep doing so. The strong secular component of the Yeti story should offset cyclical headwinds.

Fears about a rising interest rate environment, largely because the impacts have not yet hit, is another area where pockets of opportunity can be found.

Techtronic (HKG: 0669), a stock previously owned by the International Fund in 2020, was recently added again during the 2022 weakness. The company has shown strong resilience and continues to take market share from competitors in the tools space (it owns Milwaukee drills). Techtronic invests heavily in R&D relative to competitors and even if there is continued pressure, the company should emerge from the recession much stronger than it came in.

The last area of focus is where smaller companies have been hit by rising interest rates alone. Where the underlying business is still performing well, but investors are applying higher discount rates to compensate.

Janus International (NYSE: JBI) is exposed to the consumer storage space. This is an industry that is booming and at all-time high utilisation rates in the US. The company itself has been outperforming expectations throughout the year, but the share price has lagged to reflect this.

Janus, alongside companies like eGain (NASDAQ: EGAN) and InMode (NASDAQ: INMD), are all showing signs of resilience and are coming into next year at near-rock bottom valuations relative to their history. And ultimately, lower prices present an opportunity for better returns.

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Forager Funds Management Pty Ltd (ABN 78 138 351 345). Australian Financial Services Licence (AFSL) No. 459312. PO Box R1848, Royal Exchange, NSW 1225. Ph: (02) 8277 4812. General advice only Forager Funds Management provides general information to help you understand our investment approach. Any financial advice we provide has not considered your personal circumstances and may not be suitable for you. Product Disclosure Statement: The Trust Company (RE Services) Limited (ABN 45 003 278 831 and AFSL No. 235150) is the Responsible Entity and the issuer of the Forager Australian Shares Fund (ARSN No. 139 641 491). Fundhost Limited (ABN 69 092 517 087 and AFSL No. 233045) is the Responsible Entity and the issuer of the Forager International Shares Fund (ARSN No. 161 843 778). Before deciding whether to acquire or continue to hold the product, you should read the relevant Product Disclosure Statement, any ASX notices, and seek advice from investment and taxation professionals to determine if the product is appropriate for your needs. The PDS for the Funds are available at Forager Funds. The Target Market Determination(TMD) is available for the Forager International Shares Fund from Fundhost’s website. The TMD for Forager Australian Shares Fund will be available from Forager Funds when required by law. Performance: Past performance is not a reliable indicator of future performance. The Trust Company (RE Services), Fundhost and Forager Funds Management do not guarantee investment performance or distributions, and the value of your investment may rise or fall. Total returns and estimated valuations have been calculated using the mid-point of unit prices, before taxation, after ongoing fees, and assuming reinvestment of distributions. We encourage you to think of investing as a long-term pursuit. Disclaimer: To the extent permitted by law, The Trust Company (RE Services), Fundhost and Forager Funds Management, their officers, employees, consultants, advisers and authorised representatives, are not liable for any loss or damage arising as a result of any reliance placed on this document. Information has been obtained from sources believed to be reliable, but we do not represent it as accurate or complete, and it should not be relied upon as such. The Responsible Entity of Forager Australian Shares Fund has determined that it will rely on ASIC CO 13/655 from 20 April 2022. Forward Looking Statements: Sometimes, forward-looking statements are made which reflect the expectations of Forager Funds Management about the future prospects of companies held within the portfolios of the funds. While Forager Funds Management considers its expectations to be based on reasonable grounds, there is no guarantee that those expectations will be met. Actual performance of the portfolio companies will be impacted by a variety of factors, including circumstances that cannot be foreseen, and could differ significantly from the expectations of Forager Funds Management. These statements should therefore not be relied upon as an accurate representation or prediction as to any future matters. Where portfolio companies do not perform in line with Forager Funds Management’s expectations, the funds could be adversely impacted.

Steve Johnson
Founder & Chief Investment Officer

Steve began Forager Funds in 2009, and now manages approximately $350m across two funds. Offering a listed Australian Shares Fund (FOR) and an unlisted International Shares Fund, Steve focuses on long-term investing in undervalued companies.

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