The Australian small caps market generated strong returns in 2019 (from an end 2018 low) which has continued so far into 2020, driven by accommodative monetary policies by global central banks which have encouraged investors up the risk curve.

Record low interest rate and recent liquidity injections have elevated asset values across most global asset classes, including the Australian small cap market, which is now trading at the highest valuation level in over a decade.

As highlighted in a previous article, the recent strong returns have been driven largely by multiple re-rate rather than earnings growth which continue to remain challenged given the sluggish domestic environment.

Source: Factset

The AMP Capital small caps team continue to remain supportive of the Australian small cap market and see plenty of investment opportunities given the accommodative landscape, earnings growth above that of large cap companies, reasonable valuations (outside high growth technology and healthcare stocks) and generally solid balance sheets.

However, investors need to be vigilant and focus on the risks inherent in the supportive conditions that have driven equity markets higher. Given elevated valuations levels and high market expectations, can small cap companies deliver in the upcoming reporting season in February?

Earnings delivery required

Similar to previous years, market earnings forecasts continue to be downgraded into the February reporting season, given typically over-optimistic consensus expectations.

Source: Factset

We acknowledge the domestic environment remains challenging, with both consumer and business confidence still cautious and we’re yet to see the flow-on impacts on the economy from the bushfires and drought. However, given the breadth and depth of opportunities available in the small caps market, we remain optimistic about the opportunities ahead.

Despite tough conditions, companies that have been able to deliver strong earnings growth, notably technology and quality stocks, have been highly sought out by investors and are trading at elevated valuations. As has been the case over the past few reporting seasons, these stocks will need to keep delivering on the market’s lofty expectations to justify current valuations and share price momentum.

We remain very selective when investing in high growth stocks, and reduced our exposure to this part of the market mid-last year as we believed market expectations had run ahead of fundamentals and weren’t being supported by valuations.

We have already seen some of this momentum unwind occur post-August 2019 reporting period, notably in the technology sector, and expect this to continue in February. However, we remain supportive of companies which we expect to deliver this reporting season, including IDP Education (IEL) and EML Payments (EML).

Value and cyclicals have stabilised, but need to see more stimulus

Value stocks have experienced a challenging environment over the past few years. We highlighted in our last reporting season wrap-up that there were signs of life in value segment of the market and have subsequently seen select stocks do well, including diversified financials IOOF Holdings (IFL) and Janus Henderson (JHG). Unfortunately, this hasn’t extended to a broad-based recovery. For this to happen, we need to see earnings stabilise which is yet to occur, and this requires the domestic outlook to improve, which does not appear to be happening.

We believe a coordination between monetary and fiscal policy is critical to enable a credible activity recovery to emerge. This reporting season, we expect positive commentary from infrastructure exposed companies, including Seven Group Holdings (SVW, via their Coates exposure) and Wagners Holding Co (WGN), which are likely to benefit from the many government funded infrastructure projects along the East Coast ramping up again after a previous slowing. Some of infrastructure construction exposed companies are, in our opinion, trading on cheap valuations compared to the market and we believe have the potential to re-rate on the back of contract awards.

Focus on improving fundamentals

At this stage of the market cycle, the largest gains may potentially be generated from stocks that move out of the value trap stage of the earnings cycle and start to exhibit improving fundamentals. A stabilising earnings base coupled with a better outlook typically leads to a strong re-rate and potentially the start of an earnings upgrade cycle. We typically wait to see some evidence of a turnaround emerging in order to avoid being caught in value traps, but do see the potential for some of our portfolio holdings to exhibit improving fundamentals this reporting season.

Resources and mining services outlook improving

Gold stocks were the standout performer in the resource sector last year, and while we believe they’ll continue to be well supported, investors likely won’t see the same level of returns this year. With an improving macro-economic outlook and reflationary signals that appear to be supported from a global fiscal pulse that is moving from optionality to some form of reality, investors should focus on industrial metals, including copper and nickel. Global supply of these commodities has been rational and with physical metal availability starting to tighten, and the potential for an increase in end demand could lead to good price appreciation. We consider Western Areas (WSA) to be the cleanest pure play nickel stock on the ASX. 

Source: Factset

We believe the improving resources outlook should also translate to mining services stocks, which are trading at valuation levels which don’t adequately reflect this. Mining capex levels are increasing, notable among the iron ore majors, and earnings are set for a cyclical recovery. This is a volatile segment of the market, however we believe Macmahon Holdings (MAH) is well positioned with a sector leading order book and plenty of upcoming catalysts. 

Source: Factset

Watch out for the bushfire impact

We have already seen a number of companies downgrade earnings so far this year due to the tragic and devastating bushfires in NSW and VIC impacting trading conditions. We expect these companies won’t be the last to feel the effects and are keeping a close eye on companies with retail and tourism assets in these regions although the impacts will be far reaching.

In summary, Australian small cap reporting seasons never fail to throw some real curve balls at investors and this upcoming reporting season will be no different. AMP Capital remains well served by our rigorous fundamental investment process and we see some very attractive opportunities emerging given the breadth and depth of the Australian small cap market.