While equity markets globally have mostly celebrated the Trump rally, investors within Australian smaller and mid-cap growth companies have not felt so enthused. Continued fund flow rotation back towards larger cap Financials and Resources coupled with a weaker end to the AGM season has seen some fairly dramatic downgrades and weakened sentiment across the sector… With high quality businesses seeing a rapid PE compression, one also expects to see an accompanying demise in sentiment toward the space. Investor mindsets move away from dreaming about the upside and more toward “what can go wrong” with any slippage in reported earnings forecasts dramatically punished. This is a regular part of the Fear vs. Greed cycle and whilst sentiment is all pervasive, we remain acutely aware it can also just as easily turn on a dime. With prices 20 – 30% lower in some cases on no news, we’re genuinely excited by some of the opportunities currently on offer.
Unfortunately for listed companies, reporting decreased earnings expectations through a period of negative investor sentiment can greatly exaggerate the resultant share price reaction. Like the rush to buy upgrades when market sentiment is high, the exact opposite occurs on the other side of the cycle and the velocity of sell-offs experienced through November has been a testament to this. Downgrades outnumbered upgrades almost 2:1, further dampening the animal spirits.
Front of mind in November would be updates from CSG Group (-45%), Adairs (-35%) and iSentia (-28%) where businesses have lost more than a quarter of their entire market cap in a single trading session. Perhaps most telling is the quantum of the sell-offs have materially eclipsed the numerical EPS downgrade, essentially telling us the market is also applying a lower earnings multiple going forward.
On the other side of the equation, stocks that exceeded expectations and reported earnings forecasts above market estimates largely saw stock price movements well below the percentage upgrade. This is frustrating for holders, however it reaffirms where we are currently positioned in the cycle. History tells us there are ample opportunities to make highly profitable investments at the peak of the Fear cycle and we feel the opportunity set to uncover these opportunities is certainly widening.
If we look back on the Ophir portfolio’s in November, we held 7 stocks that had upgrades this month and avoided every one of the ~21 material downgrades reported within our investment universe. To have that kind of outcome and still underperform for the month is frustrating, however for us it reinforces two key messages:
1) Our investment process and style continues to work well – ultimately as investment managers we focus our efforts on forecasting the future cash earnings of businesses. Whilst PE’s will compress and expand with broader market sentiment and flow-related issues, as long as our process continues to deliver a relatively reliable ability to predict the ‘E’ then we can ultimately wait for the ‘P’ to take care of itself;
2) Whilst not at a peak fear level currently, the recent price retracements have greatly widened the opportunity set available to us to buy high quality businesses at attractive valuations. When upgrades are not rewarded and downgrades are severely punished, we know we are in an environment where we will come across excellent opportunities to deploy capital into high returning businesses. With prices 20-30% lower in some cases on no new news, this greatly reduces our investment risk of losing capital and we are genuinely excited by some of the opportunities currently.
Smart Group (SIQ) – An Opportunity to Buy
One such opportunity would be salary packaging and fleet management provider Smart Group (SIQ). The fleet management space was almost a market darling sector in its own right amongst small cap managers only 6-8 months ago as investors were drawn to the industry’s high margins and opportunity for further consolidation.
Following pre-Election commitments from both the Liberal and Labour Governments to not meddle with the existing Novated Leasing legislation, the business traded on a forward PER as high as 18x mid-way through the year as regulatory concerns within the sector subsided. In August of this year, the stock was trading north of $7.50, at a time when Directors and Management bought over $500,000 worth of stock personally. Management are highly regarded in the space with a strong history of under-promising and over-delivering.
Fast forward 3 months and the stock has retraced more than 25% in price. At current levels, we can buy shares in the business on just 14x CY17 earnings, delivering what we estimate will be ~10% in organic growth per annum pre any acquisitions.
The business has no balance sheet issues, and actually looks under-geared at 1x Debt/EBITDA, providing ample room for further growth. With a well-executed M&A strategy (of which management have already established a great record) and organic growth, ultimately we think this is a business that can comfortably generate >15% EPS growth per annum for the next 3-5 years.
14x PER for an under-geared business operating in a concentrated industry generating 45% EBITDA margins and 30% returns on equity. We don’t get opportunities like that every day – we have used the share price weakness as an opportunity to add the stock to both portfolio’s.
Andrew Mitchell is a Co-Founder & Portfolio Manager of Ophir Asset Management: (VIEW LINK)