The shake out of some of the larger cap money from the small cap space through the back end of 2016, came primarily on the view that the reflation trade had taken hold and resources and cyclical-type businesses were now back in favour. The market sold good quality, highly cash generative businesses to fund a rotation into lower quality, cheaper businesses that would benefit from a broader economic recovery.
Looking at the global data to date and earnings updates from the majority of those cyclical names, it’s hard to see any real evidence of that recovery yet really taking hold. As a consequence, a number of very good businesses were, for a small period of time, priced cheaply. The market has begun to close this valuation gap and we’d expect this re-rate to continue in the better managed, higher growth businesses.
We’d be hesitant to call it a ‘turning point’, as we don’t feel the underlying investment environment ever substantially changed. Growth broadly remains difficult to come by, and businesses that can generate solid earnings growth independent of the economic cycle will attract a valuation premium.
Small caps now need to deliver on their earnings to make up ground. In a low interest rate, low inflation environment, businesses that deliver earnings growth will be rewarded by a market that is starved of growth options - particularly at the larger cap end.
Identify companies that can grow regardless of the backdrop
Companies that can demonstrate an ability to grow earnings consistently will be rewarded with above market multiples, and rightfully so. We don’t really see it as a “large caps vs small caps” or “growth vs value “ debate – ultimately we’re looking for businesses that will deliver growth regardless of the softer economic environment.
These will typically be businesses that have a strong business franchise, solid returns on capital and lowly geared balance sheets. However, as 2017 has already demonstrated– if you miss your earnings, then your growth premium can disappear almost completely overnight. This is a time to be highly selective and to own businesses where you are completely confident in the numbers and broader underlying operating environment.
PMV: Record sales despite a weak market
Premier Investments (PMV) has been caught up in the broader retail malaise as the markets frets about weaker consumer data and the pending arrival of Amazon. Despite a softer retail environment and an unseasonably cold October period, Premier still delivered record sales and earnings from their retail business at the recent half-yearly report, avoiding the slew of downgrades that were hitting the retail space through the period.
The real attraction for us, however, has been the growth in children’s stationary brand Smiggle, a business that has grown sales by +81% over the last two years. If the US retail experience teaches us anything, it’s that businesses that deliver brands that are unique, difficult to replicate and who control the distribution can continue to thrive in a post-Amazon world. Smiggle fits the bill on all fronts and the success of the business in the UK (where Amazon has held a significant presence for some time) would highlight the brands resilience to the online threat. The business added 26 new stores in the UK in the last half alone, taking the overall store count above 90. We expect this store roll-out to continue in both the UK and into new geographies, providing Australian investors with exposure to the first genuinely global retail label in some time.
Smiggle is becoming a much larger driver for the PMV business – management are guiding an expected $200m in sales out of the brand by 2019, representing over 30% of Group sales. Despite the strong growth, net cash balance sheet and best-in-class management team, the stock still sits at a 26% discount to its trading price in August 2016, the beginning of the growth stock rotation.