Small cap investors call time on Australian AI trade. Here are 3 ASX stocks for the next cycle

In terms of the Australian AI trade, a big chunk of those companies are small cap data centre contractors. So, where does a small cap investor that rode the wave go when the tide turns? For Centennial Asset Management’s Matthew Kidman the answer is to go more defensive.

“We’ve had a pretty big run in stocks like SKS Technologies (ASX: SKS), Southern Cross (ASX: SXE), Genusplus (ASX: GNP), and more recently Megaport (ASX: MP1),” Kidman says.

“We’ve cycled through those now and we’re in this defensive position, holding a bit more cash and gone a bit bigger in market cap.”

He adds that investors also need to be cognisant of the bigger picture, particularly what's happening with bond yields and global capex impacting the AI trade.

“What you've found is the market has started to cycle out of some of those stocks that are reliant on the capex cycle, but it’s not ready to go into the interest rate sensitive groups, because rates are still going up.”

Where this leaves investors is stuck in a middle ground where defensive stocks - or what people perceive as defensive - have come to the fore.

“At the small end of the market, unfortunately, there are not a lot of defensive stocks. They've all got some exposure to cycles,” Kidman says.

“For the moment, we've taken more cash. We've gone a bit more defensive, where we're looking at this capex cycle and asking whether it's the end of the growth in it.”

Another small cap manager that has exited their position in “AI beneficiaries” is 1851 Capital, with CIO Chris Stott telling the Rules of Investing podcast that even though names like SKS have been among the best performing ASX stocks in recent years, “the easy money's been made”.

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“AI is here to stay. There's no doubt about it. There are lots of winners and losers along the way, and it will continue to evolve very, very quickly. But we feel as though the easy money's been made in some of those names,” Stott says.

“For contracting businesses, their price-earnings ratios went north of 30 times. To give you an example, the general PE ratio for a contractor that I would have observed over the last 25 years on the ASX would be around that 10 to 15 times mark. So from a valuation standpoint, we felt as though they'd run a little bit ahead of themselves.”

It's a financing problem, not a demand problem

In much the same way that these stocks were bolstered by the broader AI theme driving spending, it’s not really the businesses themselves that are causing investor concern.

Reporting season produced no “hand grenades”, Kidman says. “Most of them earned well, but the market is a bit nervous about it.”

What investors need to understand, he adds, is that these businesses have seen their earnings jump enormously in a relatively short period of time but that the level of investment isn’t guaranteed to continue.

“Is the AI spend disappearing? I don't think so. Is it slowing? Definitely.”

“These companies, and I'm talking Southern Cross and SKS here in particular, got re-rated on much bigger earnings. So we're looking at the outer years, all of a sudden, is there as much work? Maybe not.”

When stocks are trading on multiples above 20 times earnings, “the outer years count”.

The real problem, he says, are supply constraints and financing. His concern is how data centres get paid for. Firmus failed to raise around $7 billion in its float, AirTrunk pulled a smaller raise in Singapore, and NextDC has been hit by delays and downgrades at one of its big sites.

“If you can’t get your equity, you can't get your debt, and all of a sudden their data centres aren't funded.”

NEXTDC shows how this plays out. One of its big data centres fell through because they couldn’t secure an energy contract, leading to delays and downgrades.

“So what does NEXTDC do now? It's got a very geared balance sheet because it's been building these data centres, but the equity price is down. Every bank, every lender will want equity to be raised, and they'll be hesitant to raise it. Funding gets tight.”

What Kidman is buying

Just because Centennial is moving more into cash and getting more defensive, that doesn’t mean it’s given up on picking stocks, with Kidman outlining three new investments in The Level 18 Fund that he believes are positioned to perform.

CSL (ASX: CSL)

The former market darling has come storming back to life over the last six months and its inclusion in the fund is emblematic of Centennial’s shift to include large cap names with a defensive angle.

“What we've seen globally is that healthcare has had a bit of a renaissance. Everyone's being defensive, and healthcare is a go-to place. CSL is benefiting from that. It's a global company, and its earnings are probably not going to fall off the edge of a cliff here,” Kidman says.

“They've kind of reset, so it's a safe place to hold for the moment. Do I think we hold it for five years? No, a lot of its growth is done. It's mature, but it's not a bad holding spot at the moment.”

Bapcor (ASX: BAP)

Bapcor is a turnaround, with its third or fourth change of management in recent years and a large wholesale car parts business. Even though it is a small cap business, Kidman says it still has scale and revenue, it’s just lost its profitability.

“What encourages me, even though that smaller retail part is struggling because of the higher interest rate market, is that Bapcor still has quite a large revenue base. If it can rebuild even half the margin it had before, it's worth a lot more than it is today.

“We've owned it for a little while now, a few months, and it's been one of our better performing stocks. We've got a reasonable position, but it's at that small-to-medium end.”

He adds a warning: “Turnarounds are harder than what everyone thinks, so be careful with your turnarounds. But on this occasion we think management seems to be doing the right thing. They've brought people back in who are industry players and understand the industry, which encourages us a little bit.”

The Koala Company (ASX: KOA)

Koala is a global growth story that many first dismissed as “the next Temple & Webster”, but Kidman says that a closer look reveals far higher margins, a narrower range and the US launch was profitable straight away.

“Now they've gone to the UK and they intend to go to Canada. It’s a high margin, and they've been able to go into these geographies without spending much money and getting results pretty quickly,” Kidman says.

“The stock re-rated and now it's not as cheap. When we first saw it, it was on single-digit multiples, maybe 10, and growing at 30%. Perfect, we'll take that every day of the week … Now the multiple's in the higher teens, but it could probably still grow 20 to 30% for a while.”