Small Ords Index hits new 17-month low: So which managers are making it out alive

Ally Selby

Livewire Markets

The Small Ordinaries Index - the gauge of small-cap stock performance, has plunged around 14.6% from its highs. It hasn't been this far in the red for at least 17 months. 

Who can blame investors for running for the hills? In the last few months alone, central banks around the world have started to raise rates for the first time in a long time, while inflation is at levels we haven't seen in decades. There is also an ongoing war in Eastern Europe, heightening tensions in Asia, an ongoing climate crisis, and a local federal election which at this point has proved to be more of a joke than it has any right to. 

But amid all the chaos, several investment managers have managed to outperform, delivering double-digit returns when investors, like you, need it most. 

Livewire reached out to Morningstar for an independent list of small-cap fund performance over 1 year, 3 years, 5 years and 10. This list of high returning funds includes well-known names like Ausbil, Perpetual and Regal, as well as under the radar managers like Microequities, SG Hiscock, Armytage and Cromwell. 

Luckily, one of these top performers agreed to an interview, where they shared what has been working, some new portfolio additions, and answered the million dollar question: is the sell-off in small caps nearly over? 

Plus, we also spoke to a long-term performer that has suffered from short-term pain to see what went wrong, whether they are sticking to their guns, and which small caps they believe will lead the recovery. 

Note: The data below was supplied by Morningstar. Returns were calculated as of the 11th of May, 2022. 

The highest-returning managers over 1 year 

  • Mid/Small Value: Microequities Value Income - 18.15% (cumulative return) 
  • Mid/Small Growth: Ausbil Australian Emerging Leaders Fund - 9.76% (cumulative return) 
  • Mid/Small Blend: Perpetual Pure Microcap Fund - 20.12% (cumulative return) 

The highest-returning managers over 3 years 

  • Mid/Small Value: Regal Emerging Companies Fund II - 24.99% (annualised return) 
  • Mid/Small Growth: SGH Emerging Companies - 22.75% (annualised return) 
  • Mid/Small Blend: Armytage Micro Cap Activist - 26.71% (annualised return) 

The highest-returning managers over 5 years 

  • Mid/Small Value: Cromwell Phoenix Opportunities Fund - 16.84% (annualised return)
  • Mid/Small Growth: SGH Emerging Companies - 20.83% (annualised return)
  • Mid/Small Blend: Regal Australian Small Companies Fund - 27.2% (annualised return)

The highest-returning managers over 10 years 

  • Mid/Small Value: Cromwell Phoenix Opportunities Fund - 18.89% (annualised return)
  • Mid/Small Growth: SGH Emerging Companies - 15.92% (annualised return)
  • Mid/Small Blend: Ausbil MicroCap - 19.93% (annualised return)

Outperforming in a sell-off: What's working and why? 

Ausbil was one of the top performing managers over both the short and long term (over both 1 year and 10 years). And according to Arden Jennings, it's the firm's robust process and ability to be completely style agnostic that has helped it lead the pack. 

"For example, during the lows of COVID when interest rates were being cut and fiscal stimulus increased, we were very much growth orientated. Close to 70% of the SmallCap portfolio was in growth names," he said.

"But when the COVID vaccine was announced, and Biden mandated a push towards the green energy transition, we shifted the portfolios to be more cyclical. We moved early, in October 2020, which was against the grain. Now, materials make up 27% of the portfolio, financials is close to 15%, and we have continued to be underweight tech."

It also has recently derisked its portfolios by increasing the number of stocks in portfolios, increased the spread of its exposures, moved up the market spectrum from a market cap perspective and continued to avoid unprofitable companies, many of which are in the technology sector, Jennings said. 

So why materials and resources? Well, you've probably noticed that rising inflation and a war between Ukraine and Russia have pushed commodity-related stocks higher in 2022. While decarbonisation and the transition to cleaner energy sources help buoy the sector over the long term. 

"Resources is at about 26% of the Small Ords, but peaked at about 46% in the previous supercycle. And decarbonisation and the energy transition is here to stay," Jennings said. 
"On Ausbil's forecasts, we see copper demand increasing by two and a half times, nickel at three times, cobalt at four, graphite at eight and lithium at 10 times by 2031. These projects don't come online overnight - you want to pick the ones that are in a tier one jurisdiction like Australia." 

So what is a top-performing manager backing as small caps sell off? Jennings pointed to long-term favourite DGL Group (ASX: DGL) as his highest conviction call, despite the stock's already stellar performance since listing (it's up 210% in less than a year). 

In fact, he said that DGL reminded him of the early days of long term winners and founder-led holdings Uniti Group (ASX: UWL) and Johns Lyng Group (ASX: JLG).

"We've been topping up this position after it pulled back in share price recently," he said,  (referencing recent media attention surrounding founder and CEO Simon Henry and the subsequent share price sell-off). 

DGL group is a specialty chemical supply chain company with three main businesses, chemical manufacturing, warehousing and distribution, and recycling and treatment solutions. For Jennings, it's DGL's strong market position and excess of $100 million of debt capacity on the balance sheet that has him excited (possible firepower for acquisitions down the line). 

"There are also significant barriers to entry into the dangerous goods industry such as regulatory permitting. And they own or lease over 55 sites, across Australia and New Zealand, providing significant scale for customers versus its competitors," Jennings said.

"And we love founder-led businesses because they generally outperform. We believe there is still a significant long runway of growth for this company." 

He also points to lithium developer Core Lithium (ASX: CXO) as one of the top stocks powering the future of the energy transition in the small-cap space.

"Core Lithium is a lithium development project in the Northern Territory coming online this year. It's 88km from Darwin via a sealed road, it's got access to labour but also a port to be able to export their product," Jennings said. 

"It also is low risk from a development perspective given its an open pit. We also like that it had very low upfront CAPEX to start this project, it's low on the cost curve, and limited processing because its high grade with low impurities." 

It also has secured an offtake deal with Tesla (NASDAQ: TSLA). Which, depending on the fortunes of Tesla over the coming four years, lends itself well for Core Lithium at a time of high market pricing and an incredibly tight supply environment.

Those dealing with short-term pain: What's not working and why?

With the recent sell-off in high P/E names, growth-focused small-cap managers have two choices - either change tack or accept this (hopefully) short-term drawdown.

"We're unashamedly growth investors, we own a bit of technology, and our style is deeply out of favour at the moment. There's no way to sugarcoat it. Performance has been tough," said Donny Buchanan, co-founder and chief investment officer at Lakehouse Capital. 

"During times of volatility like this, the market's view shortens considerably. But we are sticking to our guns and our long-term growth-focused investment style, and we are seeing lots of great opportunities out there at the moment." 

For Buchanan, there has been a widening disconnect between the fundamental performance of growth businesses and their share prices. 

"To me, that's just a great opportunity. And it's where I would be wanting to put my money at the moment - rather than cyclical value stocks or commodity and energy companies benefiting from a war between two of the world's largest commodity producing nations," he said. 

"I don't know how long this grinds on for and I don't believe that anyone really does. But I have conviction that three and five years from now, these growth businesses will be in stronger positions competitively and they'll be generating strong cash flows. And that's what I want as an investor." 
Interestingly, Buchanan's background is in Value Investing. However, after nearly 20 years in markets, he believes investors can generate the better returns by taking advantage of depressed growth stocks during periods of market volatility, like during the GFC, COVID crash, and now. That is, instead of trying to time the market and/or cycle to cash. 

So what has Buchanan been buying during this recent sell-off? Well, he points to Audinate (ASX: AD8) and Nearmap (ASX: NEA) as two examples. 

"Between lockdowns and semiconductor chip supply shortages, Audinate's had a tough couple of years," he said.

"Despite this, the management team continued to make long-term strategic steps to entrench and grow Dante in the professional audio industry, and also to gain a foothold in video. We also have a lot of respect for this management team's long time horizon as it aligns well with ours.

"Audinate is one of the most competitively advantaged businesses in our investible universe, is being offered at an attractive price relative to its long growth runway, and with the company emerging from recent challenges, we've been topping up." 

Meanwhile, Nearmap has also been capturing Lakehouse Capital's attention in recent times, with its share price down 22.4% since the beginning of the year.  

"The business is built on a capture-once, sell many times business model and you're seeing that operating leverage come through in the key North American business where gross margins widened 24 percentage points over the last 12 months," Buchanan said. 

In addition, the company recently announced that it had commercialised its new generation camera technology, which should improve efficiency and help the business to enter new geographies, he added. 

"This optimism needs to be balanced with the heavy investment in sales and premium content, and the uncertainty of the ongoing legal battle with Eagle View," Buchanan said. 

"But with the business growing in the mid-20s with strong incremental unit economics, growing optionality, carrying around $100 million in net cash, and selling for one of its lowest multiples in a decade it's an interesting set up from here." 

Is the sell-off in small caps over? Probably not. 

Buchanan believes small-cap investors have suffered two blows, one from growth being deeply out of favour with rates on the rise, but also from liquidity drying up significantly, pushing prices even lower. He also notes that a "surprising" level of shorts has emerged in some of the quality growth names within the small-cap universe. 

"This could definitely grind on for a lot longer," he said. 
"However, we're not concerned about that, we're sticking to our knitting. We own businesses that we think can continue to grow through this period and emerge competitively stronger. 
"It is certainly challenging at the moment and I'm sure investors are not enjoying seeing the red on their screens. But when you look through market history, periods like this have also been the periods of greatest opportunity for investors."

The Federal Reserve does not have a good track record of a "soft landing" following rate rise cycles, and thus, Buchanan believes that the US could be in for a recession over the coming months. 

"For that reason, we are not interested in cyclical businesses. We are looking for businesses that can grow throughout the cycle, and selective enterprise software is a good example of that," he said. 

Meanwhile, Jennings is avoiding unprofitable growth and tech and believes investors should be incredibly selective over the coming months to avoid further drawdowns in their portfolios. 

That said, Ausbil still sees the ASX outperforming its global peers in 2022, given the bourse is resources heavy and underweight tech compared to US markets like the NASDAQ and S&P 500. 

"But from a small and micro-cap perspective, we see significant downside risk for the illiquid and unprofitable part of the market ahead, as rates are rising and quantitative tightening has begun, which is a headwind on valuations and will potentially create continued selling pressure as emergency liquidity settings globally are removed," Jennings said.

"So that's the area of the market we are avoiding." 

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Ally Selby
Deputy Managing Editor
Livewire Markets

Ally Selby is the deputy managing editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian...

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