The big opportunities and risks for small-cap investors and tips to manage these in your portfolio

Inflation and interest rates are the biggest themes for markets at the moment, but could these also be opportunities?
Sara Allen

Livewire Markets

Inflation and rising interest rates are driving a lot of volatility in markets at the moment. Small-cap stocks are not exempted from this. While it’s something to be mindful of, Richard Ivers, Portfolio Manager for the Emerging Opportunities Fund at Prime Value, doesn’t see it as all bad news.

In fact, Ivers is taking a contrarian approach on heavily sold-off businesses where he sees quality and solid fundamentals.

“We are taking on some cyclical risk but only in quality businesses that have a lot of bad news priced into them and have a very strong long-term outlook with strong balance sheets that can survive some earnings headwinds,” Ivers says.

He points to Domain Holdings Group (ASX: DHG) as one such company Prime Value has identified and invested in for the portfolio.

It might just be a question for small-cap investors of holding their nerve in the tough times. In this edition of Expert Insights, Ivers discusses the impact of inflation and rising interest rates on small-caps, the opportunities and risks he is watching for and his tips to small-cap investors.

Edited transcript:

How is the inflationary and rising interest rate environment affecting small cap companies at present?

It's causing a lot of volatility at the moment. When there are scares about inflation and bond yields start rising, small caps get hit and fall and vice versa. When bond bond yields are falling, small caps and the market in general is rising and you're seeing a lot of movement, particularly at the speculative end. 
We think you need to be quite careful. A lot of the times, big macro things are driving these businesses, but at the end of the day, fundamentals drive stock prices. 

In January, for example, we saw this in a business that a number of our peers own called Megaport (ASX: MP1). It's a $1 billion business. It has potentially a good outlook, but it's one we don't hold. With the market rising strongly through January, the stock was up 17% in the month till the 31st when it put out a quarterly update and the stock fell 25% on the last day of the month. 

It shows you that you've got to be careful getting caught up with the momentum and the macro drivers in the short term because fundamentals will play out at some point and they'll drive the stock prices.

What are some of the key risks you see for small cap investors in the year ahead?

I think the economic outlook, interest rates and the impact of interest rates on the economy is a key risk. So do we go through a downgrade cycle? And therefore, is there compression on earnings per share for stocks? That's a key risk. 

In investing, often the things that cause downturns are the ones that come out of left field. Going back 25 years ago, I'm sure I'll be showing my age a bit, but long-term capital management came out of left field back in 1998 and caused some severe market flows. And the subprime crisis in the GFC which wasn't really anticipated or well known, particularly over here in Australia. Covid is another great example of pandemic that came out of nowhere.

So they're often the things that you've always got to be conscious of that come and can come out of left field. They are often are the ones that cause the, the biggest falls in markets, the ones that aren't expected. 

Later this year, we've got the risk of the US debt ceiling. Congress has shown that it's relatively dysfunctional at the moment and there are some risks around the debt ceiling in the US. That's one that could come on the radar a bit more. 

What are the key opportunities are you are seeing across small-cap companies?

As we progress through this year, we are taking a contrarian view on some stocks that have been heavily sold down. So the likes of Domain which has halved in the last 12 months, we think is a good opportunity to pick up a high quality growth stock. 

We are taking on some cyclical risk but only in quality businesses that have a lot of bad news priced into them and have a very strong long-term outlook with strong balance sheets that can survive some earnings headwinds.

We've brought the cash level down over the last 12 months as opportunities have arisen but we still have a reasonable level of cash. We'll be willing to deploy that as stocks get cheaper. In fact, we'd love stocks to get cheaper. That would be the sign to really go in more aggressively.

What tips do you have for investors in small-caps?

You've got to focus on the fundamentals. Don't get caught up too much in momentum. There's often flavour of the months within small caps. 

Resources were the flavour of the month. Particularly in the last couple of years, we've gone through different phases where buy-now-pay-later was the flavour of the month and therefore most of those have reverted back and fallen heavily. 

I think you've got to be careful about not getting caught up and getting excited by the new shiny thing that everybody else is focused on and instead focus on the fundamentals. Because when things change, they can often change very quickly and suddenly. You can get caught out.

The other thing we do is look at the long term and we invest on that basis. If you've got a high level of confidence that the share price will be higher in a few years' time - it might go through some dips and troughs in the  meantime - but what really counts is that you'll make a good return over the longer period of time. 

No one can really pick where share prices will go in the short term. If you've a business  that has a good outlook for earnings, typically the share price will follow that. If it's at a reasonable valuation multiple, then you should get a decent return.

One of Australia’s most trusted managed funds

Founded in 1998, Prime Value was established to meet a growing demand by investors for a privately owned managed fund that would exclusively manage investments on their behalf and not be driven by typical institutional shareholder demands. Click here to find out more. 

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Sara Allen
Content Editor
Livewire Markets

Sara is a Content Editor at Livewire Markets. She is a passionate writer and reader with more than a decade of experience specific to finance and investments. Sara's background has included working at ETF Securities, BT Financial Group and...

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