The small-cap sectors to avoid (and where to invest)

Buy Hold Sell

Livewire Markets

When volatility is up and risk appetites are down, small caps invariably take a hit. Investors will naturally gravitate towards more liquid areas of the market. 

But the sell-off has been about more than just risk-off sentiment. Fundamentals have changed. Consumer-facing stocks are feeling the pinch while rising rates are set to hurt long-duration names with a lot of debt on the books. 

You can still remain invested in the market, though, so long as you replace any sells with high conviction buys. 

"It's ok to be active, but don't forget to buy something on the other side," says Josh Clark from QVG Capital. 

In this edition of Buy Hold Sell, Josh is joined by Gary Rollo from Montgomery Investment Management to offer up some tips that will help you "aim small, miss small." 

They'll also discuss the tech growth names that have 35% upside. 

Read or watch below. 

Note: This episode of Buy Hold Sell was shot on Wednesday 25th May 2022. You can watch the video, read an edited transcript or listen to the podcast below. All data provided by Mathan Somasundaram (DeepData Analytics)

Edited Transcript

James Marlay: Hello, and welcome to Buy Hold Sell, brought to you by Livewire Markets. My name's James Marlay, and today I'm joined by Gary Rollo from Montgomery Investment Management and Josh Clark from QVG Capital. My two guests are specialists in smaller company investing, and I reckon they're pretty brave because it's been a bit of a tough time at the small end of the market.

The small ords are down 14% year to date. One of the bright spots has been the resources industry, but not everyone is drawn to resources. Today, we're going to be talking about what's happening in the small caps, how much more pain might be ahead of us, and what are some of the opportunities and tactics you have at your disposal to take advantage of the sell-off. Josh, I'll start with you. Why has it been so tough in small caps, and is the worst behind us?

Josh Clark: I think it's close to impossible to say which way the market's going from here. I wouldn't rule out markets moving lower. What I would say is, given the severity of the price movement so far, it's pretty hard to imagine the worst still being ahead of us - it is potentially behind us.

I think there are a few reasons why it's been so tough in small caps in particular. The first one is that the upwards revision to interest rates has had an impact in terms of compressing valuations. Small caps are particularly sensitive to that because they are typically higher growth, longer durations and more sensitive to that rate move.

I think the other thing to mention is the composition of the index. Large caps are very dominated by banks and resources. In a unique inflation-up, interest rates-up type environment, they tend to outperform. You've seen money move from smalls into large caps. 

And then maybe the last reason is just momentum begets momentum. We're in a bit of a risk-off environment, so the perceived safety in large caps is more attractive than in small caps.

James Marlay: A few reasons there. Gary, have you got anything to add to that? And any crystal balls telling us as to how far down the selling path we're on?

Gary Rollo:  I agree with what Josh has put on the table there. I just say that look, in a risk-off world, which we're seeing, you have a lot of selling arrive and you're seeing that at the top end of town as well. But in small caps, the liquidity pool is a lot thinner and so that amplifies the effect.

You do need to check up on what's going on with fundamentals though. It's pretty clear that in some areas of the economy, fundamentals have changed. For example, in consumer, which I'm sure we'll touch on later, things have changed there. You could argue that there are some good reasons, beyond sentiment, that explain why we're seeing some of the share price changes that we've seen. But - and Josh has mentioned some inflation positive sectors - there are definitely some areas of the market we can invest in as well.

James Marlay: You touched on a point that I wanted to discuss there; I get the impression that the small-cap end of the market is more influenced by sentiment than others. How much of the selling that we've seen is down to that, a shift in the fundamental outlook versus just risk-off sentiment? Hard to quantify?

Gary Rollo: No, Josh and I, we're both fundamental guys. We'll sit down and try and quantify things in spreadsheets all day long, every day. That's what we do. There's no doubt that we can try and get to the bottom of some of this. Whether we'll be right or not, because sentiment is a factor too, we'll have to see.

But coming to that discretionary consumer point, the small-cap index has a lot of its growth stocks in discretionary, consumer-facing areas and things have changed there. The cost to acquire customers has gone up because of the rule changes with Apple. You've got consumer spending under pressure from the effects of inflation that we're seeing in markets today and likely more. Demand destruction is on the risk side of the curve there.

And you've also got changes in economics for these businesses. Funnily enough, some of those big growth stocks and small caps, like Breville, ARB, ZIP, those kinds of businesses, they're seeing a change in their fundamentals and investors are going to reprice them. I would say those sectors, you want to not take on unless you've got a better view of the macro world than I have and you've got a better crystal ball than I have. Because the market is starting to come to grips with what those inflationary forces mean, but we're not at the end of that realisation yet would be my call.

James Marlay: Anything to add to that, Josh?

Josh Clark: Yeah, I think it's interesting. I'd certainly echo those comments with the risk of repeating some of that. But one of the interesting things to think about is if you look at Bitcoin - it has halved. 

Has the outlook for Bitcoin changed? I don't know if Bitcoin has an outlook, just given the lack of fundamentals there. That has to be pure sentiment. There's no doubt that sentiment is playing a role in what we're seeing at the moment.

To echo some of Gary's comments around the outlook, it has has changed. For me, one of the most significant things is that interest rate expectations are higher than we've seen and what that does to valuations, especially long-duration assets. Anything that's expensive typically falls in that bucket. And then I'd also agree with some of that potential consumer weakness that could be on the horizon.

There are examples like Walmart and Target in the US that have been talked about quite a lot in terms of their recent results. There's some early signs of that. Shouldn't be too surprising just given mortgage rates are higher, along with other cost of living pressures. The petrol price would be one of those. But we haven't quite seen that yet I think in Australia, and maybe somewhere like the UK, so still on the horizon. But they all form part of the outlook, so I think the outlook certainly has changed.

James Marlay: We're going to get to a couple of investment ideas and opportunities in just a moment. But in the scenario that you're fully invested and you've been riding this downturn, feeling some pain, what are some techniques that you can use? What technique can you use to free up some capital before we go and deploy into some new opportunities? And maybe just a quick checklist of some of the things that might be on your hit list, Josh.

Josh Clark: Sure. Well, I think the thing to remember is you can free up capital. Even if you're fully invested, doesn't mean that you don't have any money to spend. You might have something in your portfolio that's gone down, that still has good prospects and is starting to look cheap. But that's not to say you can't sell that and buy something on the other side with better prospects from here.

The caution I'd make is if you're going to sell things in this environment, it's okay to be active, but don't forget to buy something on the other side. 

I think if I was to give a bit of an overarching comment around portfolio management, and this is maybe echoing some of the comments Gary's already made, is anything facing the consumer, I'd be a bit cautious on. And to make that a broader statement, anything that has earnings risk in it, I'd just be ruthless about cutting those names. And I'd be looking to rotate more towards defensive, durable growth names.

James Marlay: Okay. Portfolio management tips, Gary? When you're fully invested and you've felt some pain. How do you capitalise on weakness in the market and what are some of the techniques you use?

Gary Rollo: Look right now it's aim small, miss small. If you're invested, be very certain of the earnings outlook of the companies that you're in. Don't hold onto stocks and sectors that you're not already 100% certain of. 

And I think the acid test is to ask yourself, "If this stock dropped 20%, would I buy some more?" I think that's something that you need to gravitate around as a rule at this particular point in time.

For us, we are a bit like Josh's point, looking in sectors where the certainty is low, and asking ourselves is there a valuation reason to be there? And if it's not, you need to move on to sectors where that certainty is higher and you can gain conviction that the earnings profile is strong enough and the investment case is strong enough to allow you to stay invested.

James Marlay: Okay. Well, let's have a quick chat about a few sectors. Discretionary retail, healthcare, and tech have all been brutally sold off. I'll put some charts up in the wire from this that I have. Just looking at the small-cap industrials sector and the worst 25 stocks, I think it's the year to date. If you own the 25th worst performing stock, you'd only be down 40%. If you own the worst-performing stock, you'd be down nearly 80%. That's Zip it's been brutal. Has the sell-off gone too far in some of those sectors, or what are some of the sectors that you do like?

Small Cap Industrials Worst 25 YTD (as as 23 May 2022). Source: DeepData Analytics

Small Cap Industrials Worst 25 YTD (as as 23 May 2022). Source: DeepData Analytics

Gary Rollo: Okay, so you listed out three sectors there. Discretionary retail, as Josh and I have explained is not plan A right now.

James Marlay: Line through that one.

Gary Rollo: Line through that, red pen. Let's move on to the next one. You mentioned healthcare. Well, in small caps, healthcare, those businesses are some of the toughest to value asset types, and they're also generally cash burning. That wouldn't be my first place to go looking. Tech, I think it's a bit different. Consumer-facing tech has all the same problems as the consumer. Don't look there. And that's why Zip's been spanked and a few of the other more e-commerce-related names. Temple & Webster, those types of businesses.

James Marlay: Red bubble.

Gary Rollo: Not for today, Red Bubble. But I would look in tech that's exposed to enterprise spending, and that is cloud-related names and data centres. You can find good businesses with solid business models. And actually, the sector fundamentals are super strong. Those big three hyper-scale companies that provide the base DNA for cloud technologies, their businesses are still growing at 35%.

Spending's not missed a beat because the enterprise is facing the same challenges that the consumer is. It needs to improve its flexibility and lower its unit costs. And the answer to that is technology in the cloud. And they're still spending and spending hard. There are some good business models in small-caps in that space. That's where I'd start. That's where I'd be looking.

And funnily enough, those stocks are all being sold off too. Not to the same extent as the consumers, but look, high grade your portfolio. Get into something with much better fundamentals at a cheaper price. That's the name of the game in investing.

James Marlay: I'm going to get you to pitch me a name in a moment.

Gary Rollo: Sure.

James Marlay: Josh, sectors, anything to add to what Gary said? He's okay to pick through some of those B2B enterprise-level tech stocks. Yourself?

Josh Clark: Yeah, just to quickly run through them. I'll skip discretionary retail, because we put a line through that, but I certainly don't disagree. Healthcare, I think it's absolutely a mixed bag, but I'd be looking at the companies that are already on an earnings recovery trajectory and they are throughout the market cap spectrum.

Maybe an example of a smaller one, Pacific Smiles, a dental business that has a massive dent in the share price. That's already on an earnings recovery trajectory. Obviously, the product's particularly defensive. And if you go right up the other end of the market cap spectrum in healthcare, you've got something like a CSL. Also a defensive, durable business model that is on an earnings recovery trajectory. I think they're reasonable places to start looking.

And then I'd echo some of those comments from Gary in terms of technology, but it is still a mixed bag. There's been a lot of cash bleeders, cash burners, and capital destroyers in the tech space. And they're not coming back anytime soon. In fact, some of them will be lucky just to get the capital to keep going.

Yeah. I'd be looking somewhere where you've got a high level of earnings certainty. If you use something like maybe a Hansen Technologies, as an example where they've got an extremely sticky utilities customer base. High level of certainty around revenue and earnings for that business. And it's also got a very reasonable valuation at that point. I think they're the kind of places you want to be looking.

James Marlay: Okay. I was going to get you each to pitch a stock, something that's not resource-related, that's defensive in a risk-off environment. Have you got a stock you wanted to pitch? Was that it, Hansen?

PSC Insurance (ASX: PSI)

Josh Clark: No. I'll give you a different one. Something like PSC Insurance (ASX: PSI) comes to mind. They're an insurance broker. In a way similar to Hansen, their product is very defensive. It's going to be just as in demand next year, as it was last year and this year, regardless of the environment that we move through. That's been defensive from both revenue earnings and share price perspectives.

But I think on top of that, you know that you're going to be in safe hands because you've got a significant portion of insider ownership. You've got a long track record of execution. You're getting in double digits for earnings growth if you add up things like volumes price and inorganic growth or acquisitions. That's certainly a defensive name that comes to mind for me.

James Marlay: Okay. Now Gary, you can do resources.

Gary Rollo: Yeah.

James Marlay: But I'll let you pick what you want to do. Can you picture something in that small end and that something's proving defensive in the risk-off environment?

Stanmore (ASX: SMR)

Gary Rollo: Defensive resources? OMG, I don't know that such a thing exists! Let's eliminate the word defensive. I'm actually going to go with the resources stock because the resources sector offers you some positive exposure to inflation.

And you can also see that there are some major events happening in the world that the resources sector is the place to play: decarbonisation and energy security (for example). There are changes that are happening that you can only really play in resources. I'm going to go there. My fund can play there but I'm going to go old school, not the all super sexy new EVs and lithiums, I'm going to go talk to you about metallurgical coal (met coal) because there's something big happening in the met coal space.

Look, met coal is one of Australia's biggest exports. BHP has been forced, let's use that word, to sell its coal assets probably for ESG reasons. It's effectively disposed of one portion of its portfolio to a small company called Stanmore (ASX: SMR). At current prices, Stanmore will be able to pay for that in one year because the prices are so strong.

Now, sector fundamentals in met coal were already strong before the Russians decided to invade Ukraine. And we've got repercussions from that. The EU has said, "No more Russian coal, thank you very much." And they are a big part of that market. Let's just think about it. The deal closed in May. They need probably about $600 million of cash flow to get their balance sheet back into what you would call a neutral-ish type position. They'll be able to achieve that in three or four months of owning this business at these price levels.

Big changes happening for ESG reasons. Take a look at the resources sector because there are stocks like Stanmore that are taking advantage. And I don't think the majors are finished at disposing of these high-quality assets. Just to give you a sense of the quality of this asset, this is a through-the-cycle cash generator. 

There are mine assets in this portfolio that are the benchmark price for coal. When you see PCI coal price, that's actually come from the mine that's been sold here. It's that high quality.

There are shifts going on. And as far as I'm concerned, we want to make some money and have our spurs on and have a go. Even if the world is a tougher place, you can still find pockets of opportunity. And for sure, some of them are in the resources space. That's what we've been looking for.

James Marlay: Well, folks, it sounds like the game in small caps has changed. The winners of yesterday aren't going to be the winners of tomorrow. It might be time to brush off your notebooks and think about some new strategies presented by our guests today.

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Buy Hold Sell
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Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.

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