Undervalued defensive stocks are thin on the ground, but here’s one

In a risk-on period where investors are perhaps more willing than ever to pay up for stocks, I believe we're onto at least one - in the healthcare space - that is still trading below what it’s worth.

When a company has good cash flow and is a world-class operator in its field, that usually spells “expensive” – especially in the healthcare space. But in this case, the firm is firmly in the sights of private equity firms.

Zooming out, we're confident Australian small caps have the fortitude to ride out a sustained period of volatility, our local economy has already demonstrated it’s better equipped than many.

On a sector level, in the following interview, I outline a few others that should also benefit from the strong demand environment we believe will persist. 

Edited transcript

Katie Hudson: Corporate Australia has navigated the challenges and the volatility well. And in small caps, they met expectations, from an earnings perspective through reporting season.

Margins were a little lower, revenue a bit higher but, overall, I'd say the demand environment, which is strong, is offsetting the emerging cost pressures that we're starting to see come through.

There were a couple of points I'd call out:

1. Inflation is not yet at peak. We spoke to several companies, particularly manufacturers and producers who are starting to filter those cost pressure through to the end consumer. One company we know of has pointed to a 10% price increase to supermarkets. So, inflation is still coming through and we're not yet at a peak.
2. The second point I'd make is that demand is really strong across a range of sectors. For example, the media sector probably had less disruption than we expected from Omicron.

Other sectors benefiting from the strong demand environment are:

• Agriculture,
• housing construction,
• retailers, and
• commodities.

Across the small-cap market, we're seeing a strong demand environment. Balance sheets and cash flow are in great shape.

One exception is possibly retailers, where we’ve seen inventory build up, largely around companies wanting to avoid a supply chain disruption. But overall, we’re coming out of this environment with heightened corporate confidence

Another key point

There’s certainly a strong and increasing risk appetite for acquisitions. Through the rest of 2022, M&A will continue to be very strong. And that's at both the outbound and inbound end of transactions. And in some cases, mergers can make more sense when valuations are elevated.

Private equity firms are well capitalized (flush with cash), which is why we believe strategic assets will continue to be well bid in the small-cap sector.

We've had an interesting example in our portfolio recently, Virtus Health (ASX: VRT). Why? It’s a good example of a strategic asset, with world-class capability operating in a growing healthcare sector, with excellent free cash flow generation.

And prior to the bid, the stock was trading below private market valuations. And that's the sort of asset that we'll continue to hold in the portfolio, and which we think will attract that very strong M&A cycle.

More broadly, interest rates continue to dominate the conversation. It's important to understand that this is a very different interest rate cycle than anything we've seen in the last 30 years. Interest rates are going up because inflation is rampant, not because of strong global demand. So, as we go through the balance of this year, we could see an environment where costs rise, inflation is strong, and global demand is (surprisingly) slowing. Against that backdrop, Australia looks like a relative haven.

The demand environment is good. We talked about several areas where the economy is performing well, and that the strong commodity cycle will continue to support the Australian economy.

With the small-cap sector having a much bigger exposure to the Australian economy, it looks very attractive. Together with the fact that it's trading at north of a 20% discount to large caps, very significant relative to history with a stronger earnings profile, the small-cap sector does look relatively attractive at this point. And so from our perspective, with the sell-off with companies coming under pressure, we'll continue to build positions in what we think are quality franchises and take advantage of those opportunities.

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Australian investors can access the Yarra Australian Smaller Companies Strategy via the UBS Yarra Australian Small Companies Fund, a fund which has been managed by Yarra Capital Management since December 2018. To be notified of my latest insights, hit the follow button below.