The S&P/ASX Small Ordinaries Index has staged an extraordinary comeback, lifting 50% in value since the 23 March COVID trough. For Simon Conn of Investors Mutual and Dean Fremder of Perpetual Investments, the surge in prices means the sector is fully valued.

The strategy now is all about finding hidden gems that have been left behind, and luckily for investors there's plenty where that came from. As Fremder says:

"There's lots of profitable companies out there that are probably under the radar because everyone's really focused right now on the sexy, conceptual tech companies and whatnot. "

In this extended interview, they expand on their views on valuations, what they're looking for in companies in this environment and which fads they're wary of. Dean and Simon also share their secret "fishing spots" for value and three small caps they like right now.

Notes: Watch, read or listen to the discussion below. This episode was filmed on 17 June 2020.


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Edited Transcript

Vishal Teckchandani: Welcome to Buy Hold Sell brought to you by Livewire Markets. My name is Vishal Teckchandani, and today we're discussing small caps. Have we missed the boat on small caps? To discuss this, we've got Dean Fremder from Perpetual and Simon Conn from Investors Mutual. Simon, let's start with you. Big gains in the Small Ords Index in recent times. We were just 7% shy of the February high. Are you seeing value in the asset class?

Simon Conn: It's been an amazing rally; but look, the market's pretty full. It's pretty hard to find a lot of value, to be perfectly frank. There's a huge amount of uncertainty. The stimulus in the real economy is massive, about $160 billion, and that's distorting the real world. So it's very hard to work out the fundamentals. Then the financial markets have been heavily inflated by very low interest rates and a lot of liquidity. So look, it's generally pretty difficult to find good value in the market currently.

Vishal Teckchandani: So that's a really strong keyword there, valuations are full. I'm going to take that and lob that your way, Dean. Are valuations full? Are small caps expensive?

Dean Fremder: Valuations for the broader market definitely seem to be full. But having said that, there's plenty of opportunities if you know where to look. I think we try and fish where there's less fishermen around; and ultimately, there's lots of profitable companies out there that are probably under the radar because everyone's really focused right now on the sexy, conceptual tech companies and whatnot. But if you actually know where to look, you can find some great profitable businesses with long track records earning good cashflow and trading at a reasonable valuation. So yes, overall, the market's expensive, but there's some good pockets available of value too.

Has the government distorted valuations?

Vishal Teckchandani: Okay, we'll talk about where you're fishing in a moment. There's something I'd really like to know about what's happening with value managers right now. You're both quality and value managers, and you rely on seeing a company's cashflows and earnings forecast to model returns and whatnot. But in an environment of lockdowns, how do you value a company's cashflow?

Dean Fremder: That's a fantastic question. I think ultimately you need to start with, is this company going to survive through what could be a very uncertain and potentially damaging period? We always prioritise the balance sheet as the first part of our process. So, fortunately, if a company has a good balance sheet and is not too geared, it means that no matter what the circumstance, they will be able to survive through it. 

I guess what we're really trying to do is understand on more of a normal type of year. So once we get through this period of uncertainty, whether it's two or three, six, 12 months, I wish I knew, but ultimately once they get through that, has the long-term earnings power of the company changed? And if it hasn't, where do we think that earnings power exists? So what we were doing is looking forward to more of mid-cycle earnings and then valuing companies based on that basis

Vishal Teckchandani: Simon, same question to you. Has the government disrupted value investing?

Simon Conn: It's certainly distorted the market, the real economy significantly. I mean, we've got a huge number of loans on furlough, not paying interest. We've got the JobKeeper distorting the employment market. The banks, rental abatement. There's just a huge level of noise in the market.

So look, as Dean was saying, when assessing a fundamental valuation, you've really got to look at the franchise, the strength of the competitive advantage the company has. The quality of the management teams is really important, and I think that's really what's come through over this last two month period is talking to management teams, you've really assessed who's got their management team positioned well, and who's been able to react really well? Those that are the floundering have become more obvious and I think reporting season really high like that.

Then again, as Dean said, you got to look forward beyond this disruptive period and trying to work out a reasonable level of earnings based on history, but not assuming that we're going to go back to what we were before. Because I think it's fair to say the economy was pretty soft. Reporting season wasn't stellar. There's going to be a lot more unemployment going forward and a lot less housing starts, for instance. Confidence is going to be a bit lower, and we've just got to get past this September cliff that everyone's talking about when the JobKeeper ends and then make a reasonable assessment. It's going to be a very interesting Christmas period.

Key indicators to keep the Small Ords momentum going

Vishal Teckchandani: And that's a great segue into the next question. What are the key indicators you're looking for that will shape the performance of small caps? And something I'm curious about is, is the small cap story tied to international broad market sentiment, or is it tied to the reopening of the domestic economy? Because small caps, their earnings are more domestically oriented.

Simon Conn: I think traditionally, the small cap market is more domestically focused. Companies such as McPherson's, Austbroker, Steadfast, these are companies that are more focused on the domestic market. Really, it's the performance of the Australian economy that will determine their outcome. I'd have to say that the outlook for the Australian economy, given how we've dealt with the health outcomes, has got to be a lot better than some of the overseas markets. So it's probably a good place to be investing. But look, there's a lot of noise in the economy and in the market, which makes it very difficult.

Vishal Teckchandani: Okay. Dean, same question to you. What are some of the key indicators you're looking for?

Dean Fremder: Sure. I think just to finish off on Simon's point, which I completely agree with, I think small caps, one of the great things about it is that a lot of the companies have more stock-specific drivers than just the broader economy. So if you're able to find some of these gems in industries that are growing for different reasons or companies that are growing for reasons beyond just the general economy doing well, it's a great place to really find some good returns. So small caps is a great place for that.

I think undoubtedly, as Simon mentioned, that the level of stimulus from by both central banks and governments is pretty insane, pretty crazy. I don't want to use the word unprecedented because everyone uses it. But, oh well, I did it anyways.

Beyond that as well, you've obviously got question marks around the economic recovery, which who knows how that will shape out? But I think at the end of the day, the big question is how are both those two factors, both the stimulus and the economic recovery, going to impact company earnings? As Simon mentioned, it's less so about how they're going to impact company earnings this year, and more about what does it actually do to the longterm earning power of these businesses? The truth is, some of the better-positioned businesses with better business models are going to come out of this stronger than some of their weak competition. It's really about just finding the companies and making sure you back those companies that can do that.

Portfolio positioning

Vishal Teckchandani: So let's talk about the inner workings of you as managers. Portfolio construction, what have you been doing since March? Where are you overweight? Where are you finding those opportunities? And what's your cash level looking like as well?

Dean Fremder: Sure. So from a portfolio construction perspective, nothing's really changed that much in the sense of we only invest in profitable businesses. We don't invest in any concept stocks. We don't invest in companies that have excessive levels of debt. So from that perspective, nothing's really changed too much.

What we tried to do is always focused on businesses that have a track record of earnings, a track record of generating cash, reasonable balance sheets, and management teams that have a long track record of being able to deliver value. So coming through this, that hasn't changed too much.

If you look at where we're really exposed, we have quite a bit of exposure in the insurance sector, in agriculture. We've had a reasonable gold holding, which has helped us really nicely through the period. Clearly, mass printing of money all around the world isn't too bad for the gold price. But ultimately, we're focusing on companies and industries that can grow independently of what the economy does. I mean, ultimately, the economy could go anywhere in the next six months, and we're focused on businesses that can grow regardless.

That's our position, quite diversified. We were able to pick up some great babies thrown out with the bathwater during the period, which is great.

Cash levels have hovered between 5% and 10% over the last three or four months, which is pretty much standard for us. The portfolio was quite defensive to start with.

Vishal Teckchandani: Same question to you, Simon. What's your portfolio construction looking like? How's that changed since March?

Simon Conn: Look, the portfolio construction process hasn't changed, Vishal. It's always about looking for companies with a competitive advantage, the recurring predictable earnings, good management teams, trading at a reasonable price. So that hasn't changed.

What we've been doing is really thinking about the exposure going forward and where the risk is in the portfolio. I've obviously taken a view, looking at the housing starts and the level of unemployment, that the housing market's kind of slow. So we've had a long holding in GWA, which has been a good performer for us. We had a position in CSR, and we've reduced and exited those positions. We've reweighted to sort of more defensive businesses. So things like Metcash and InvoCare, where we think they're good longterm businesses and more resilient and trading at attractive prices. They both raised capital recently. There were opportunities to buy into those businesses.

So trying to make the portfolio more resilient to what we think is going to be a pretty tough environment.

Vishal Teckchandani: And what's your cash level at and does it reflect a defensive posture?

Simon Conn: Currently about 12% to 13%. Look, cash is an outcome of the process. I mean, there's capital raisings coming every day. So it does change around, but we've got a reasonable level of liquidity, and I think that's always a bit of an insurance policy in a market like this. But look, at the end of the day, still 85% invested. That's what really drives the outcomes, and it's the stocks you hold that matter.

Fads to watch out for

Vishal Teckchandani: Okay. In the last question, Dean mentioned concept stocks. If we think about Investors Mutual, one of the things you're very wary about, Simon, is investing in fads. You avoided the tech wreck. Are there spots in the small cap market which are worrying you?

Simon Conn: There's extreme levels of enthusiasm in particular bubbles of the market. I often think that there's not one share market, there's two. There's not one investor or one class of people buying shares, there's two. There's investors and speculators. There's the racetrack. I'm in the casino, or I mean, I'm in the stock exchange. And then there's people investing for the longer term. I think the stock market's a great place to make money gradually through time, and it's a great way to lose money in the short term.

So we've seen fads, the tech wreck, the mining sector pre-GFC. At the moment, it's the buy now, pay later sector that's been really very hot. Afterpay, but also with Sezzle and WISR and all these other things that have popped up. Around January, February, the medtech sector has been one that's very hot. So companies such as Nanosonics, Pro Medicus. Good businesses, but valuations really pushed well beyond where we think fundamentals sit.

Vishal Teckchandani: Simon's view on BNPL is pretty clear. It's sell now, sell later. What are you thinking of the fads in small caps?

Dean Fremder: Yeah, I think there's two more, I guess, all-encompassing fads to pick up on. One is the next stock. So it's the next Afterpay, it's the next CSL. There seems to be this notion that you can pay pretty much any price for an early-stage company if it looks similar to what those companies did 10 years ago or whenever they first started. There will be some winners, of course, but paying silly prices for anything that looks similar is tricky.

The other thing would be, I guess, companies with large addressable markets. A large addressable market, don't get me wrong, is a really attractive thing. If a company has something special, that means it can actually capture a large part of that market. But paying, again, a crazy multiple or a crazy valuation for a stock just because it's going after a big market, again, is a little bit crazy. I think people have this tendency or this desire to buy lottery tickets. They feel, "I buy a share, and if they crack the code, I'm going to make a fortune." But the problem is, how many times have you won the lottery?

Summing it up, where is the value?

Vishal Teckchandani: So we talked about fishing earlier on in the episode. What is your one favourite spot where you're fishing for value right now?

Dean Fremder: I think I would say companies that just are operating in industries that aren't that sexy. Everyone's focused, like I said at the start, on the tech industry and whatnot. But there are some really great profitable opportunities in old world, more boring industries.

I'll give you an example. Here, There & Everywhere (ASX:HT1), it's the largest radio station network owner in the country. They've also got the benefit of being Kyle Sandiland's boss, which is potentially a tricky situation to be in. But you can basically buy the whole company today for $280 million. With that, you get $110 million of cash. You get a stake in a digital business worth, we think, between $50 million and $100 million, and you get a radio network that's generated on average a cashflow of $50 million a year for the past five years. So perhaps it's not as sexy as the next Afterpay or the next CSL, but we think that's pretty attractive.

Vishal Teckchandani: Okay. Simon, same question to you. What is your one most favoured area within small cap land right now?

Simon Conn: I quite like the packaging sector. It's a pretty boring, as Dean was saying, sector, and it's been a bit on the nose. But Pact Group Holdings (ASX:PGH) and Pro-Pac Packaging (ASX:PPG) are two stocks that we own. Propak was trading at 7 cents in the selloff, and it's one that's now trading at 20 cents. All they had to do was confirm guidance and say that they had paid down debt, and the stocks double. It's a really boring business. They make flexible packaging, which underpins a lot of the activity, a lot of the food that we're consuming now in supermarkets. They provide the packaging for that. And Pact in the rigid sector, again, a new management team. Rigids, I think, it's a really solid business. Obviously, the debt got a bit too high. But these businesses generate good cash, and I think through time, debt will reduce, and the stocks will rerate as they continue to deliver and hit their targets.

Vishal Teckchandani: Whether markets go up or down from here, it's all about recognising that there are good businesses out there, and that they're not necessarily sexy.

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