Why WAM is bullish on small caps (and the team's 30 best ideas for the recovery)
If there is one thing readers can take away from this article, it's that Wilson Asset Management's small-cap team is resoundingly bullish.
If you are a diehard Livewire reader, you probably already knew that. After all, lead portfolio manager Oscar Oberg already revealed he was positive about the outlook for small caps a few months ago as part of our Outlook Series.
But now, things are different. In fact, last week there was a "noticeable change" in US Federal Reserve chair Jerome Powell's language. Now, January's gains were not just a bear market rally... Now, it's a sustainable recovery.
"[Powell's] been very negative on inflation for a good 12 months and now he's basically said there are only a couple of hikes to go. We've had another 25 basis point hike and the market is now pricing in another 25 basis points," Oberg explained.
"Times will be tough this year, there's no doubt about it. But analysts and the market have factored in a very negative outcome for a number of sectors and stocks. We think that won't eventuate. And that could be very positive for the market in 2023."
So which stocks are portfolio managers Tobias Yao and Oberg backing for the small-cap recovery? In this wire, I outline some of their favourite sectors for the year ahead, the biggest duds in the WAM Capital (ASX: WAM) portfolio last year, as well as their top stock picks for compelling value and growth.
Note: The quotes below were recorded from a Q&A webinar Wilson Asset Management held on Friday 2 February. You can check out the recording here.
The biggest mistakes of 2022 (and WAM Capital's five portfolio duds)
Let's rip off the bandaid and start with some of the major mistakes the team conceded to have made during the calendar year. For Oberg, there were three, honestly very relatable headwinds, that the team miscalculated (or couldn't predict). These include:
- The war in Ukraine - which was, for the most part, completely unexpected.
- The speed of inflation - which WAM assumed was COVID related and would come off a lot faster than it actually has; and
- How hard and fast the US would go on rate hikes.
While the small-cap team didn't have much exposure to technology stocks early in the year, it did have exposure to the retail sector.
"At that time we were coming out of Omicron and we thought people will be going back into shops and not doing anything online. And that space got hammered as investors worried about a recession," he explained.
He pointed to GUD Holdings (ASX: GUD), Costa Group (ASX: CGC), DGL Group (ASX: DGL), Codan (ASX: CDA), and Redbubble (ASX: RBL) as portfolio duds during this period.
From market darling to dud to market darling once again?
On the other side of the coin, the pariah of the market in recent years, AMP (ASX: AMP), is reportedly now starting to look attractive. That's according to Oberg, who believes the worst is now behind this financial services player.
"It's going to be one of our biggest holdings, if not the biggest, in the portfolio this year," he said.
Why? Well, he points to two main reasons:
- The new CEO, Alexis George, is doing a fantastic job. She's really cleaned the decks of the business, letting go of management and board members from the firm's troubled past. She's taken costs out of the advice business and put those back into service. She's growing that business, the platform and the bank as well. So it feels like AMP is on track.
- And probably more importantly, we've just seen an announcement that two of the final parts of the sale of AMP Capital are due to close in the next six months. And one of them has actually closed already.
"Given that the market cap of AMP is $3.5-$4 billion, it's quite material. So we think that'll be very, very positive for the company."
In addition, the company is also trading at a discount to its net tangible assets, with Oberg calculating that the firm's assets are actually worth $1.70-$1.80 a share. Then, of course, AMP's market exposure will be a tailwind for its share price if the ASX continues to rise.
A sector on a serious growth runway
Both Yao and Oberg are "very bullish" on the tourism sector, particularly given the reopening in China.
"We think that inbound tourism from China is going to be the next leg of growth for a number of these companies," Oberg said.
Yao named companies like Webjet (ASX: WEB), Flight Centre (ASX: FLT), Event Hospitality and Entertainment (ASX: EVT), IDP Education (ASX: IEL) and Tourism Holdings (ASX: THL) as current portfolio holdings - and ways the team is getting direct exposure to the sector. But they are invested in indirect exposures like oOh!Media (ASX: OML) as well.
In addition, retailers like Myer Holdings (ASX: MYR) are also likely to rake in tourism dollars, he said.
"Over the next 12 months, there's going to be a lot more flights. Cathay Pacific has 17 flights now per day versus a month ago - when it was zero. So we think the number of flights and hotel rates will continue to stay elevated and potentially go up further as we get more tourism coming into Australia," Yao said.
What's more, there are still "undiscovered gems" in the sector, Oberg added.
"Experience Co (ASX: EXP) is our largest holding in the WAM Microcap (ASX: WMI) portfolio, we really like that stock," he said.
"It's very undervalued and we think the shares, once [demand] returns to normal, could actually double from here. So there are a lot of opportunities in that space right now."
If you are like me, you are probably wondering why Flight Centre is on that list. After all, it's the most shorted stock on the ASX (and has been for quite some time).
"A lot of that short interest is actually hedging out a convertible bond," Yao explained. "So the real short interest is a lot lower."
"Prior to COVID, some of the challenges Flight Centre faced were around the brick-and-mortar travel agents business. At the time, the corporate business was going really well, but the leisure business was languishing."
However, over the last three years, management has focused on reducing costs and right-sizing the business, Yao said, with the corporate business continuing to grow in the background.
"So you are going to have two growth drivers going forward," he said.
"I think a lot of the shorters are waiting to see whether they can actually deliver on their promise. They've given an FY25 target of making a 2% profit before tax margin. And that equates to roughly around $500 million of profit before tax. So if they do hit those numbers, we think the shorts will have to cover."
Currently, analysts are forecasting a 1.6% profit margin for Flight Centre, Oberg added.
"That's an example of where analysts have assumed a very negative scenario," he said.
"If they do 1.8%, the company will be disappointed, but we'll be very happy because analysts will be upgrading their numbers."
Top 3 stocks for growth over the next 12 months
If you thought that was a lot of stock ideas, just wait, there's more. When asked about their top picks for growth over the next 12 months, Oberg and Yao happily obliged.
For Oberg, it's MMA Offshore (ASX: MRM), one of the largest providers of vessels and marine services to the offshore energy sector and maritime industry.
"It's a company that has had a chequered history. It basically went broke twice and it's in a new form. Now the balance sheet is great and there's very minimal debt," Oberg explained.
"And we've got this beautiful situation now where there's a lot of offshore oil and gas projects that are happening at the moment. A lot of offshore wind farms ... And effectively there's been no construction of new vessels or tugboats over the last decade. So MMA Offshore is incredibly well placed."
Like AMP, MMA Offshore is also trading at a discount to its net tangible assets, Oberg said, and a 20-30% discount at that.
"Over the last 12 months, the stock has doubled. It had a great announcement in December. And we still think there's some very positive news flow in the company over the next six or 12 months," Oberg said.
Another attractive growth opportunity right now is Nexted Group (ASX: NXD), Oberg added, which is a holding in both WAM Capital and WAM Microcap (across these LICs, they own around 10% of the company).
"That's probably one of the highest growth companies we are seeing with a very strong two to three-year outlook," he said.
Nexted was once iCollege, and before that, Red Hill Education, Oberg explained. It provides investors with exposure to the growing demand for English language colleges.
"That sector got absolutely decimated, as you'd expect, through COVID, and a number of competitors have left the industry. Nexted is now the largest player by some margin and is seeing a huge increase in students," he said.
"They had 4,000 students in the English language school at the end of December. And by the end of January, that had increased to about 4,800, and it is still increasing."
Meanwhile, Yao's top stock for growth over the next 12 months is Tuas Limited (ASX: TUA).
"It's the TPG Singapore business. It was founded by David Teoh, the same founder as TPG Telecom. He set up a mobile company in Singapore and now is rapidly taking market share away from the incumbents," Yao explained.
"It's effectively the same blueprint as TPG Telecom back in the days when they competed with Optus and Telstra and Vodafone, and we believe they can replicate that success in Singapore.
"We think they will go into other product categories opening up new revenue growth drivers."
Why small-cap tech could have a comeback
For years, the WAM Capital team have berated the overvalued tech sector. Now, they've been snapping up these same companies at a discount.
"That sector has been obliterated over the last 12 to 18 months, and there's been a lot of acquisition and takeover activity in that space," Oberg said.
"One of our holdings, Tyro Payments (ASX: TYR), has been in the paper a lot in terms of takeover activity... And we have been positioning the portfolio in more growth names such as Life360 (ASX: 360), Pro Medicus (ASX: PME), and Fisher & Paykel (ASX: FPH), which has done pretty well for us over the last quarter."
The outlook for tech companies over the next 12 months looks particularly interesting, Yao added, given the scrutiny on cost-cutting over the past year.
"Over the last few months, you've seen some of the large tech companies in the US cut costs. That's a new narrative," he said.
"We need to find out what that means for the growth rates of some of these businesses because ultimately, they are really stress-testing to see whether they can achieve similar amounts of growth with a lower cost base."
The companies that are able to deliver robust growth rates while cutting costs will emerge as the winners, Yao added.
"That's what we are spending most of our time researching," he said.
The sector set to have a stellar reporting season
While the WAM team is unable to invest in mining stocks, it can invest in mining services.
"It's been extremely tough watching the mining sector go up every day for the last six years, but it's been turbocharged in the last 12 months," Oberg said.
"Mining services is the way we can play it. And it's actually been our best sector over the last 12 months."
He points to companies like NRW Holdings (ASX: NWH), Perenti (ASX: PRN), Austin Engineering (ASX: ANG), SRG Global (ASX: SRG), Seven Group (ASX: SVW), Imdex (ASX: IMD), ALS Limited (ASX: ALQ) and Worley (ASX: WOR) and MMA Offshore as examples.
"Outside of commodity prices being high, the sector has benefited over the last six months with state borders re-opening and a lot of those COVID costs starting to come off," Oberg said.
"Efficiencies and productivity are improving. And now we've got immigration coming in, their access to labour will also improve. So we really like that space. And all those stocks should have a positive reporting season."
This one's sure to surprise you! The region (and stocks) with the most compelling value right now
"You won't expect me to say this, but I've never seen value on offer as I have in New Zealand," Oberg said.
"And I think it's because their economy has been hit harder than ours."
In fact, around 10% of WAM Capital assets are currently invested in New Zealand-based or New Zealand-related stocks - names like Fletcher Building (ASX: FBU), Vulcan Steel (ASX: VSL) and Tourism Holdings.
In addition, building materials-related companies are also an interesting area of the market, Oberg said.
"The reason is analysts have really cut their numbers hard, as you'd expect, with house prices, approvals, and new housing falling off," he said.
"But again, we think that they've just cut too much and interestingly, looking at a company that's been around for a very long time, like Fletcher Building, it's trading on a PE of nine times at these depressed earnings levels."
Normally, as cyclical companies, when earnings are depressed, building materials will have higher valuations, he explained.
"At the moment, analysts expect earnings to come back in probably three or four years. We actually think they'll come back in two or three. So we like that sector, it looks very, very attractive," Oberg said.
"Other stocks we own there would be CSR (ASX: CSR), Boral (ASX: BLD), and Maas Group Holdings (ASX: MGH), which is a key holding of ours."
Meanwhile, for Yao, the best value right now is in aged care - specifically Estia Health (ASX: EHE).
"The aged care industry has had a very long period of negative news coming out of the Royal Commission into Aged Care. And obviously more recently, COVID," he said.
"But we are now at this juncture where we believe the government will have to fund the space a lot more. And that benefits the aged care players, like Estia Health, which is buying other assets at very, very attractive prices.
"It's one of the only consolidators in this space, the management is really good, they're very efficient. We think they can acquire these assets, turn them around, and run them effectively."
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Ally Selby is a content 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 Group, Your...
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