Why we are bullish on these cyclical stocks

Lead portfolio manager Oscar Oberg and portfolio manager Tobias Yao discuss how the team have continued to identify opportunities despite continued heightened volatility and share their views on the technology, mining services and retail sectors.

Edited Transcript

Question: This year the markets have experienced continued heightened volatility. Can you talk through the investment process and how the team has continued to identify opportunities during this period?

Oscar Oberg: The volatility that we’ve seen across the small cap space which started in September 2021 has continued. It has been an incredibly volatile market and when we see periods of volatility, you generally see investors be more favourable towards larger cap companies such as banks and resources because they are much more liquid or a bit more of a safe haven, let’s call it, compared to smaller cap companies and that trend has broadly continued over the start of this financial year. Pleasingly from our perspective we have been able to outperform the market in the first four months of the year which has been great. It has been really pleasing despite those headwinds and if we look at our portfolio at the moment we are very positive on the upward flow and this reflects the fact that valuations are very, very cheap at the moment. Small cap companies relative to large cap companies are trading at 25-year lows in terms of valuation. Balance sheets are very strong. Vast majority of our portfolio has more cash or property than debt owing on their balance sheet. We believe our company is in a very good position to face what was probably going to be a tough year in the calendar year 2023. The pleasing thing for us is markets always look 12-months in advance and if we look at the macroeconomic environment at the moment it does feel that interest rate rises are starting to peak. Inflation, we are seeing a lot of the inflationary indicators come off such as freight, logistics, used car sales and so forth. We do think the market will start pricing in a more stable environment for interest rates in the future in calendar year 2023 and that will be very good for small cap companies that have been heavily sold off.

Question: Throughout the year you have spoken about stocks trading at tough valuations. What are a few exciting examples?

Oscar Oberg: There are plenty of stocks out there at the moment that we are interested in that are trading at a share price below their property value and you are getting an operating business for free. A good example of a company we own in the agricultural sector is Select Harvest, the ticker is SHV. It is the largest almond producer in Australia. Tobias, what do you reckon, almonds, the worst commodity over the COVID period? It is probably the only soft commodity that has not gone up over this period and it is largely because the United States or California had a record crop two years ago and are just working through that carry over of almonds at the moment and what you are seeing at the moment in California is a chronic drought. It will take time for that to come through, but we are looking through this weakness and looking at what the actual assets of the company are worth. Now the share price is currently trading at about $5.50 a share and we think the market value of the assets are $6.50 to $7.00 a share, so we are buying this company at a 20% discount to the asset value and we are getting the operating business for free. For us, we are happy to wait there, wait for almond price to recover and we will see the rewards come through in the share price.

Tobias Yao: Another good example is a company called Estia Health (ASX: AHE). It is an aged care operator run by a very competent board and management team. The aged care sector as a whole has had a very tough time over the last few years, firstly with the Royal Commission into aged care and more recently with COVID. However we believe that is now behind us. We believe if you are an efficient operator in the aged care space there are a lot of opportunities from a merger and acquisitions (M&A) perspective to acquire good assets at very attractive prices and at the same time we have seen quite a few large takeovers of aged care operating groups and we believe Estia itself is a target of potential acquisitions. We think the intrinsic value is over $3.00 and currently the risk reward looks to be very attractive.

Question: What is your view on the technology sector and recent technology takeovers?

Tobias Yao: We continue to be very selective in tech, however more recently we have invested in a few new positions. We are drawn to the defensive business models and the growth profiles of some of these companies and the valuation has come back quite a bit. For us to be interested in a technology company, it needs to tick three boxes. The first box is it needs to deliver at a minimum 10 to 15% of organic growth rate. Secondly, it needs to have a net cash balance sheet and finally it needs to have strong operating leverage and to be trading on a very reasonable earnings multiple. Our preference is also for founder lead businesses given the stronger focus on cost. We believe these companies are the ones that the market will gravitate towards when they look for growth, in fact we are already seeing some signs of this in private equity players and strategic buyers are seeing value in the small cap tech space, been quite a few acquisitions and takeovers recently. If you look over the last 18 months, over 30% of the tech companies in the All Ordinaries Index have received at least one takeover bid, so we continue to see this trend playing out and that is why we are getting more positive on the sector.

Oscar Oberg: Tobias you are being very modest here, we have participated in a few of those takeovers in WAM Microcap (ASX: WMI) and WAM Capital (ASX: WAM), including Elmo (ASX: ELO), Readytech (ASX: RDY) and of course Tyro Payments (ASX: TYR), so well done.

Question: What is your view on mining services?

Oscar Oberg: We have been in the Mining services sector for a long, long time. It was a frustrating sector for us coming out of COVID because a lot of these companies were getting hit by labour pressures from minimal interstate migration and also immigration from overseas. Since the borders have reopened, these companies are now receiving a tailwind around their cost base and also with very strong commodity prices we are seeing a very strong outlook for construction and also producing assets for mining companies across the country. In terms of our favoured exposures across WAM Capital, we have NRW Holdings (ASX: NRW), Seven Group (ASX: SVW) and then in WAM Microcap we also have Mermaid Marine (ASX: MRM), SRG Global (ASX: SRG) and Austin Engineering (ASX: ANG).

Question: Heading into the Christmas period, what is your view on Retail?

Oscar Oberg: We are quite bullish on the retail sector. Unemployment is very low. There is still a lot of pent up savings out there. No doubt it is going to be a very tough calendar year 23, however a lot of these companies have been priced in in terms of their share prices, so we are actually quite bullish into Christmas for a number of companies such as Myer (ASX: MYR), Premier Investments (ASX: PMV ) and also Lovisa (ASX: LOV). These companies have also very strong balance sheets and we think they can weather the storm and I think the valuations are cheap enough that they can get through this tough calendar year 23 and it will look good into subsequent years. year the markets have experienced continued heightened volatility. 

Question: Can you talk through the investment process and how the team has continued to identify opportunities during this period?

Tobias Yao: The volatility that we’ve seen across the small cap space which started in September 2021 has continued. It has been an incredibly volatile market and when we see periods of volatility, you generally see investors be more favourable towards larger cap companies such as banks and resources because they are much more liquid or a bit more of a safe haven, let’s call it, compared to smaller cap companies and that trend has broadly continued over the start of this financial year. Pleasingly from our perspective we have been able to outperform the market in the first four months of the year which has been great. It has been really pleasing despite those headwinds and if we look at our portfolio at the moment we are very positive on the upward flow and this reflects the fact that valuations are very, very cheap at the moment. Small cap companies relative to large cap companies are trading at 25-year lows in terms of valuation. Balance sheets are very strong. Vast majority of our portfolio has more cash or property than debt owing on their balance sheet. We believe our company is in a very good position to face what was probably going to be a tough year in the calendar year 2023. The pleasing thing for us is markets always look 12-months in advance and if we look at the macroeconomic environment at the moment it does feel that interest rate rises are starting to peak. Inflation, we are seeing a lot of the inflationary indicators come off such as freight, logistics, used car sales and so forth. We do think the market will start pricing in a more stable environment for interest rates in the future in calendar year 2023 and that will be very good for small cap companies that have been heavily sold off.

Investing in 2023

In this year's WAM Vault video series, our investment team discuss how they are utilising the proven investment processes to identify new opportunities in the market and share their outlooks for investing in 2023. You can find out more here.