The benefits of self help
With the reasonably aggressive sell-off in the third quarter this year, most major world indices have moved into negative territory for the year. The causes of the equity sell-off, politely referred to as “de-risking” in professional circles, appear to be relatively numerous but centre around China’s slowing growth and at the other end of the spectrum the improving prospects in the US with a consequent potential rate rise. Smaller companies of course have not been immune to the general malaise although more recently have outperformed their larger peers. Smaller cap investing is more of a stockpicker’s market. The Small Ordinaries Index is a relatively broad index and has numerous sub themes running through it. The 10 largest stocks in the Small Ordinaries Index comprise just 14.5% of the overall index weight compared with 54% for the top 10 stocks in the ASX100. This breadth in smaller companies has helped small cap investors differentiate their exposures from larger cap investing as smaller companies are not simply hostage to the movements in large banking and resource stocks.
At the top of the returns list for the September quarter lie some unlikely candidates with Pacific Brands, Blackmores and St Barbara mines rounding out the top 3. The bottom 3 positions went to LNG Ltd, Beach Energy and Medusa Mining. The index thus has shown some remarkable dichotomy with several gold stocks performing near the top of the pack and several near the bottom. We’ve touched on the gold sector in a variety of ways in previous commentaries – generally highlighting the lack of shareholder focus amongst management teams. On the other hand when stocks have gone through a particularly bad patch, yet retain a reasonable core business they can get overlooked and prove to be good investments. Regis Resources springs to mind here, which has been a holding in the Schroder Australian Smaller Companies Fund for close to 12 months and has been one of the better performing stocks over the past quarter. When we entered the position near the end of 2014, we highlighted the falling AUD and the drastic reduction in labour and contracting costs as rapid air inhalations to the gold sector. In addition, Regis was doubly impacted by some poor grade reconciliations with their reserve statement. Most gold companies, Regis included, have learned some lessons from previous cycles and have hedged out neither the currency nor the gold price. The fall in the Australian dollar, minimal balance sheet gearing and some good cost reductions have led to the business starting to generate large windfalls in cashflow. Regis has just paid a reasonable dividend to shareholders so there are at least some signs shareholders are within management’s focus – let’s hope this continues.
Out of favour sectors with improving fundamentals often prove to be successful investments for the smaller companies and microcap funds. In that camp I would also place stocks like Pacific Brands, The Reject Shop and SMS Management. Each of these stocks performed exceptionally well. In addition, each of these businesses had limited gearing or a net cash balance sheet – and I’ll return to the importance of this later – reasonable to excellent market positions but had gone through recently challenging trading conditions for a variety of reasons. These stocks had been sold down to levels that would have made sane investors blanch. This is not to say that all out of favour stocks or businesses prove to be fabulous investments. In some cases, businesses are or remain in terminal decline and restructuring simply postpones their inevitable demise. In other cases the balance sheet gearing can stop you out. By this I mean, that a year or two of poor results can force a highly indebted company into either an emergency capital raise at lower and highly dilutive equity prices or receivership. Either of these scenarios is a bad to terminal outcome for longer term investors. Where balance sheet gearing is negligible however, investors can wait out the bad times, until results improve. If the business is sound but being poorly managed, a change in management can see the re-emergence of the true strength of the underlying business. Once this has been made manifest you are likely to see a consequent re-rating of the depressed share prices which was the case with each of the three holdings above.
Another major theme which has been playing out for some time but had a pronounced effect over the past few months has been the impact of the Chinese consumer in Australia. A potent combination of the falling Australian dollar, creation of a number of Free Trade Zones in China and a strong perception around Australia’s products being “clean and green” has driven a boom in a number of consumer categories. Chief amongst those we have exposure to in our various funds has been infant formula and vitamins. In the first category our microcap strategies have owned Bellamy’s since the company IPO’d in June 2014. The story at the time was a simple one, a great consumer brand offering at a small price premium to existing incumbents that was taking share aggressively on the back of very limited marketing. Clearly something good was going on and after several meetings with management we grew comfortable with their organic supply chain and passionate focus on product quality. In the second category our small cap strategy has owned Blackmores. This stock has been a core holding of our strategy for many years and whilst the business has grown solidly both in Australia and South East Asia for a long time, a more recent boom via Chinese interest has seen a sharp increase in sales growth rates. Given the sharp re-ratings both shares have enjoyed, we have reduced the holdings in both names but still carry exposure in both.
The last major driver in our space has been the continued boom in M&A. This has been a theme we have referred to for some time and indicated that the preferred way to play this would be via smaller company exposure. With very few exceptions, all the listed M&A activity in Australia has taken place in the smaller company space. With many US and international corporates retaining significant foreign currency balances and being unable to repatriate funds into their home countries without incurring additional taxes, M&A becomes an increasingly popular option for multinational companies. During September we saw Equifax bid for Veda Group at a 40% premium and Vocus agree a merger with M2 telecommuncations at a premium. Although there is good evidence some parts of the global economy are doing well, for instance the US, most other major economic zones are decelerating making organic growth a rare beast. We continue to believe Australian small caps will be an outsized beneficiary of corporate activity whilst prevailing interest rates remain, corporate confidence remains high and the Australian dollar remains below longer term averages.
Whilst not wanting to sound unduly optimistic, the dominant theme in this missive has been to demonstrate the variety of themes small companies are exposed to. Several years ago, the smaller companies index was comprised of up to 45% poor quality resource stocks. During the last several years, the market process of ‘creative destructionism’ has turned over the universe such that resources now comprise a more realistic 13% of the small cap index. The process of growth, decay, takeovers and IPO’s has further seen a significant change in the composition and broad quality of Australian smaller companies. It is worth noting for instance, that 20% of the Smaller Companies Index is now composed of companies that were unlisted two years ago. Although we are not advocating universal investment in all IPO’s nor suggesting that the quality or value of these will make good investments, the renewal of the smaller companies space has been significant and welcome. We will seek to judiciously invest capital in the better quality spectrum of the universe subject to realistic valuations and welcome the occasional goodwill gesture from the Chinese consumer.
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