“How am I gonna be an optimist about this?”
But if you close your eyes,
Does it almost feel like
Nothing changed at all?
Does it almost feel like
You’ve been here before?
How am I gonna be an optimist about this?
How am I gonna be an optimist about this?
Chorus from “Pompeii” by Bastille
As cheeky as it is for us to borrow from pop culture when trying to make our point, lyricists always make points extremely eloquently. Now, if we could just sing. The S&P/ASX Small Ordinaries Index was down 1.16% for the month but rose 0.89% for the quarter with the Schroder Australian Smaller Companies Fund outperforming for the month and quarter by +.59% and +2.79% respectively. The market continues to edge higher although we continue to feel increasingly isolated in our cautious views. Why the caution, why the grumpy man syndrome when things are going up and people are making paper money? Simply put we think the market moves are fictitious in their meaning and cause. We could name many shares, often in companies we fundamentally like, whose share price is currently stretched far above levels we feel comfortable owning them. It’s times like these that grit and resolve are required. The Schroder Australian Smaller Companies Fund and Schroder Microcap Fund have both continued to perform admirably against their relative benchmark of the S&P ASX Small Ordinaries Index, though the relative performance against our peers has slipped back a bit. Whilst we are highly competitive by nature and care passionately about earning our investors good returns on their investments, we are also concerned about how we make the money. Playing a long game in any sport is both a game of offense and defence. So too with investing!
To put smaller companies in context, we decided to quantify the large momentum effect we have observed in the smaller companies space. We went back 12 months and screened for high PE stocks (these are stocks that are already trading at high valuations – indicating the market’s preference for these businesses). We looked for stocks in the S&P ASX Small Ordinaries Index trading at 20x forward earnings and created an index of these twelve names – we dubbed them the Dandy Dozen. These comprise many market favourites including Realestate.com.au, Invocare, Domino’s Pizza and Sirtex. To be clear we are fans of many of these businesses but we are not fans of investing in many of them at the current valuation levels. The Dandy Dozen index would have given you +60% return over the past year vs. the S&P ASX Small Ordinaries Index of close to 0%. Whilst many of these companies offer decent earnings growth, many of these names have shown a large re-rating over their underlying earnings growth. All these signs indicate to us that the market has moved firmly from the GARP (growth at a reasonable price) phase to GAAP (growth at ANY price). Whilst we like investing in good businesses, we don’t like following the thundering herd as it pushes these valuations ever upwards. The lamentable choice we are left with is to search amongst the less glamorous parts of the small cap market for reasonable businesses at reasonable prices.
Investing in stocks with better valuations adheres to the second principle of investing which we have promulgated for some time. That is, to minimise risk. We’ve lamented before about the lack of industry focus on risk and return. Virtually all industry charts simply compare fund managers’ returns with no measure of risk (even an inadequate one like volatility) being appended to the all enticing return scores. We therefore seek to maximise return and minimise risk by not only selecting companies with lower financial and operating leverage but that also have valuation support – even if this runs counter to the momentum trend we outlined above. Fortunately, we are not in the business of trying to win popularity awards. However we do want to position our investors’ money to prosper when the clamour comes off the glamour.
In a slowing Australian economy that looks likely to be running budget deficits for the foreseeable future, we would flag the heightened risks around sectors which are heavily reliant on Government funding (read largesse). The two sectors we would point to are the government funded VET (Vocational Education Training) sector (90% of revenues sourced from governments) and the Childcare roll up sector (50-60% of revenues sourced from governments). The latter in particular makes us want to repeat the chorus line again. Although childcare centres are clearly a very necessary part of a working society, the extent to which the private sector has and is profiting from this space appears unsustainable. Operators in the space proudly report that pricing has risen at 7% p.a. compound for 10 years. The reason parents haven’t been particularly fazed by these steep day care cost increases is due to the current government subsidies for childcare, in particular the non means tested CCR (Child Care Rebate). The CCR and CCB (means tested Child Care Benefit) now cost the government a staggering $5.0bn pa. Critically the CCR costs over $2.5bn and this is the component that is growing the fastest. Our current Treasurer has stated that the “age of entitlement is over” and is looking to cut the budget deficits. To that end the Productivity Commission is currently reviewing the child care industry and is due to make its submissions to the Government before October this year. Don’t expect an increase! Equity holders have benefitted disproportionately from a service that should arguably be delivered by the State. G8 education, the poster child for this space, now trades on 4.5x book value, coincidentally the same peak valuation reached by another child care centre roll up story that ended spectacularly poorly for investors in 2007. I think I’ve made the case for caution at least.
Our outlook on the small cap space hasn’t change materially. We are firmly playing a game of defence (to follow through with the initial analogy) and looking to find under-appreciated assets in a broadly expensive market. As the speculative phase of the market comes to an end, and it always does, we will look to become more constructive in the small cap space. Until then we will remain highly selective with respect to the virulence of the IPO pipeline and wary of sectors which derive a large proportion of their revenue base from an increasingly indebted Federal government.
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