A turning point is coming for small caps. Here's where Monash is investing

Macro headlines have dominated in the past few years, and that has spelled bad news for small caps. The traditionally ‘riskier’ side of equities, with smaller balance sheets and less flexibility in servicing debts, has not been served well by an environment of rising inflation, high interest rates and increasingly conservative investment patterns.

Despite this, Monash Investors have argued in a recent webinar that opportunities still remain for investors, and in fact, the changing environment could see small caps surge again.

The underperformance of small caps in the past year

In a challenging year, Aussie small caps have significantly underperformed their large cap counterparts. The small caps price index fell 19.3% from highs in December 2021, compared to the ASX 100 price index remaining almost flat (a fall of 0.2%) in the same period.

August was particularly volatile off the back of reporting season.

Monash noted 25% of stocks had positive price moves of greater than 7.5%, and a third had falls greater than 7.5% due to earnings surprises. The best performing sectors were energy and consumer discretionary, with worst performers financials, industrials and healthcare. In fact, taking a closer look at energy, 50% of energy stocks listed on the Small Ords actually had a price increase of more than 7.5%.

Source: Monash Investors, Factset

Consumer discretionary was a surprise performer – consumer spending had held up better than expected with many companies in this sector having better than expected sales. Although, it’s worth noting that those ‘better than expected sales’ in some cases simply meant less of a decline than expected and prices rallied on that basis.

Monash Investors sees promise in this sector going forward and have rebuilt holdings in this sector. It holds the view that easing inflation will see cost of living pressures start to plateau and an end to rate rises along with seeing good prospects for holdings like Lovisa (ASX: LOV) which is undertaking a global store roll out and Temple & Webster (ASX: TPW) which is rapidly growing its online platform.

Though volatility might put some investors on edge, Monash Investors see a silver lining in it.

“It’s normally when you see these volatile periods in the marketplace which is a trigger for seeing a turning point. It does feel to us like we are at a turning point, and the downdraft we’ve seen in small caps is probably coming to an end,” said Shane Fitzgerald, Director and Co-founder of Monash Investors.

Inflation is starting to ease off which should see interest rates hold (or even fall in the coming year). In this the type of environment, there is less uncertainty and greater liquidity. This is typically more positive for small cap companies, but Monash Investors believe stock picking is key in this market compared to a top-down view in less certain points of the cycle.

And if there was any time to be looking, it could be now.

Simon Shields, Director and Co-founder of Monash Investors, notes that small caps are looking cheap on the whole, particularly when looking at averages for EV/EBITDA (effectively market cap compared to profit) or price to sales metrics. 

Source: Monash Investors, S&P Dow Jones Indices, FactSet

Positioning for a rebound in small caps

As part of its investment process, Monash Investors looks for businesses that are likely to go through step-changes or recurring situations which could lead to material share price movements which are underestimated by the market. For example, store roll outs or business disruption.

It aims for companies that could see a 60% upside in price in its long positions and those that could see up to 30% downside for short positions. Typically this process has seen around 90% of the portfolio in small cap companies.

Taking the view that the market is at a turning point, particularly for small caps, Monash Investors have overweighted exposures to consumer discretionary stocks (including education), healthcare and materials. 

It views a positive outlook for consumer discretionary from easing cost pressures, while innovations in healthcare from a sector perspective as well as specific advances within companies could be significant step changes. For example, Telix Pharmaceuticals (ASX: TLX) recently announced positive results for its renal cancer imaging study which could be a significant step up for its future outlook and earnings profile.

It breaks materials into three sub-sectors including electrification, gold and other which includes iron ore, coal and the likes. The overweight position for materials is in the electrification area due to the enormous potential of and investment in the green transition. Monash Investors currently invests in 8 companies across lithium, graphite and copper.

Some examples of companies in the portfolio which it views positively includes:

• IDP Education (ASX: IEL): the new ‘FastLane’ service is a competitive advantage which should accelerate the business.

• Sandfire Resources (ASX: SFR): Monash Investors have a bullish outlook on the prospects for copper.

• Impedimed (ASX: IPD): Monash Investors view the Board “raid” as a positive and operationally it should be a big 2 years for the business.

But this is just the start according to Shields, who says Monash Investors continues to find stocks that meet their criteria in this environment. 

This article was originally published for Livewire Markets on Wednesday, 20 September 2023.