This article was first published for Livewire Markets On Thursday, 16 March.
Risk appetite and investment sentiment are poor. It’s not quite at GFC levels, but not far off. Chris Prunty, principal and portfolio manager for QVG Capital, has never seen less interest in equities. And as it stands, the gap between large and small-cap indices performance is as wide as it’s ever been. Despite a challenging market, QVG Capital maintains its high conviction on small caps – and is even buying. Selectively.
We’re focusing on more profitable businesses with sustainable organic growth. Back in the covid pandemic, people flocked to growth, but it was typically unsustainable with poorer business models that appealed to investors.
He notes it doesn't have to pay premiums for growth industrials due to rotations favouring coal, lithium, energy and financials. That's surprising, in a market that Prunty considers otherwise fairly priced.
Chris Prunty and Josh Clark, Portfolio Manager for QVG Capital joined Livewire for 10 questions on the market and their strategy.
Reporting season was frustrating. We didn’t have any blow-ups but not too many ‘go-ups’ either.
Of our holdings that reported in February, 43% of holdings beat expectations, 30% met expectations and 26% missed. This ratio was a little worse than usual. The cause of the misses included cost pressures, weather and lingering Covid impacts in the case of healthcare and travel.
Fortunately for us among the companies that missed, there were no disasters as they tended to give decent outlook statements.
I’m a Cricket nut so when assessing results, I look for a hat-trick of a beat, strong cash flow and an upgraded outlook.
Of the three, Trajan was the biggest surprise as the cash flow and outlook were stronger than expected. Trajan makes consumerables that go in to analytical and life science testing machines. Trajan listed in June 2021 and only has a $300m market cap so is largely ignored. We like it because it’s founder-led and the end markets it serves grow through the cycle at mid to high-single digit rates we can see it being a much bigger business in time via organic growth and acquisition.
Prunty: Tony has a cautious view on the markets while I have a cautious view on making predictions about markets!
Having said that, we think it’s likely there will be a delayed impact of interest rate rises on household budgets. In a typical cycle, if there’d been 300bps of rate rises retail spend would have been smashed but Covid savings has delayed this.
Evidence out of reporting season backs this view if the share prices of Nick Scali (ASX: NCK), Temple of Doom (Temple & Webster (ASX: TPW)) and Hardly Normal (Harvey Norman (ASX: HVN)) are anything to go by.
Don’t remind me!
Large caps outperformed small industrials by over 20% last year and we were no better.
This is one of the largest divergences on record. Index composition has played a big role here with cyclicals such as banks and resources working while growthy industrials – of the sort we like – being ground zero for underperformance.
Two catalysts for a reversal would be the end of the tightening cycle or a period of underperformance in banks and large resources. The underperformance of these mega-sectors could cause all the money that’s sloshed to one side of the market [cyclicals] chasing returns to move to the other [industrials].
Johns Lyng is our largest holding, and we are strap-the-horns-on bullish.
Our view is that the market underestimates the pace and duration of its earnings growth.
The bottom line is Johns Lyng has grown earnings at over 30% p.a. since they listed 6 years ago but consensus expectations are for this pace of earnings growth to slow to 13% over the next couple of years. We think this is unlikely. Johns Lyng has a unique corporate culture that attracts and rewards high-energy, highly motivated people who like to win. We believe this culture and rewards program is hard to replicate and will drive strong organic growth well into the future.
Prunty: We recently fell on our swords on telecommunication software provider Symbio (ASX: SYM).
My colleague Tony describes small company investing like reading a novel. Every day, month or year you get to turn over to a new chapter as new information is presented to you. The trick is to keep an open mind as to what is coming next and respond appropriately as the story changes.
Symbio’s increased capitalisation of expenses, delays in their Asian expansion and finally an earnings downgrade all led us to decide to read a different book.
Clark: The short book has been the driver of portfolio returns over the last 6 months so it’s a really valuable tool to have in the tool kit. We have over 30 individual positions, more than we typically would, but too many ideas are never enough. We never struggle to find new ideas for the short side, our challenge is always sizing the positions based on the attractiveness of each idea and the timing of the execution.
The upside to being more diversified than usual is that we’re able to endure volatility. The importance of this shouldn’t be underestimated because our most profitable shorts are usually our most painful shorts 12 months prior.
Companies like Isignthis (ASX: ISX), Speedcast (ASX: SDA), Pioneer Credit (ASX: PNC), Megaport (ASX: MP1), Appen (ASX: APX), Dubber (ASX: DUB), Nuix (ASX: NXL), Ecofibre (ASX: EOF) and PPK (ASX: PPK) have all been very painful for us at one point or another, yet they are some of our best contributors.
Zero carbon, zero revenue is the most obvious one in the portfolio.
Clark: You won’t find zero carbon, zero revenue under the official list of sectors but it neatly sums up the opportunity. We’re on board with de-carbonisation just like everyone else but in order to make money for our unit holders, we need to see a low-risk path to earnings that more than justify the market caps of these companies. Instead, what we see is billion-dollar-plus valuations for companies with huge execution risk ahead of them with large cash outflows for the next few years. Many non-producing, lithium companies fit into this category.
The other main theme in the portfolio is companies that have over-earned during covid and are now starting to see cost inflation and margin pressure. Many of these companies are consumer-facing and are at risk of spending levels normalising as they appear to be in 2023.
Clark: It’s dangerous to throw all tech companies across both markets into one category and call it distressed.
It’s true that the move in bond yields has impacted valuations across both markets but that’s backwards looking and there’s a very important distinction to make between profitable and unprofitable tech.
Unprofitable tech has been reliant on cheap equity capital from bull market investors. The model for cash-burning tech has been to spend big on product development and marketing to acquire customers with the hope that one day you can stop spending and the customers stay with you.
Megaport (ASX: MP1) is a case in point.
The problem with the ‘worry about profit later’ approach is that the unit economics haven’t been truly proven. These companies are struggling to kick the addiction of injectable cash and cold turkey sucks.
On the other side of the coin, there is a whole sea of companies that are self-sufficient and continue to fund their growth without diluting their shareholders. Wisetech (ASX: WTC) has been a poster child for this.
The best businesses are self-funding and that’s where the money will be made.
Clark: There’s always something that investors are missing. If investors had it all worked out then share prices would be significantly less volatile.
In the last couple of years, returns have been macro-driven and as a result, it’s easy to fall into the trap of spending too much time on the macro e.g. focusing on interest rates, inflation expectations, recession probabilities, the resilience or otherwise of the consumer etc.
If investors spent more time trying to uncover good quality businesses at reasonable valuations that can grow earnings, they’d make a lot more money with a significantly less stress.
As an example, I was at a conference last week where we uncovered at least four good ideas. I can guarantee that this is easier than getting a degree in psychoanalytic criminology and predicting the next move of Phil Lowe.
All we have to do is get away from the screen and get in front of companies.
If you're interested in hearing more from the QVG Capital team, please register for our upcoming invest webinar to be held on Tuesday 21 March at 11am. The webinar will cover the recent reporting season, QVG's portfolio positioning and the outlook for our funds.
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