Australian small caps at an inflection point this reporting season

Overall, the February reporting season was generally positive for Australian small caps, with the domestic economy remaining resilient, and many small cap company results beating market expectations, Phillip Hudak and Matt Griffin, co-portfolio managers of the Maple-Brown Abbott Australian Small Companies Fund, said.

“There were several positive results, with upwards earnings per share (EPS) revisions triggering share price rises for many small caps, and we note that reactions to company announcements have been more elevated than what we have seen in previous reporting seasons,” said Mr Hudak.

“The consumer discretionary sector was the big surprise given more resilient top line sales relative to previous conservative assumptions. This, combined with easing input costs, has allowed retailers to continue to clear excess inventory without elevated promotional activity. This resulted in better margins, notably for Breville Group, ARB and Adairs,” he said.

Maple-Brown Abbott believes the Australian small cap market may be set for a potential significant rebound over the next two years and small caps are likely to outperform larger companies.

“Australian small cap valuation metrics look attractive with forecast earnings upside relative to Australian large caps, given the economy is performing better than previously expected. We have observed signs of easing financial conditions; any easing in interest rates by the Reserve Bank of Australia (RBA) would be constructive for small caps,” said Mr Griffin.

“For investors who may have missed the bottom a few months ago, we believe that it is not too late to buy into the sector. We are seeing substantial interest from advisors and investors in small-cap stocks, but they are not necessarily increasing their allocations to that interest. We think that eventually allocations will catch up,” said Mr Griffin.

A robust level of mergers and acquisitions activity is likely to continue in 2024, underpinned by the lower Australian dollar and potentially lower interest rates, supporting the performance of the Australian small cap sector.

“We believe merger and acquisitions (M&A) activity will continue this year. The lower Australian dollar and the prospect of lower interest rates going forward are expected to result in a flurry of corporate activity,” said Mr Hudak.

“This reporting season has seen the high level of recent M&A action continue with France's Cie. de Saint-Gobain bid for CSR, Seven Group’s bid for Boral and most recently Altium, which is being sold to Japanese chipmaker Renesas Electronics and Aussie Broadband’s bid for Superloop. We're also seeing more M&A activity in the mining sector.

“With the lower Australian dollar, we believe M&A activity will continue to create opportunities in the Australian small cap sector and be far more pronounced than IPO activity which we also expect to ramp up. Many companies, particularly at the smaller end of the market, could see M&A activity as the year continues.” said Mr Hudak.

The portfolio managers said several themes are supporting small-cap companies, including artificial intelligence and clean energy themes.

“Some Australian companies that are benefiting from the huge interest in AI stocks, as evidenced by the surging demand for semiconductor company NVIDIA, include datacentre exposed companies including NEXTDC, Megaport and Macquarie Technology Group. These companies are being caught up in the AI theme and we think this trend is set to continue through 2024,” Mr Hudak said.

“In terms of our portfolio we have invested in medical imaging company Pro Medicus because we think the integration of AI in the radiology imaging area has the potential to create significant advances in imaging technology and upside for this company,” said Mr Hudak.

A recent rebound in lithium prices has also boosted lithium miners and other miners linked to clean energy production.

“Following on from the fall in nickel and lithium prices, we have seen a growing number of mine closures in battery materials metals, driven by oversupply and changing battery technologies. Nickel is likely structurally challenged and lithium is highly cyclical,” said Mr Griffin.

“However, we feel the lithium price could be bottoming and in recent days, we have seen the prices of lithium miners rise, which is likely being driven by short covering.  The lower prices have created opportunities with lithium miners, and we are looking at positioning for the next cycle in companies like Patriot Battery Metals,” he said.

“We are also seeing opportunities to get into the gold mining space. We've seen a recent drop in price of some gold miners which has opened up opportunities. At the same time demand for gold is strong, particularly from central banks. Gold could also benefit from lower interest rates throughout 2024 and we are focussing on companies that continue to deliver production growth, meet cost guidance and build cash reserves such as Genesis Minerals and Persus Mining,” said Mr Griffin.

Maple-Brown Abbott also expects the uranium price to rise, lifting uranium miners. Strengthening fundamentals and increasing urgency to reduce carbon emissions from utilities may increase contracting levels in an environment of supply uncertainty. Companies that could stand to benefit include but are not limited to Boss Energy and Paladin Energy.

The structural shift to electric vehicles (EVs) is also benefiting car dealers and fleet/novated leasing companies. Sales of EVs are rising, and account for approximately 8 per cent of all vehicle sales in the 2023 calendar year. Fleet and novated leasing companies have also been major beneficiaries of recent fringe benefit tax changes, including Smartgroup.

However, rising wage inflation will hold back some companies especially those which are not able to pass on price rises, including some discretionary retailers exposed to younger demographics. As a result, we are investing in companies which we consider to have pricing power, such as Technology One and Monash IVF Group.

Separately, buoyant financial markets have seen fund inflows recover for both the platform and fund manager providers. The Maple-Brown Abbott Australian Small Companies Fund has international equity fund manager GQG Partners as a key stock pick.

“Strong inflows, lower management fees compared to competitors and attractive operating margins will likely see this company outperform. GQG is also trading at a discount to global and local fund managers, but it enjoys strong distribution capability supporting strong net inflow performance and new product opportunities,” said Mr Hudak.

However, we have observed that cost-of-living pressures, including higher mortgage rates and muted wage growth, is impacting companies exposed to younger demographics, including Baby Bunting. Media spending continued to see both a structural and cyclical shift away from television and radio to both digital and out-of-home, Mr Hudak said.

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