Clear themes behind winners and losers for Australian small caps

The impact of higher interest rates and the rising cost of living is yet to take full effect on the Australian sharemarket, meaning there is likely to be further downgrades on earnings expectations for certain sectors and stocks over the next 12 months, according to Phillip Hudak and Matt Griffin Co-Portfolio Managers, Australian Small Companies at Maple-Brown Abbott.

“We think we are early in the downgrade cycle for certain segments of the market. It follows a pull back in earnings expectations for FY23 during the most recent reporting season,” says Mr Hudak

“The Australian market is at an interesting juncture, with the shift to the new “post-pandemic” normal well underway; however, the end point is still uncertain.

“In particular, the impact of higher interest rates and rising costs is yet to fully play out, and in this context Australia seems to be 6 to 12 months behind the rest of the world.

“The opportunity for investors is to find those companies with structural growth stories and industry tail winds that are well placed to withstand any future downturn, and we believe that active management will be key to this.”

Mr Hudak and Mr Griffin say there five key characteristics they are looking for in companies in the current environment: pricing power to offset cost inflation coming through; earnings certainty that are trading at reasonable valuations; exposure to industry tailwinds and structural growth stories; cost flexibility – in an environment where growth may slow; and mining services.

Mr Griffin says that some companies are struggling to pass on cost rises which has affected their share price. However, this is not consistent across the board and depends on the company and sector.

“We are therefore looking for companies that have pricing power or that are cost leaders.  Companies that can maintain margins and profitably should continue to perform well for investors.”

He pointed to the retail sector as a good example of the importance of active management.

“The retail sector has been holding up well but we believe this reflects the fact that most people still have a good savings buffer and haven’t started to cut spending.  As a result, the impact of the rising cost of living hasn’t yet flowed through. 

“The lead up to the Christmas shopping period will therefore be crucial for the retail sector.  Inventory levels look elevated and continue to rise, as a result of concerns about supply chain risk which has led a number of retailers to order well in advance to have stock on hand.

“However purchasing decisions and forecasts may be based on last year’s Christmas sales which were very elevated.  This means there is a big risk if demand slow, as those retailers with a high inventory level will need to discount heavily which will hit margins and profitability.  We’re starting to see this in global markets already.

“As investors, we are therefore focusing on retailers with good cashflow models, very light inventory models, and scalability.”

Mr Hudak added that travel is a sector with industry tail winds.

“Travel – both leisure and corporate – is benefitting from significant tail winds as we exit the pandemic.  Europe and the US are both well advanced on this trajectory, however there is a lag in the recovery in Asia as lockdowns continue indefinitely in China. 

“While the sector looks attractive over the next few years, there are risks to the recovery profile.  However, some companies have emerged from the pandemic much stronger than before and are recovering at a faster rate than the broader sector, and we see material upside to these.

“Overall, we see upside potential for those companies that have sustainable business models and strong medium-term earnings trajectories.  This is particularly crucial in the small cap end of the market, which has experienced a significant multiple de-rating so far this calendar year.

“The pullback, triggered by tightening financial conditions, elevated inflation and higher living costs, has been indiscriminate across many stocks which brings stock-picking to the fore,” says Mr Hudak.