While global equities hit record highs, Australia’s small-cap industrial sector remains in a prolonged downturn, creating what one small and micro-cap investor sees as a rare valuation opportunity.
The case for looking beyond small-cap indices has strengthened following the return of inflation and interest rate rises, according to Richard Ivers, portfolio manager for the Prime Value Emerging Opportunities Fund and Prime Value Microcap Fund.
The Small Industrials Index has experienced a surprisingly sharp fall in recent months and is now only +6 per cent over the past six years since the onset of COVID – equivalent to just 1 per cent per annum – despite solid earnings growth over the period.
“There’s a lot of talk about indices and markets being at all-time highs, but this part of the market is far away, far off that. In fact, since October, the index is down about close to 20 per cent,” Ivers told Investor Daily.
“Unsurprisingly, there are now many quality smaller companies with resilient earnings which now look more attractive over the medium-to-long-term … there are plenty of small and micro-cap companies with relatively reliable earnings well into the foreseeable future, such as those tied to critical infrastructure, which appear more attractive during times of volatility.
“And while this short-term volatility creates some discomfort, it can provide the grounds for future outperformance by providing access to quality companies on sale.”
Ivers said infrastructure assets operating as monopolies with long-duration earnings streams looked particularly attractive during economic and geopolitical uncertainty.
These companies include New Zealand’s Auckland Airport and Napier Port, with earnings that stretch well beyond shorter-term interest rate and oil price rises, and which have sold off in recent weeks.
The divergence has been driven by a combination of higher interest rates, a powerful rally in gold and mining stocks, and growing concerns around the disruptive impact of artificial intelligence on smaller growth companies, according to Ivers.
While earnings across many small industrial businesses have continued to grow, valuations have compressed sharply as investors rotated toward large-cap and resource-focused exposures.
He said this divergence has been driven more by macro forces and sector rotation than by a deterioration in the underlying quality of companies within the universe.
“You’ve had indices go virtually nowhere, earnings have grown, [and] the valuations have gone down, so it means that there’s more attractive opportunities… This is one of the best opportunities I’ve seen in a long time.”
Ivers argues the index headline masks both structural biases and misperceptions.
“Within small caps, you have small-cap fund managers – they were just selling industrials and buying resources, that was a real headwind as well. Rate hikes, gold and mining, switching, and then AI… those reasons all put together,” he said.
“There’s a perception about the quality of small caps that I think is perhaps misplaced, I’d say that there’s actually a lot of high-quality, structurally growing companies that provide really good opportunities in these times.”
Historically, small caps struggle when rates rise, but Ivers says this cycle is different.
“You’ve had basically three big things come together at once – the role of mining, the role of AI, and then super funds focusing on in-housing and largely going index… which means there’s less active management out there.”
“There is definitely earnings risk out there, some of the more cyclical parts of the economy really did slow.. but even in the case of those more cyclical companies, I think a lot of them are really pricing it in already.”
In this environment, Ivers says active stock picking is crucial.
“Passive strategies just own everything. When you get dispersion in stocks and you see large levels of volatility, that’s when you get opportunities. If you’ve got a clear view of the fundamentals, you can take advantage of that volatility,” he told Investor Daily.
“These are great times – quite stressful in a way – but… at some point the market will see those earnings and those extreme valuations, and then it’ll normalise and rebound.”
The opportunity in the sector has prompted the fund to reduce its cash position to record lows as it selectively adds to companies it believes are trading at attractive valuations.
“We’re seeing so many opportunities that the cash level is at a record low – we’re down to about 2 per cent cash now… and I’ve put money into the fund myself in the last few weeks.”
Looking ahead, Ivers suggested that any stabilisation in interest rates or improvement in economic sentiment could act as a catalyst for a re-rating in parts of the sector that have been most heavily sold off. However, he cautioned that the environment is likely to remain uneven in the near term, with continued dispersion between winners and laggards creating an ongoing focus on bottom-up stock picking.
“The small-cap industrials part of the market has been one of the few parts that has performed poorly on a stock price level, but the earnings growth is still there and the valuations look really attractive now. For it to be wrong, is if we go into a deep economic downturn… it will be tough for equities to perform and tough for small caps in particular to perform in that environment.”
Source: InvestorDaily