Small-Cap Bargains Beneath The Gloom

Canny investors should be keeping an eye on the huge gap between soaring tech/mining stocks and a "black hole" of underperformers that could be set for takeovers.

Australia’s small-cap universe is diverging into two worlds – a narrow group of soaring tech and mining stocks, and a black hole of underperformers that are vulnerable to takeover.

This unusual trend is worrying fund managers, amid fears the Australian sharemarket’s fall from its record high is the start of a correction or something worse.

As the profit-reporting season unfolds, valuations are finely poised. The slightest disappointment from tech stocks that are priced for perfection could send share prices tumbling, as could signs Australia’s softening economy is hurting small-cap earnings.

Half the stocks in the S&P/ASX Small Ordinaries index have a negative total return (including dividends) over one year, AFR Weekend analysis shows. Small caps typically outperform in a bull market’s late stages as risk appetite grows.

Not this time. Small-cap returns deteriorate noticeably beyond the top performance quartile. For every star stock such as Pro Medicus, Nearmap, WiseTech Global or Appen, many more are languishing, despite solid operating results.

“The dichotomy in small-cap valuations is as extreme as I have seen,” says Microequities Asset Management CEO Carlos Gil. “At one end are star tech stocks trading in ‘bubble’ territory. At the other we have some small caps with GFC-like valuations in some cases.”

Odd timing

Such divergence is strange in a bull market, says Gil. “You would expect to see more small caps rallying and outperforming large caps at this stage of the cycle. Small-cap stocks, it seems, are either highly overvalued or highly undervalued. There’s not much in between.”

Fat Prophets CEO Angus Geddes expects a flood of mergers and acquisitions (M&A) in unloved small caps.

“It is just a matter of time before more are taken over,” he says. “With the Australian dollar below US68¢ and record low interest rates, foreign predators will be running their ruler over our market. M&A is a no-brainer for offshore companies. It will come thick and fast.”

Conditions are ripe for heightened small-cap takeover activity. The Small Ords index – a barometer of stocks ranked 101 to 300 by market capitalisation – has returned 5 per cent over one year. The S&P/ASX 100 index delivered 10 per cent, partly because falling interest rates are encouraging income investors to buy large-cap stocks for franked dividend yield.

After lagging for three years, small-cap stocks have outperformed large caps this quarter. If those gains continue, a narrowing performance gap between large and small stocks could encourage corporate predators to pounce sooner rather than later.

“There is a lot of cash on the sidelines looking for M&A deals,” says Geddes. “In a sluggish economy, many domestic and international companies will be forced to grow by acquisition. They will be aware of the value in small caps, particularly if our currency edges lower.”

However, buying small-cap stocks in anticipation of a takeover is risky. Takeover speculation attracts headlines even though targets can underperform for years before receiving a bid – or never receive one because they are poorly managed, messy companies with weak business models.

Tenuous takeovers

Also, a takeover approach does not mean a deal: private-equity firm Bain Capital last year abandoned takeover talks with cosmetics group BWX after due diligence. AGL walked away this year from a $3 billion takeover of Vocus Group, as did a Swedish private equity group.

Further, investors often focus on troubled small caps as takeover targets, believing their lower valuation will attract suitors. The smart money usually uncovers landmines in the due-diligence process and favours small caps with clean balance sheets and operations.

A better approach is to buy quality small caps when they trade below fair value and offer a large margin of safety – and to view any takeover as a bonus.

Caveats aside, there are signs that large companies and private-equity firms are making their move on undervalued stocks outside the ASX 100. Japan’s Nippon Paint Holdings Co acquired Australia’s largest paint manufacturer, DuluxGroup, in a $3.8 billion takeover in April.

Among microcaps, fintech GBST Holdings has received takeover approaches this year and its directors in July recommended FNZ Group’s deal to shareholders. The bidding war helped drive GBST shares from a 52-week low of $1.20 to $3.83.

Marketing-services provider Wellcom Group soared this month after a $265 million takeover offer from South Korean advertising firm Innocean Worldwide, which Wellcom directors recommended. Wellcom had traded mostly sideways for three years before the bid, typifying the market’s propensity to forget about small caps in out-of-favour sectors.

Consumer-finance marketplace Credible Labs Inc rallied after entering a merger agreement this month with a Fox Corporation subsidiary. The deal valued the ASX-listed San Francisco company at $585 million. Like Wellcom, Credible had drifted lower before the bid.

Overseas bids

Transport minnow Chalmers soared in July after Qube Logistics announced a takeover offer. And a private-equity consortium led by BGH Capital concluded its acquisition of education provider Navitas in June.

Elsewhere, junior telco Superloop earlier this year received an acquisition proposal from QIC Private Capital, which subsequently ended its due diligence. And electrical group Legend Corporation rallied after its board recommended a takeover bid from private equity.

Several takeover bids or aborted ones this year have involved foreign companies. Although it is too soon to draw conclusions given the small M&A sample, offshore companies, notably Japanese, are showing greater interest in Australian businesses this year.

In addition to Nippon’s acquisition of Dulux, Japan’s Asahi bought Australian brewer Carlton & United Breweries (CUB) for $16 billion in July. Lendlease rallied in May after unfounded rumours that a Japanese company was set to pounce.

Private equity is adding to heightened M&A expectations among languishing small caps. “The gap in small-cap valuations could work out well for private-equity funds with capital to deploy,” says Michael Glennon, chief investment officer of Glennon Small Companies, a listed investment company.

Money is pouring into alternative investments. Private equity and venture capital assets in Australia hit a record of just over $30 billion in June 2018, according to the latest yearbook of the Australian Investment Council (AIC).

Local superannuation funds and overseas pension funds are allocating more to alternative investments in search of higher returns. AustralianSuper expects its private-equity allocation to grow to 7 per cent of its portfolio within five years, from 3 per cent.

Private equity

AIC noted a “significant increase” in private equity and venture capital activity in 2018 after a few years of decline, aided by sufficient “dry-powder” levels (cash reserves in funds), a low-risk environment and attractive fundamentals of many privately-backed companies.

Private-equity funds sometimes unlock significant value by taking over small-cap stocks and fixing them up under private ownership. They sell the restructured business to a trade buyer or another private-equity firm, or return it to the market through an initial public offering (IPO).

Glennon says the longer-term approach of private-equity funds is needed with small caps. “There is considerable value emerging at the bottom end of the market. But it could take some time for that value to be recognised. Investors buying small caps today need to be prepared to hold them for at least a few years, which suits private equity.”

Private equity could also benefit from structural factors that are transforming the investment landscape in small caps and widening the gap between star stocks and the rest.

Microequities’ Gil says algorithmic trading strategies are pushing small-cap stocks with strong momentum to dangerous valuations, and discarding the rest. “Index investing is indiscriminate in capital allocation; it doesn’t care about company valuations and fundamentals. When the company’s weighting in an index rises, the index funds (ETFs) have to buy more of it. When the stock’s index weighting falls, ETFs have to sell. They accentuate pricing extremes.”

The effect of computerised trading on small-cap stocks is hard to quantify. Anecdotally, small caps that downgrade profit guidance, miss the consensus analyst forecast or breach support on their share price chart are falling further and faster than before – and staying there longer. To some, that suggests computerised trading programs at work.

Also, large-cap fund managers seeking alpha – a return above the market benchmark – are thought to be venturing further down the market for higher returns. Buying the so-called WAAAX stocks (WiseTech, Appen, Altium, Afterpay Touch Group and Xero) has been a source of outperformance, even though many fund managers believe these stocks are overvalued.

A decline in fund managers in small-cap stocks could be contributing to small-cap valuation extremes. More than a dozen managers have closed shop in the past 12 months as super funds increasingly internalise investment decisions rather than outsource them to fund managers. The upshot is fewer fund managers that live and breathe small-cap stocks.

Fewer avenues to promote prospects

A reduction in small-cap stockbroking analysts, or reliance on less experienced ones, compounds the challenge. Small-cap companies have fewer avenues to promote their prospects to domestic and international investors, via broking research or roadshows.

Avoca Investment Management’s co-founder John Campbell says the revolution in quantitative and index-based investing is creating opportunity in small caps. “More and more money is migrating away from fundamentals-based investing to momentum styles. Momentum investors have little regard for valuation metrics and are paying dangerous prices for earnings growth.”

Campbell says this is a good time for small-cap funds that can invest through the cycle. “When the tide inevitably turns, it will be violent and there will be a lot of carnage. Many small-cap stocks in the top performance quartile are horrendously overvalued. They could fall 50 to 60 per cent or more in a market downturn. Quality small-cap industrials that are trading on undemanding valuations today are likely to be the big winners in the next few years.”

Campbell is surprised at the divergence between top small caps and the rest. “The growth names in tech and other sectors are on unprecedented valuation metrics,” he says. “Yet typical industrial stocks are on valuation multiples that have not changed much in 10 years.

“We see many instances of small-cap industrials likely to deliver modest and consistent medium-term earnings-per-share [EPS] and dividends-per-share [DPS] growth that are on very attractive initial price-earnings [P/E] multiples and dividend yields that are little changed over the last five years. But it takes courage to move out of the high-momentum sectors that are grabbing all the headlines and buy value when it is so out of favour.”

Steve Black, co-manager of Pengana Emerging Companies Fund, one of the market’s top small-cap funds, says the valuation divergence in small-cap stocks is the largest he has seen in 10 years, but cautions against simplistic comparisons between leaders and laggards.

Challenged industries

“A lot of small-caps on low P/E multiples are in retail, media or other structurally challenged industries,” Black says. “Or they are in building materials or other cyclical sectors that are struggling with a slowing Australian economy and construction cycle.

These stocks look cheap on paper but could stay that way for a long time, or fall further on any bad news.”

Adelaide Brighton is an example. The cement group tumbled in late July after its second guidance downgrade in four months.

Black sees value emerging in building stocks such as CSR but wants more evidence of industry stabilisation during this month’s reporting season before taking a larger position. “You have to be very careful in this reporting period,” he says.

“It looks like there is plenty of valuation support in small and mid-cap companies in construction, retail and media, but we are cautious of the unknowns and how the cycle will play out. The pain may not be over for a lot of small caps.”


By Tony Featherstone

Financial Review

24 August 2019

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