By David Rogers
WAM Capital is starting to see some light at the end of the tunnel for small caps investing after a challenging period of share price underperformance versus large companies since the Ukraine war.
In the past two years, the S&P/ASX Small Ordinaries Accumulation Index returned just 8.4 per cent, whereas the broader equity market returned 22.5 per cent.
But despite a lack of exposure to the top 50 companies that make up about 70 per cent of the Australian market, the Geoff Wilson-chaired fund outperformed its benchmark by 7.2 per cent, and in the year to June 30 it achieved a solid 18.2 per cent return.
The underperformance of small caps began in the March quarter of 2022 when inflation was driven by supply shortages and energy price increases from the war, and capital markets activity slowed to a trickle.
WAM only participated in about 20 deals last year versus more than 70 in 2020.
“It was a big contraction in that part of the portfolio,” said WAM Capital’s lead portfolio manager, Oscar Oberg.
“Now pleasingly we are starting to see light at the end of the tunnel for small caps.
“And the most important thing that we’ve seen in some time was actually in the June quarter of 2023, where small cap industrial companies outperformed the broader market for the first time in two years.
“These are the companies that WAM Capital largely invests in, so it’s a really positive sign as we head into the 2024 financial year.”
Perhaps counterintuitively given the downside risk to per capita economic growth after the most aggressive interest rate hikes in three decades, the most interesting sectors as far as WAM is concerned at the moment are those exposed to the economy.
Oberg said share prices in the retail, automotive, media and building materials sectors were trading on “very attractive” valuations after some sharp falls in their share prices in the past few years.
These sectors are important for the small cap market because they make up about 30 per cent of the small cap benchmark by value, so for small caps to outperform, these sectors need to do well.
By way of example, Mr Oberg pointed to shares in household goods retailer Harvey Norman, which hit a low in June and were actually trading below the value of its property assets. It was only the third time that had happened in the past 15 years. That meant when WAM was Harvey Norman around $3.20, it was getting a share of Harvey Norman’s retail business – which does over $400m of profit – for free.
WAM’s investment process also needed to see a positive share price catalyst. On that front, analysts were projecting lower earnings for Harvey Norman in 2025 than it made in the pre-Covid year of 2019, but WAM saw the retailer taking market share in a period in what may be a better than expected for the sector that could trigger an “upgrade cycle” for earnings.
“Pleasingly, it does feel like the market is turning towards small caps and in particular those stocks exposed to the consumer,” Mr Oberg said.
“Companies such as Nick Scali, Tabcorp, GUD Holdings, Baby Bunting have all performed above expectations, which were negative, and that has seen their share prices go up as a result.”
Overall, WAM was “very positive” on the outlook for small caps, and Mr Oberg was seeing a lot of opportunities that fit his investment process.
Part of his positive view on the economy stemmed from his expectation of an extended pause in interest rate hikes by the RBA because of uncertainty over the impact of such a large amount of home loans rolling from extremely low fixed rates to much higher fixed rates.
He did note a major difference in the impact of rate hikes on younger cohorts of people, facing mortgage rate and rental cost increases, compared to older people who were more likely to own a home, but overall he felt there was too much uncertainty to allow more rate hikes.
One positive sign for the inflation outlook that he’d seen from the first few weeks of the August reporting period was that much of the logistics and freight costs that were big drivers of inflation over the last two years were “really starting to come off and it’s actually now back in pre Covid levels.”
“So we’re starting to see, (Tuesday) with the wages number, which was below expectations, that it’s (inflation) starting to normalise, which is great. And we think they’ve done enough, at least in relation to cash rates. So we think they’ll be on hold.”
Labour force data for July are due Thursday, with economists expecting a slight uptick in the unemployment rate to 3.6 per cent from 3.5 per cent and a 15,000 rise in jobs.