By WAM Capital, WAM Microcap, WAM Research and WAM Active Lead Portfolio Manager Oscar Oberg

From the middle of 2023, over 800,000 Australian households with fixed-rate home loans written at rock-bottom interest rates began switching to much higher variable rates. This, combined with rising inflation and decelerating consumer sentiment, heralded a painful period for consumer discretionary stocks in sectors such as retail, automotive, building materials, media and tourism, which make up approximately 20% of the S&P/ASX Small Ordinaries Accumulation Index.

While cognisant of a deterioration in the economic environment, our team saw this period as an exciting opportunity to invest in the consumer discretionary sector despite analysts aggressively cutting their forecasts in the 2024, 2025 and even the 2026 financial year. Using our investment process, the team compared analysts’ future earnings projections for companies to the period before COVID in 2019. In some cases such as Beacon Lighting (ASX: BLX), Nick Scali (ASX: NCK), Lovisa (ASX: LOV) and Premier Investments (ASX: PMV), we saw analysts predicting future profit (on a per store basis) lower in 2024, 2025 and 2026 than what the company produced prior to COVID in 2019. For these reasons we saw the potential that these companies could go through an earnings upcycle despite a tough economic environment given our view that analyst forecasts had been cut too hard.

During the recent February reporting season, company results in the consumer discretionary sector have proven that analyst earnings expectations have been too pessimistic with a number of companies including JB Hi-Fi (ASX: JBH), Harvey Norman (ASX: HVN) and Lovisa (ASX: LOV) reporting positively. Within the e-commerce sector, companies that have performed well over the period include Cettire (ASX: CTT) and Temple & Webster (ASX: TPW), which have fully cycled over the impact of COVID period and are now reporting stronger than expected growth. As we look forward, we continue to see catalysts for earnings upgrades over the course of the year across the consumer discretionary sector. We are backing companies that are supported by strong balance sheets and capable management teams with valuations continuing to look attractive.

Moving onto the wider small to mid-cap market, we are also favouring companies that are taking the opportunity to prudently grow by mergers and acquisitions (M&A). Companies such as Kelsian (ASX: KLS) and Aussie Broadband (ASX: ABB) have used this challenging period to make accretive acquisitions to diversify and benefit their business through synergies over the medium to long term. We expect to see more M&A activity in the small-to-mid cap sector given a more stable outlook for inflation and are encouraging the companies we own within our portfolio to use their strong balance sheet to make earnings per share accretive acquisitions.

In the past six months, we have also seen a number of smaller companies being taken over including Adbri (ASX: ABC), Link Administration Holdings (ASX: LNK), Pacific Smiles Group (ASX: PSQ) and Ansarada Group (ASX: AND). With valuations in some small to mid-cap sectors at attractive levels in sectors such as financials and healthcare, we see the likelihood of additional takeover activity which could be a catalyst for a number of sectors to achieve a rerating.

It feels the macroeconomic uncertainty of the post COVID-period is now behind us, leaving investors a clear path for individual stock selection. In this environment, we are seeing the most opportunities we have seen since 2020 in the small to mid-cap sector with our team remaining disciplined with stock selection under our proven investment process.