Compelling small-cap plays
We are witnessing one of the strongest environments for small and mid-cap companies. Oscar and Tobias explain why sectors such as retail, travel, agriculture, building materials and automotive stand to benefit from the reopening of the Australian and global economies.
James Marlay: When we caught up in May, you outlined a bullish view which turned out to have been a solid call. What is your current view looking forward, are you bullish or bearish? How would you answer that same question as we sit here in November?
Oscar Oberg: Talking to my parents this week, they were having a heated discussion about how you can currently receive a fixed term interest rate for five years, for less than 2%. They would have loved to have those rates in 1991 when interest rates were close to 20%. It is hard not to be bullish on the market, with the current backdrop. We are very positive on markets moving forward, particularly after witnessing the extreme measures globally by central banks and governments to support economies coming out of the coronavirus, combined with a relatively positive outcome in the US election and news of a potential vaccine.
Within this context, we are very positive on small caps. Previously in May we were positive towards large caps. We currently see one of the best environments for small caps that we have seen in some time, largely reflecting the fact that around 40% of the stocks that we looked at in the small-cap market are exposed to the economy in some way. This includes sectors like retail, building materials and automotive. We see a very strong period for small cap companies going forward.
James Marlay: Do you feel like there is confidence in this reopening process now and that it is really the opportunity for you to find opportunities going forward?
Oscar Oberg: This is best answered in two parts. If we go back to when we last spoke in May, we talked about sectors like retail, domestic tourism, housing that we were positioning the portfolio into, with a lot of these companies exposed to Australia. Australia was in a much better place than the rest of the world, at that point in time. We are now in November and Australia has done an incredible job at managing the coronavirus. A lot of those trades have played out and we have reduced our weightings to those sectors.
Where we see some value at the moment is looking at those companies that have significant international operations in coronavirus impacted regions such as Europe and the United States, where analysts have been forecasting a very negative scenario for these companies over the next two or three years. We like a number of companies, including United Malt (ASX: UMG) one of the largest malt processors globally, Ramsay Healthcare (ASX: RHC) one of the larges private hospital operators, and also we’ve been adding positions in some of our existing names like skincare manufacturer BWX (ASX: BWX) and technological company Infomedia (ASX: IFM).
James Marlay: It is quite a different set of companies to what we talked about in May. One of the themes we did touch on in depth in May was agriculture, do you believe this theme still presents an opportunity?
Oscar Oberg: Agriculture is a great theme. Our bullishness on the sector is driven by the fact that the crop has received rain observed on the East Coast and this rainfall has continued to improve. If you look at the recent crop forecasts from ABARES, the government body that forecasts the size of crops. They forecasted 24.3 million tonnes in September, the largest forecast that we have witnessed in the last decade. The recent rain we have seen over the last few months means we believe this crop forecast will be upgraded again. Generally after periods of long drought is when you have a big crop, or a lot of rain as seen in the La Nina period, and this extends for a number of years.
We remain very positive on the sector and our two biggest holdings are Elders (ASX: ELD) and GrainCorp (ASX: GNC). Elders will benefit as more farmers buy crop protection products. GrainCorp is the most leveraged to an increase in the crop size and we believe that a number of the efficiency gains and cost savings implemented by management over the last few years will be present in the numbers. We believe several other companies will benefit over the medium term, including one company that is slightly under the radar, Select Harvest (ASX: SHV), one of the largest almond processors in Australia. They have been impacted by the coronavirus and a lack of demand for almonds in regions such as India and China. If we have a vaccine and observe greater support in the almond price we should witness significant upside to Select Harvest’s share price.
James Marlay: The agricultural sector is cyclical. You briefly outlined your bullish thesis. What are some of the areas you look out for? What can derail the thesis there?
Oscar Oberg: That is a fascinating one. I recently visited Byron Bay and Yamba. I really like Yamba, it is a great spot. I was examining the weather while there, delving into it and all I saw was thunderstorms. For a company like GrainCorp. who were on the verge of harvesting a record crop and the outlook suggests the onset of hailstorms, the weather represents a big risk, therefore we sold some GrainCorp, as the forecasts for hailstorms were likely to be quite large. As it turned out, the weather was not as bad as our initial thoughts and we bought back in a week or so later. Definitely the weather is the biggest impact for these agriculture stocks, however it is a record crop. Generally, there will be a good few years after this, therefore we are very positive on the sector.
James Marlay: We cannot talk about small caps without talking about the high flying technology names and they are not small anymore. A number of these WAAAX stocks (WiseTech (ASX: WTC), Altium (ASX: ALU), Afterpay (ASX: APT), Appen (ASX: APX) and Xero (ASX: XRO) are moving up into the top couple of hundred. What is your view on technology, and if you can talk specifically around valuations, and how you get exposure to technology in a sensible way?
Tobias Yao: The WAAAX companies are the technology leaders on the ASX. The challenge for us is that often these companies are not always fairly valued. As a team we spend more of our time trying to identify the undervalued growth companies that could be the future technology leaders.
There are two themes that we like. The first theme is around the disruption to traditional retail by the ecommerce companies, which we have spoken extensively about over the last twelve months. The recent share price appreciation and the volatility has garnered a lot of interest, however we continue to be strong believers in the e-commerce names because we believe the structural shift is here to stay. The key for us is to be very selective. We believe companies like Temple & Webster (ASX: TPW) and Adore Beauty (ASX: ABY) are exhibiting very strong unit economics combined with strong customer loyalty and as a result we believe they are very well positioned for continued growth in the future. For example, both of these companies were growing at more than 50% in a pre-coronavirus lockdown environment. That is a signal to us that these companies can continue to generate similar strong revenue growth in the future.
James Marlay: We are sitting at a point where the prospect of travel is becoming more real than it has been in the past. We have had news about a vaccine and people are talking about the prospect of heading offshore, potentially more movement domestically as well. What is the opportunity in tourism, is it a local opportunity, is it a global opportunity?
Oscar Oberg:We believe it is a mixture of both. We talked about domestic tourism back in May, and thought we were all mad to be investing in those companies at that point in time. However, when you were looking forward, analyst projections were very negative for these companies, forecasting a doomsday scenario. As it turned, out Australia has done a fantastic job to stop the coronavirus effectively. With borders reopening, we see a very strong period for companies such as SeaLink (ASX: SLK) the largest bus and ferry operator in Australia, Ingenia (ASX: INA) a provider of manufactured homes and tourist parks, and also Tourism Holdings (ASX: THL) the largest rental company of motorhomes in New Zealand, Australia and the United States.
A really interesting anecdote, around June, we and the WAM Global (ASX: WGB) team caught up with Thor (NYSE: THO) and Winnebago (NYSE: WGO), the largest manufacturers of campervans effectively in the world, at the time they were experiencing soaring growth. They were not able to place enough stock on the ground. Effectively pricing was increasing and they said it was a very similar scenario and environment to what they saw during September 11, 2001. There was a period of two or three years where people did not want to fly and were choosing to drive. If you look back at Winnebago and Thor their revenue growth over that period of time was very, very strong and that was a big catalyst for us to invest in a number of those companies that were exposed to driving, hence why we are positive on domestic tourism.
James Marlay: What about globally? I had a trip to the Maldives to go surfing, put on hold indefinitely and I am itching to go surfing. That is not an opportunity for me at the moment. Are you thinking about playing offshore players?
Tobias Yao: We also invested in Flight Centre (ASX: FLT) and Corporate Travel Management (ASX: CTD). The initial thesis for these companies, was their cost out management programmes were going better than expected, which gives them ample liquidity to navigate the next 24 months from a coronavirus environment perspective. More recently, the potential vaccine has potentially pulled forward the revenue profile, therefore we continue to be bullish with these companies.
James Marlay: You have looked at how those companies got themselves in good shape, then considered the outlook a bit further?
Tobias Yao: One hundred percent.
Oscar Oberg: Interestingly, during August reporting season, there was a number of companies that had performed well in various sectors. However, there was one sector that had not – and that was international tourism. Short interests were building in companies like WebJet (ASX: WEB), Corporate Travel, and Flight Centre. We did extensive work around their balance sheets and thought they were fine and capable of getting through the period. We were choosing to invest in those companies. As Tobias mentioned, they have performed well for us and we have now seen the next leg, which is a potential vaccine. This means that when people are forecasting the earnings for these companies, they might have been saying, “well in five years’ time it is going to be similar to what it was in 2019.” Maybe it is not five years’ time. Maybe it is four years’ time, and the potential vaccine has brought this forward. This is why we quite like the sector.
James Marlay: You mentioned a road trip, and that has been a big theme in domestic travel. You hear stories about people not being able to get access to new cars. For example, Toyota Prados being out of stock. We talked about automotive having been strong. Is it still an opportunity, or is that something that is rolled over now?
Oscar Oberg: Auto has been a fascinating sector for us. We really did position the portfolio towards a number of names back in May as we saw the potential for increased kilometres driven as people prefer to drive a car instead of use public transport when they go to work, and to drive a car when they go on a holiday instead of travel by plane or by cruise. While that is partly driven the auto sector, we believe a more important factors is that Australians cannot travel overseas.
Australians spend around $50 billion to $60 billion dollars every year offshore. A large portion of that money is now being spent domestically and the automotive sector has been a big beneficiary. Companies such as Bapcor (ASX: BAP), Super Retail (ASX: SUL), GUD Holdings (ASX: GUD), AP Eagers (ASX: APE), Motorcycle Holdings (ASX: MTO) have performed very well for us. We witnessed very strong updates over October and took the liberty to reduce our positions in these companies, however remain very positive on the sector. What has been lost on the market is the cash flow these companies are currently generating are at record levels. There is going to be a lot of cash on these balance sheets with minimal debt and we see the potential for earnings accretive acquisitions in the future and believe this will be the next leg for growth in this sector.
James Marlay: We have discussed a few of the areas you are positive on, however can you summarise some of the compelling opportunities that are in the fund right now, and give people a sense of how you are positioned for the next period?
Tobias Yao: Housing is definitely one of them. This time last year we talked about our positive outlook on housing. Unfortunately, due to the coronavirus market volatility, we had to significantly reduce our housing exposure in the last financial year. More recently, we have started to invest back into housing on the back of our view that the historically low interest rates, strong government fiscal support and that over time lenders will relax lending criteria, will drive housing activity. Companies we like include Brickworks (ASX: BKW) a brick manufacturer in Australia and the US, and the owner of the largest network of mortgage brokers, AFG (ASX: AFG).
Oscar Oberg: Childcare is another interesting industry. It has been one of the more impacted industries through the coronavirus and is a very important industry for the government, in particular, to get people back working. We believe the government will support the industry. However, this industry for the last five or six years has been impacted by an increase in supply of childcare centres. We do not expect this trend to continue over the next few years. We believe the large incumbent operators, such as G8 Education (ASX: GEM) in Australia and Evolve Education (ASX: EVO) in New Zealand are poised to benefit.
James Marlay: What are some of the areas that you believe are not grabbing headline attention that may be getting overlooked?
Oscar Oberg: Over the last ten years, we have seen companies exposed to the housing market underperform the ASX by about 50%. We believe this will turn around over the next few years, due to record low interest rates and fiscal support for the industry, leading to an Australian housing boom over the next two to three years.
James Marlay: Do you have a message for shareholders as you did not have an opportunity to meet face to face with them in November? What message would you leave them about the opportunity in WAM Capital (ASX: WAM) and WAM Microcap (ASX: WMI) at the moment?
Oscar Oberg: We would like to take the opportunity to thank everyone for their support. It has been a very difficult time. We are back in the office and it is nice to be seeing everyone. Yesterday, I had my first meeting with an analyst from a stockbroker since January. It is great to be getting back to normality, the team is doing very well – and that is the wider team, with the everyone in WAM Leaders (ASX: WLE) and WAM Global. All of the shareholders have been very supportive, and fingers crossed we can catch up with you all soon.
James Marlay: Thank you both for taking the time to sit down and talk us through how you are putting shareholders money to work.
Tobias Yao: Thank you.
Oscar Oberg: Thank you.