2019 ASX small cap observations

A year ago we noted that the 14% 4Q 2018 quarterly decline in the S&P / ASX Small Ordinaries Index was the 6th worst quarterly performance since 1990. Simply examining the subsequent performance from large quarterly falls, we noted at the time that in the prior observations of falls of a similar magnitude (anything greater than about 10% in a quarter), the subsequent performance was likely to be positive (70-80% of the time over one and two years) with an average 12 month return of 8%, and average two year return of 22%.

Put simply, at the end of 2018 after a poor six months and a terrible three months, this looked like a great time to buy Australian small caps.

Price movements are one thing, but what were we buying at the time? Well if we look to the end of January (when markets had already started to recover) we can observe the fundamentals of the index and the Longwave Australian Small Companies Fund.

Both had a P/E of around 16x. Both had a dividend yield of around 3.5%. Companies within the index and our portfolio were both growing sales at around 11% per annum.

Relative to the risk free alternative, these small cap portfolios had a pre-tax earnings yield of around 9%, which was 7.5% higher than the then RBA cash rate of 1.5%.

After a year of strongly positive returns, the market P/E has expanded to around 19x, whilst our portfolio is still trading on 16x. The market dividend yield has fallen to 3%, while our portfolio yield has increased to 4%. Companies within the index have seen sales growth slow to around 8% per annum and our portfolio is growing sales at around 7% per annum.

Relative to the risk free alternative, the small cap index now has a pre-tax earnings yield of around 7.5%, which is still almost 7% higher than the RBA cash rate of 0.75%. Our portfolio has a pre-tax earnings yield of almost 9%, which is 8% higher than the RBA cash rate and an even greater difference than was observed in January 2019.

The simple conclusion we make is that the index seems to have become slightly less attractive after a year of strong gains, however our portfolio remains priced relative to its fundamentals at similar levels to the beginning of 2019.

Two risks worth bearing in mind;

1. Significant tail risk is ever present in equities – almost impossible to forecast, the risk of a surprise near term decline of 20-25% (or more) is ever present. We show our portfolio pre-tax yield relative to cash rates as a simple observation. We do not use a model that links this spread to subsequent near term returns, rather it highlights the current disconnect between equities and interest rates. Nothing about the medium term fundamental attractiveness of our portfolio says anything about near term downside risk being reduced.
2. Not all small caps are equal – we believe part of the reason we have a higher quality (higher return on capital, lower leverage) and more attractively priced portfolio than the benchmark is due to the insane prices (our opinion) being paid for speculative small cap growth stocks which we don’t hold. Our research suggests over time taking this risk is not rewarded and is the part of the market we most actively avoid. Should near term returns (positive or negative) be concentrated in these stocks, the performance of our portfolio and the index are likely to meaningfully diverge.

Some broader market observations

Bond yields and value: Most of 2019 was driven by falling bond yields and the outperformance of growth (long duration) equities. Investors who were cheering the performance of bonds in August look to have rung the bell as the Australian government 10yr climbed from under 0.9% to almost 1.4% by year end, giving some breathing room for value equity investors. As we have noted previously, there is a significant amount of duration exposure in small caps in both obvious (A-REIT, Gold) and non-obvious (expensive growth names across healthcare, technology, consumer) places. There is a strongly embedded market belief that bond yields cannot rise, with implications for pricing of equities overall and growth stocks in particular. We make no forecast on the direction of bond yields but we note that expecting them to stay low is an implicit forecast many are making and is aggressively embedded in asset prices. We are comfortable with our portfolio positioned overweight quality, overweight value and underweight growth.

The active manager objective function: Consider a small cap investor who has 10 years’ experience (2010 – 2020) and who is trying to optimise in this environment the investment approach required to deliver alpha. Profits haven’t mattered. Leverage hasn’t mattered. Valuation hasn’t mattered. Three things that have mattered immensely through time and across markets would’ve made little imprint on the experience of a new active equity investor over the past 10 years. All that mattered was growth. That ‘grumpy old man’ sound investors hear from those who remember prior cycles when profits and value mattered (1998 – 2002) or when leverage mattered (2006 – 2010) is due to investment approaches formed by exposure to more varied investment environments. We have no complaints with other investors running “this time it is different” portfolios so long as they have their own money in their funds and are personally exposed to the risk they are taking on behalf of others. Skin in the game acts as a filter. As a helpful side effect, the pursuit of growth at the expense of all else makes the competition for the investments we pursue less intense.