The Lower Prices Investors Hoped For Have Arrived

The S&P / ASX Small Ordinaries index closed the financial year 25% below its all-time high, reached on the first trading day on this year. As painful as this six-month performance has been, it hides the fact that more than 75% of the stocks in the index (or were at the beginning of the year) performed worse. There are dozens of stocks that have declined 60%, 70%, 80% and in some cases more than 90% from their highest prices reached in the past two years.

As we have noted repeatedly, there are many stocks whose fundamentals never justified the market caps they traded on in the past two years – and to us it was apparent at the time – and we are seeing an abrupt re-pricing of reality. There are also many small caps who are facing the normal travails of brutal competition, uncertainty in operating conditions and profit outcomes much worse than investors had expected 12 or 18 months ago.

For experienced small cap investors, this is not unusual. The distribution of winners and losers has always been extreme in this part of the market. The opportunity today is to find the quality business whose fundamental performance has been temporarily impaired, or the business that is operating as expected but whose share price has been dragged down with the pack.

Market hesitation to increasing allocations to small caps today is the fear of recession and share prices discounting the earnings downgrades which have yet to be announced. A few weeks ago the reason was higher interest rates and the impact this would have on discount rates. At every point in time, equities are influenced by a macro risk the market in hindsight has a very poor track record of getting right. We only have to go back 1-2 years to re-live the macro expectations underpinning stocks that ended up being mispriced by an order of magnitude (in that case too bullish).

On a forward P/E basis, the Small Cap index now trades close to 14x, down from almost 25x 18 months ago. Our own portfolio trades under 10x. We can’t speak as well to the index given by design there are lots of companies within it we actively do not own, but we can look at our own portfolio and consider the high quality of the companies within it (portfolio ROE 23%), positive cash flows in almost every holding, low levels of debt (portfolio debt / EBITDA 1.4x) and dividends that should be robust to lower earnings as the current yield of 4.5% is reflective of around a 40% payout ratio.

Risks remain and there are parts of the market we continue to tread very cautiously around or avoid entirely (microcaps, speculative stocks, excessive leverage, expensive stocks). Prices are generally discounting bad news coming on the earnings front and usually fall further as downgrades are confirmed. For investors who tell themselves in bull markets that they are long term holders of quality compounding companies but are waiting for better prices, we can confirm better prices have arrived. It is now a behavioural question of whether investors take advantage of them or wait for better news and higher prices before acting.

Total cost of debt (whatever it takes) and TPG telecom

In July 2012, Mario Draghi made the famous comment that the European Central Bank (ECB) would do “whatever it takes” to support the Euro, bond and corporate credit markets. For the past decade, investors and corporate borrowers have basked in the low interest rate regime that the ECB and all other central banks managed to engineer.

Without going over old ground on what central bankers have wrought on economies to achieve this, we are more interested in what the current sharp reversal of this cheap-debt-in-all-forms regime means for small caps.

For the past six months, markets have been wrestling with their excel models trying to figure out how to price changing interest rates (risk free rates and corporate bond spreads). We are now getting a glimpse of what this looks like from inside the corporate finance department. One of the more levered small companies in our universe, TPG Telecom (not owned in the fund), held an investor day where they flagged to shareholders what this means for their future profits. Interest costs, which were recorded at A$149m in F2021 are expected to be “materially higher” in F2022. Buried in appendix 9 on page 65 of the presentation was the note that for every 50bps increase in interest rates, their cost of debt would increase by A$20m. Not only that, volatility in rates markets is making their ability to hedge more difficult. Looking at recent Australian corporate debt costs, we estimate interest rates at 250bps – 350bps higher than the last three year average. For TPG this would result in an additional A$100m – A$140m in interest expense. That is quite a lot.

The share of corporate cash flow claimed by debt holders in the capital stack is going up. EPS forecasts for TPG were downgraded 15% on unchanged EBIT estimates as analysts reflected the new interest expense reality. That the stock price was largely unchanged suggest the market continues to believe the current 4.5% is a temporary anomaly in a future low-rate world. The preferred valuation for these assets (EV / EBITDA) misses all the important “below the line” changes (like interest costs changing) and much like EV / Sales 18 months ago can make investors (temporarily and incorrectly) ignorant to critical changes in business economics.

The Energy Question

Every time we look to write about energy we are struck with the enormity of the problem and the limited knowledge we have on the solution. We need to transition to a lower carbon world. We don’t have the infrastructure in place today to get where many people would like us to be. Abundant and low-cost energy is a critical component in economic growth.

There is no easy solution, and we observe absolutist views on what should happen often miss the messy reality (or have other incentives). We have Europeans turning back on coal power plants. We have Australian gas and power prices spiking and risk of insufficient availability. We have tiny EV penetration yet raw material supply chains and power grid infrastructure already over-stretched.

What is clear is that energy is an absolutely critical economic player and there are companies with deep expertise and strong competitive positions in many parts of the supply chain – in both the carbon intensive and the low carbon worlds. We continue to invest in and learn from those solving energy problems in the real world as they are more likely to find the rational path forward than the mandarins at Davos.