I thought I’d be as contrarian as possible today and write about the investment case for small-cap Australian industrials on a day where bipolar equity indices are again besotted with Europe.
While hedge funds are clearly only playing equity index futures, leveraged sector exchange-traded funds (ETFs), physical commodities and currencies on a daily basis, long-only funds have been mostly focused on mega cap stocks due to liquidity. This means just about nobody professional has been touching smaller capitalisation stocks, which suggests the greatest upside leverage to a recovery in sentiment lies in the right smaller cap stocks.
In the US, small-cap stocks have started leading Wall Street and that trend seems to be coming to Australia. There were some very solid upside moves right across the Australian small and mid-cap universe on Monday, with percentage gains large because we are coming off such low share price bases. Highly shorted stocks such as Melbourne IT (MSB) led the gains.
Growing interest and demand for small-cap stocks are key barometers of improving risk tolerance. It’s worth noting the one-year chart of the ASX Small Ordinaries (XAO) is testing both the downtrend from April and near-term trading range resistance around 2,400.
The spot price of gold, which I feel is the benchmark of true global fear, has been correcting and this is a medium-term positive for risk equities.
The point is if small caps start leading the market then just about NOBODY is positioned for it. This could easily be a repeat of what happened after GFC 1 as forced small-cap sellers were exhausted. This is strongly worth monitoring.
One of the reasons professional investors have been shying away from small caps is because there has been a feeling that capital markets are closed to them. That has been true, but it’s absolutely clear they are reopening in terms of equity capital.
It’s also worth remembering that the greatest leverage to domestic interest rate cuts and a peaking Australian Dollar (100.69 US cents) lie in small-cap industrials.
I always think the right approach to small-cap portfolio construction is a ‘basket approach’. This takes out a little of the stock-specific risk, but doesn’t really reduce the upside potential.
On that basis, I asked our quant department to run some screens over the small and mid-cap industrial universe. As we are entering a lower interest rate/slower global growth period, I asked them to screen for what we forecast to be structural growth industrials with high sustainable yield support.
Note the number of discretionary speciality retailers in this list at the bottom of the discretionary spending cycle (JBH, SUL, KMD, TRS). Mining services, engineering, and contracting are also well represented (LCM, EHL, BKN, PRG, AAX, SKE, ASL, WDS, MIN) on that WA structural capex-spend growth we keep banging on about. IT and telecommunications also make a contribution (MLB, TPM and IIN).