Two Sectors That Could Go ‘Mad’ and a CEO Comment That Was Both Memorable and Terrifying – James Marlay

Small-cap investors have weathered a long winter. But there have certainly been signs of green shoots. We’ve had some decent IPOs from Guzman and Gomez (ASX:GYG)Interest rates have almost certainly peaked by now, and throughout July we saw growing investor appetite for small-cap stocks.

But like a September southerly breeze on the coast, the latest reporting season has dimmed the shine on small-cap stocks, providing a brutal reminder to investors that it could be a few more cooler days before the sun shines again on this part of the market.

By comparison, the S&P/ASX Small Ordinaries (XSO) ended August down 2% – not a bad result considering the index had lost nearly 7% in a matter of days earlier in the month.

To get a sense of how smaller caps on the ASX fared in August, I caught up with Chris Prunty, Portfolio Manager at QVG Capital. Prunty recounts some of the ups and downs of the reporting season, two sectors he believes have “gone wild” as interest rates have fallen, and a CEO comment he describes as both memorable and terrifying.

In your recent letter to investors, you wrote that conditions in the small business market are still difficult, but are improving. What supports this view?

You mean something other than blind faith? The last three years have been as tough as I can remember for smaller companies. A combination of interest-rate-based valuation headwinds and more technical changes in market structure have left smaller listed companies struggling overall.

While technical factors like the shift to passive investing won’t go away, interest rates appear to have peaked, which tends to benefit risk-averse individuals and smaller companies.

Expectations of a cycle of interest rate cuts are growing – how important is this for smaller companies?

The playbook says that rate cuts will help directly through lower cost of funds, through increased demand for cyclical stocks like consumer, media and housing, and through lower yields for valuation-sensitive sectors like REITs. But I think the bigger impact will be on sentiment and flows.

Talk to most allocators and you will find that they are heavily invested in Private Credit. Perhaps lower interest rates will cause the allocator’s extra dollar to move from Private Credit to something that has historically produced higher returns, like smaller companies. We live in hope!

How would you describe the mood when you talk to other investors in the market?

Not many of my peers will talk to me these days, but those who do are like my beloved Essendon Bombers. They cling to memories of past glories and hope that greatness is just around the corner. As my father, also a Bombers fan, used to say: It’s hope that kills you.

Are there any small-cap sectors that you think could particularly benefit from lower interest rates?

REITs and small financials are going crazy. You would normally say consumer, but some of the larger retailers are priced as if the rate cuts have already happened. So it’s hard to get excited there.

Have you made any significant changes to your portfolio as a result of information gathered during the reporting season?

Yes. We always try to better understand the competitive advantages and long-term returns of our portfolio companies. As our beliefs about them change, we tend to change the weightings.

Looking at your Top 5 holdings, some big winners were wiped out by some laggards. JLG stands out for not living up to expectations. What went wrong?

The reporting season wasn’t what it could have been. The story of our reporting season was that a lot of the smaller wins were wiped out by Johns Lyng (ASX:JLG), which was our second largest holding, falling by a third. That hurt. Johns Lyng delivered earnings that were well below expectations, and several other quantitative and qualitative elements of the results disappointed.

We suspect the company’s shares will be on the sin list for some time.

Do you still believe in JLG?

Less than before the results were announced! There are still elements of the Johns Lyng business and culture that we really like, but there is no getting around it; the result and outlook sucked. Despite this, the market quickly and aggressively incorporated this changed outlook into the share price. Plus, the directors bought shares, so they are either true believers or very stupid; we shall see. We still hold JLG; albeit less than before the results were announced.

Momentum is clearly visible in 360 and HUB24, both of which are trading at 52-week highs. Do you still see value in these two names?

Forecasted earnings for both companies have fallen, but given the pace of earnings growth – especially in the case of 360 – valuations are not as aggressive as one might think.

What comment from a CEO/CFO during phone calls and meetings you have attended has been most memorable to you?

It was memorable and terrifying to hear Chris Ellison of Mineral Resources describe the moment as “the worst possible time” to be a mining company CEO, saying, “We’re throwing everything out there just to save money.”

Has any company achieved results that significantly exceeded your expectations?

I was scared Hansen Technologies (ASX: HSN) would have a weak result. Part of their revenue comes from high-margin royalties, which can shift from one period to another. As it turns out, the result wasn’t that bad and they raised their cash margin guidance.

I thought so too Maas (ASX:MGH) The result, while not impressive, was strong compositionally, as most of the growth came from the higher-quality building materials division.

Learn more from Chris Prunty and the QVG Capital team

QVG Capital is hosting an investor webinar on September 19 at 11:00 AM. Chris Prunty, Tony Waters, and Josh Clark will discuss key takeaways from the reporting season, portfolio changes, and current positioning.

Interested investors can register for the webinar by clicking here.