Twidale, who manages the DNR Capital Australian Emerging Companies Fund, says the inflation story has shifted from a view that inflationary pressures are transitory to a longer-term theme, and the shift in equity market leadership could have further to run.
“Greater inflationary pressure has been evident during just about all our recent discussions with various companies’ management teams. This is due to supply chain challenges, higher commodity prices, increased energy costs associated with the transition to renewables, higher property costs and ongoing labour constraints.
“Some normalisation can be expected as the impact of the pandemic recedes, but many of these issues also appear more structural in nature and may not be resolved quickly.”
Twidale says DNR Capital has been reducing the exposure to the more expensive areas of the market in the DNR Capital Australian Emerging Companies Fund.
“This shift has been in favour of the cheaper sectors of the market, including Resources, Energy and attractively priced defensives. We finished 2021 with the forward price/earnings (PE) multiple of the stocks in the portfolio at one of the lowest levels since the inception of the strategy four years ago. The forward PE multiple is 17 times currently, compared with close to 30 times a year ago.”
He believes the shift in market leadership could have further to run. “Many of the main beneficiaries from the long period of low inflation and low interest rates could find it difficult to repeat this period of outperformance. Many growth stocks were simply priced for perfection.”
“This compared with many of the more value and cyclical related sectors, where earnings expectations appear more on the conservative side and offer a margin of safety in their valuation.”
A top performing stock so far this year is commodity producer Champion Iron. The company is trading on a PE of less than six times and has a net cash balance sheet. Champion Iron is one of the Fund’s key Resource sector positions, along with Iluka Resources, IGO, Lynas Rare Earths and Deterra Royalties.
Other stocks in the portfolio that have quality business models with defensive characteristics include intellectual property services group IPH and financial services software company Iress.
High quality industry leaders with strong pricing power in the portfolio include student placement provider IDP Education and appliance manufacturer Breville Group.
The Fund returned 34.87% in 2021, compared with a return of 16.90% for the S&P/ASX Small Ordinaries Accumulation Index. Since the Fund was launched in August 2018 it has returned an average of 18.89% p.a., while the index has returned 8.99%, an outperformance of 9.90% p.a.
Twidale says: “As we look ahead to the 2022 calendar year, our outlook for the market and the positioning in our DNR Capital Australian Emerging Companies Fund remains unchanged. We continue to look for strong bottom-up investment opportunities, in quality companies trading on attractive valuations.”
“We expect that market leadership going forward could come from a narrower selection of companies, which will require a more concentrated and benchmark agnostic approach to managing the Fund.”