Callum Burns
Markets have a habit of overreacting. We’ve seen it repeatedly across decades of investing, from the GFC to COVID, and even the small cap dislocation of 2022.
Each crisis arrives with a “this time is different” claim. Yet history consistently shows that periods of indiscriminate selling often create the most compelling long-term opportunities.
We believe that today’s market environment feels increasingly familiar.
Across Australian small caps, a broad range of quality companies have experienced significant share price weakness despite continuing to deliver solid operational performance. In many cases, we believe fear, particularly around artificial intelligence disruption and geopolitical uncertainty, has overtaken rational analysis.
For long-term investors, that disconnect matters.
An ideal investing approach should be centred on finding the hidden gems in the small cap sector: that is, companies with an economic moat that will help to generate strong earnings over time. We believe in high-quality business franchises with difficult-to-replicate assets, strong customer relationships, and strong long-term earnings potential.
When markets become emotional, our focus does not change. If anything, these environments often present the best opportunities to add to positions in companies we already know well.
During the recent reporting season, most of our holdings met or exceeded expectations, while median earnings growth remained strong. Yet despite this, valuations across many holdings have fallen to, or close to, decade lows.
In our experience, periods where quality businesses continue growing while their valuations contract sharply have often been followed by strong subsequent returns. Markets eventually reconnect share prices with underlying fundamentals.
AI – the new ‘railway’
Artificial intelligence has become the dominant narrative driving recent market behaviour.
We believe AI will be like the introduction of rail, reshaping industries and driving profound change. We are extensive users of AI ourselves and believe investment research will be among the first to be disrupted by the technology.
However, markets are currently treating many businesses as though AI disruption will be immediate, universal and entirely negative. We think that assumption is often overly simplistic.
Investors appear to be ignoring the real-world competitive advantages these businesses possess. This can include regulatory licences, distribution networks, embedded customer relationships, operational scale and industry expertise. Also AI can be utilised to strengthen many of these businesses – they won’t stand still.
For example, gaming company Light & Wonder. The stock sold off heavily amid concerns that AI could make game development easier. Yet this overlooks the company’s substantial regulatory infrastructure, physical distribution capabilities and decades of industry know-how. Its forecast earnings growth is currently 18 per cent.
Similarly, insurance broking groups such as AUB Group have weakened despite operating in highly relationship-driven, complex commercial insurance markets where AI is unlikely to simply replace human expertise overnight.
We believe that many companies may ultimately benefit from AI through lower operating costs, improved productivity and enhanced customer service.
The key challenge for investors is distinguishing between businesses genuinely vulnerable to structural disruption and those experiencing temporary valuation compression driven by fear.
Experience matters in volatile periods
One advantage of managing money through multiple cycles is recognising that extreme market narratives are rarely permanent.
Our investment team has navigated numerous major market disruptions over the past three decades, and the lessons are remarkably consistent – maintain a disciplined process, avoid getting swept up in emotionally driven narratives and focus on long-term business fundamentals rather than short-term market noise.
Markets can reverse very quickly. Historically, some of the strongest periods of excess returns have followed periods of severe underperformance or blanket selling. In our own experience, previous periods where returns materially lagged small industrial benchmarks were eventually followed by meaningful recoveries and renewed outperformance.
That does not mean every stock recovers, or that volatility disappears overnight. But it does reinforce the importance of maintaining perspective when sentiment becomes negative for longer periods of time.
A long-term opportunity emerging
Today, many investors appear focused almost entirely on short-term uncertainty. Yet when we analyse the underlying businesses within our portfolio, we continue to see companies with strong market positions, attractive long-term growth prospects and valuations that imply unusually pessimistic assumptions.
In our view, this creates a compelling setup. Rather than retreating from quality companies during market weakness, we believe this is a time to selectively lean into opportunity where valuations have become disconnected from fundamentals.
Cool heads rarely feel rewarded immediately. But over time, history suggests they often are.
By Callum Burns, managing director & portfolio manager
