Callum Burns

While small capitalisation stocks have significantly underperformed large companies since the start of 2022, many quality small cap companies possess superior earnings profiles to large companies and have been indiscriminately sold down.

That’s the conclusion reached in The Small Cap Dislocation, a new research paper which assesses the performance of the Australian small caps sector.

The research separates companies of the ASX/ S&P Small Industrials into two halves – one half consisting of higher-quality companies with superior earnings growth, profit margins and debt profiles, and the other half consisting of lower quality companies.

It found that while low-quality small cap companies deserve to have underperformed the S&P/ ASX 100 Industrials Index, the higher-quality half of small caps have been oversold versus large caps.

Earnings growth, debt levels and profit margins of these companies compared to the S&P/ ASX 100 Industrials are typically more favourable and, therefore, the large underperformance of this quality group of small companies since 2022 versus large caps stocks is unjustified.

The ASX/ S&P Small Industrials Index was chosen as the control group to focus on the underlying drivers of small companies. The group was split into five quality categories, including ‘best franchises’, ‘solid franchises’, ‘typical company’, ‘below average company’ and ‘challenged and/ or loss-making’. The consensus forecast earnings growth for the year ending June 2024 was then obtained for each company across each category, and the median was calculated for each Small Industrials quality category. The same process was repeated for the Top 100 Industrials.

The earnings growth in the higher quality half of the ASX/ S&P Small Industrials is superior to that of the same quality categories in the Top 100 and superior to that of lower quality companies, whether in the Top 100 or Small Industrials. This suggests for the higher quality categories in the Small Industrials Index, the underperformance of this group since the start of 2022 is not justified.

The median quality small cap franchise in the higher quality half has better earnings growth, slightly lower debt levels and slightly higher profit margins than Top 100 companies. In contrast, earnings growth in the lower quality half of the Small Industrials is materially inferior to that of the same quality categories in the Top 100.In aggregate, the three lower quality categories have uninspiring earnings growth and trade at a discount

The findings of the research illustrate that the more challenging investment environment since the start of 2022 has unsettled investors. As a result, they have responded by buying into the perceived safety of large cap stocks and overlooked indiscriminately sold down small caps.

The sell-off in quality small companies has opened up attractive buying opportunities for shrewd investors prepared to do the work and potentially unearth quality companies with robust earnings growth, good profit margins and low debt levels – something investors in all segments of the market should be aiming for.

By Callum Burns, managing director and Roger Walling and Mason Willoughby-Thomas, portfolio managers 

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ICE Investors is a boutique fund manager based in Melbourne, specialising in franchise style investing in Australian equities.

Mr Aliev was previously employed with Franklin Templeton Investments – Global Equity Group as a research analyst for eight years. Prior to this he held research positions with Mercer Investments and AXA Australia.

He holds a Bachelor of Commerce (Hons) from the University of Melbourne and is also a CFA Charterholder.

Mr Burns said the appointment reflects both the capabilities of Mr Aliev and also the demands of the current market environment.

“Given the uncertainty in the market and the need to identify sound, long-term stock opportunities, Roman joins the business at an opportune time.

“He is a passionate investor and a high performing global equity research analyst, with strong experience covering a wide range of geographies and sectors.

“His analytical experience and focus on identifying companies that are well positioned to grow shareholder value over the long term make him a good fit for the investment team.  We’re looking forward to having Roman join the team,” he said.

ICE Investors’ SGH ICE fund is a benchmark unaware fund that has a strong long term track record since its inception in 2006. It is an actively managed predominately small cap equity fund, that aims to invest in ASX listed franchise companies with a sustainable competitive edge.

The Fund currently holds 39 stocks which are a mix of longer-standing companies growing at a steady rate, and those that have been advantaged by the pandemic and experienced more significant growth as a result.

The underlying philosophy of the investment team is to focus on franchise companies with a durable competitive advantage, organic growth opportunities, appropriate debt levels and strong cash flow generation.

“We look for franchise companies that have high barriers to entry and use assets that are difficult for competitors to replicate. This typically leads to strong pricing power and, most importantly, sticky customers,” Mr Burns said.

“Inflation will continue to have an impact on markets, and the key risk to margins is not being able to pass on material or labour costs. As pricing power is such a key element of our investment process, many franchise companies are well suited to this market environment. We’re continuing to identify opportunities for the fund,” he said.

Stocks currently favoured by ICE Investors include Ooh Media (ASX: OML), carsales.com (ASX: CAR), Steadfast Group (ASX: SDF), and medical supplier, EBOS Group (ASX: EBO).

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According to Mr Burns, the appointment reflects the recent strong performance of the SGH ICE Fund and growth prospects within the small cap sector of the market.

“With substantial experience in asset management, Mason is an excellent fit both culturally and from an investment philosophy perspective. He has a proven track record in being able to achieve strong returns and understands the demands of a retail client base.

“His appointment places the ICE Investors team in a very strong position to continue to deliver superior investment performance for our clients,” he said.

Prior to joining ICE Investors, Mr Willoughby-Thomas was senior co-portfolio manager of the Ausbil Investment Management small and microcap funds. He was also previously employed as portfolio manager/ senior analyst at Australian Ethical Investment and held analyst positions at ING Investment Management and AMP Capital Investors.

He holds a Bachelor of Commerce with honours from the Australian National University and is a Chartered Financial Analyst.

Mr Burns said the appointment of Mr Willoughby-Thomas comes at an opportune time for the domestic small cap sector, with certain industries poised for particularly strong growth.

“Companies connected to pharmaceutical distribution, cloud software, online services and food are likely to do well as the economy reopens. We’ll be continuing to focus on franchise companies with a durable competitive advantage, organic growth opportunities, appropriate debt levels and strong cash flow generation he said.

SGH ICE is a benchmark unaware fund, but draws most of its investments from Small Industrial stocks which have outperformed during COVID-19 and over the long term.

It currently holds 43 stocks which are a mix of longer-standing companies growing at a steady rate, and those that have been advantaged by the pandemic and experienced even more significant growth as a result.

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“I am delighted to move Mason up to full control of the Larger Companies Trust. He has become an invaluable team member at Australian Ethical over his 2+ years with us and is well regarded as an analyst. I have no doubt he has the necessary skills required to manage the Trust. His dedication and passion for investing is obvious for all to see,” said David Macri, CIO, Australian Ethical.

Prior to joining Australian Ethical Mason spent three years at ING Investment Management as a senior equity analyst. His career has also included time at ABN Amro and AMP Capital Investors. He is a CFA charter holder.

Mason replaces CIO David Macri as PM of the Trust to allow David more time to focus on strategic development of the current business and its offerings, as well as concentrating on managing the team and the overall investment process for managed funds and Australian Ethical’s superannuation fund.

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