Matt Griffin

The latest reporting season showed some small cap companies are under pressure – including retailers – while others have a rosier outlook, such as gold miners, according to Phillip Hudak and Matt Griffin, co-portfolio managers of the Maple-Brown Abbott Australian Small Companies fund.

They said retailers’ margins might continue to shrink in 2025, even though retail sales are holding up in Australia.

“Margins are under pressure and while retail sales are holding up, retailers are discounting prices to attract consumers who are reluctant to spend as cost-of-living pressures mount, reducing their margins. We have seen this is the case for listed retailers such as Myers and Adairs in the February reporting season,” Mr Hudak said.

“We’ve also seen more small caps downgrade earnings and earning per share (EPS) forecasts than upgrades, so there is some pressure being felt across the share market more broadly,” he said.

Looking ahead into 2025, the banks, which comprise nearly a quarter of the Australian equity market, are unlikely to provide substantial market support in 2025 due to limited earnings growth and full valuations. 

“Interest rate cuts generally aren’t good for bank earnings, and with a mixed set of results from earnings season, this could be a big headwind for the ASX100 over the coming year, given how large the banks are as a percentage of the Australian index. Couple this with insurers who are very well owned by large cap managers, in an environment where the premium rate cycle is turning negative, this could support our thesis of small caps catching up some of the underperformance over recent years,” Mr Griffin said.

In addition, merger and acquisitions (M&A) activity is boosting some small caps, including Domain and Mayne Pharma.  Maple-Brown Abbott expects more M&A activity in 2025, with the lower Australian dollar making local assets cheaper for offshore buyers, and cash heavy private equity groups circling local companies.

“Private equity money is chasing undervalued stocks in the small cap space, and so we are seeing increasing M&A activity,” said Mr Hudak.

“In recent times, Insignia shares have rallied amid an intensifying bidding war between private equity firms CC Capital, Bain Capital and Brookfield and we have also seen takeover bid for Domain, which was a top performer this reporting season, from US giant CoStar,” Mr Hudak said.

“Another example is private equity-backed US pharmaceutical giant Cosette making a takeover bid for Mayne Pharma Group, and we believe that we will see a greater level of corporate activity going forward in 2025,” he said.

Greater M&A activity could also support the gold sector into 2025, with higher gold prices triggering greater activity. In terms of other sectors, the first half of the 2025 calendar year is expected to be mixed given the upcoming Federal election, which must be held by May 2025. 

“We expect cost-of-living measures and fiscal spending to continue which should be supportive for the aged care and childcare sectors,” Mr Hudak said.

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Phillip Hudak

The higher gold price has boosted margins for gold miners who likely have further to run, while cost-of-living pressures make retailers more risky investments, according to Phillip Hudak and Matt Griffin, co-portfolio managers of the Maple-Brown Abbott Australian Small Companies fund.

Following the recent earnings season, Mr Hudak says there are good opportunities in select gold companies.

“The gold price has done very well over the past two years, despite rising real bond yields which are normally not good for gold. However the impact of bond yields has been offset by high levels of central bank buying and we see value emerging for gold producers,” he said.

“Those companies that are producing gold right now, such as Perseus and Genesis Minerals, and can take advantage of the “scarcity value”, have outperformed the gold price.  Combined with easing cost inflation, profits have been boosted.

“This contrasts to gold developers, which have underperformed the gold price, as they are seeing higher funding costs, project cost blowouts and delays,” said Mr Hudak.

The US dollar gold price is currently trading near all-time levels at US$2,500/oz, having risen over 20 per cent year-to-date.

“We believe there is still significant upside in select gold companies, especially those companies that are increasing their resource base and have low-cost options to bring gold production on, including Spartan Resources, as well as those developers that have high-quality well-funded projects, such as De Grey Mining,” said Mr Hudak.

Source: Bullion Vault, www.bullionvault.com/gold-news/infographics/olympic-medals-real-gold-silver-bronze-medal-count, MBA, FactSet, 23 August 2024. gold producers include CMM, EMR, GMD, GOR, PRU, RED, RMS, RRL, RSG, WAF and WGX, gold developers include BGL, DEG and PDI.

Greater merger and acquisition (M&A) activity is likely to continue in the gold sector into 2025, with higher gold prices triggering greater activity. With exploration activity still limited, this has led to a depletion of gold reserve, helping to boost margins for producers. Coupled with a lengthening and less certain permitting process for new mines, this is causing producers to pursue a ‘buy over build’ strategy to growth.

“Gold sector M&A activity is heating up, for both global and local small cap gold miners,” Mr Hudak said.

“It is now becoming cheaper to buy gold miners rather than build gold mines. We’ve seen Newmont and Newcrest get together, Goldfields has been active and that has flowed through to Australian small cap gold companies, including Ramelius taking a stake in Spartan, Perseus taking a stake in Predictive Discoveries, and Red 5 and Silverlake Resources merging.

“We believe this M&A activity will continue, particularly at the smaller end of the market.

“We also liked the aged-care sector, which has benefited from increased government funding in areas like wages. On top of that, the government is supplementing growth of labour,” Mr Hudak said.

Matt Griffin, co-portfolio manager of the Australian Small Companies fund, said other companies they like includes storage real estate investment trusts (REITs), with the ageing population and housing turnover driving demand for greater storage.

In contrast, other REITs such as industrial and office have seen valuations decline and are trading at significant discounts to Net Tangible Assets (NTA), especially office and industrial REITs, while gearing levels are rising.

According to Mr Griffin, the market is implying valuations are not at the bottom yet, and earnings growth will be very hard to come by for the majority of small cap REITs in FY25.

“The one bright spot we see is storage, with structural factors driving a more favourable outlook than other REITs, with downsizing, an ageing population and housing turnover driving demand for storage space, and storage REITs have a strong pipeline of growth,” said Mr Griffin.

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Phillip Hudak

Overall, the February reporting season was generally positive for Australian small caps, with the domestic economy remaining resilient, and many small cap company results beating market expectations, says Phillip Hudak and Matt Griffin, co-portfolio managers of the Maple-Brown Abbott Australian Small Companies Fund.

“There were several positive results, with upwards earnings per share (EPS) revisions triggering share price rises for many small caps, and we note that reactions to company announcements have been more elevated than what we have seen in previous reporting seasons,” said Mr Hudak.

“The consumer discretionary sector was the big surprise given more resilient top line sales relative to previous conservative assumptions. This, combined with easing input costs, has allowed retailers to continue to clear excess inventory without elevated promotional activity. This resulted in better margins, notably for Breville Group, ARB and Adairs,” he said.

Maple-Brown Abbott believes the Australian small cap market is set for a potential significant rebound over the next two years and small caps are likely to outperform larger companies.

“Australian small cap valuation metrics look attractive with forecast earnings upside relative to Australian large caps, given the economy is performing better than previously expected. There are also signs of easing financial conditions; any easing in interest rates by the Reserve Bank of Australia (RBA) would be constructive for small caps,” said Mr Griffin.

“For investors who may have missed the bottom a few months ago, we believe that it is not too late to buy into the sector. We are seeing substantial interest from advisors and investors in small cap stocks, but they are not necessarily increasing their allocations to that interest. We think that eventually allocations will catch up.”

A robust level of mergers and acquisitions activity is likely to continue in 2024, underpinned by the lower Australian dollar and potentially lower interest rates, supporting the performance of the Australian small cap sector, according to fund manager Maple-Brown Abbott.

Following on from a robust reporting season for small cap companies, takeover activity could continue into 2024, following a flurry of corporate activity seen in the backend of the 2023 calendar year.

“We believe merger and acquisitions (M&A) activity will continue this year. The lower Australian dollar and the prospect of lower interest rates going forward are expected to result in a flurry of corporate activity,” said Mr Hudak.

“This reporting season has seen the high level of recent M&A action continue with France’s Cie. de Saint-Gobain bid for CSR, Seven Group’s bid for Boral and most recently Altium, which is being sold to Japanese chipmaker Renesas Electronics and Aussie Broadband’s bid for Superloop. We’re also seeing more M&A activity in the mining sector.

“With the lower Australian dollar, we believe M&A activity will continue to create opportunities in the Australian small cap sector and be far more pronounced than IPO activity which is also expected to ramp up. Many companies, particularly at the smaller end of the market, could see M&A activity as the year continues. Spartan Resources, for example, is a potential takeover candidate and also a key stock pick given our bullish view on gold,” he said.

The portfolio managers said several themes are supporting small-cap companies, including artificial intelligence and clean energy themes.

“Some Australian companies that are benefiting from the huge interest in AI stocks, as evidenced by the surging demand for semiconductor company NVIDIA, include datacentre exposed companies including NEXTDC, Megaport and Macquarie Technology Group. These companies are being caught up in the AI theme and we think this trend is set to continue through 2024,” Mr Hudak said.

“In terms of our portfolio we have invested in medical imaging company Pro Medicus because we think the integration of AI in the radiology imaging area will create significant advances in imaging technology and upside for this company.”

A recent rebound in lithium prices has also boosted lithium miners and other miners linked to clean energy production.

“Following on from the fall in nickel and lithium prices, we have seen a growing number of mine closures in battery materials metals, driven by oversupply and changing battery technologies. Nickel is likely structurally challenged and lithium is highly cyclical,” said Mr Griffin.

“However, we feel the lithium price could be bottoming and in recent days, we have seen the prices of lithium miners rise, which is likely being driven by short covering.  The lower prices have created opportunities with lithium miners, and we are looking at positioning for the next cycle in companies like Patriot Battery Metals.

“We are also seeing opportunities to get into the gold mining space. We’ve seen a recent drop in price of some gold miners which has opened up opportunities. At the same time demand for gold is strong, particularly from central banks. Gold could also benefit from lower interest rates throughout 2024 and we are focussing on companies that continue to deliver production growth, meet cost guidance and build cash reserves such as Genesis Minerals and Persus Mining,” said Mr Griffin.

Maple-Brown Abbott also expects the uranium price to rise, lifting uranium miners. Strengthening fundamentals and increasing urgency to reduce carbon emissions from utilities will increase contracting levels in an environment of supply uncertainty.  Companies that stand to benefit include Boss Energy and Paladin Energy.

The structural shift to electric vehicles (EVs) is also benefiting car dealers and fleet/novated leasing companies. Sales of EVs are rising, and account for approximately 8 per cent of all vehicle sales in the 2023 calendar year. Fleet and novated leasing companies have also been major beneficiaries of recent fringe benefit tax changes, including Smartgroup.

However, rising wage inflation will hold back some companies especially those which are not able to pass on price rises, including some discretionary retailers exposed to younger demographics. As a result, Maple-Brown Abbott is investing in companies with pricing power, such as Technology One and Monash IVF Group.

Separately, buoyant financial markets have seen fund inflows recover for both the platform and fund manager providers. Maple-Brown Abbott has international equity fund manager GQG Partners as a key stock pick.

“Strong inflows, lower management fees compared to competitors and attractive operating margins will likely see this company outperform. GQG is also trading at a discount to global and local fund managers, but it enjoys strong distribution capability supporting strong net inflow performance and new product opportunities,” said Mr Hudak.

However, cost-of-living pressures, including higher mortgage rates and muted wage growth, is impacting companies exposed to younger demographics, including Baby Bunting. Media spending continued to see both a structural and cyclical shift away from television and radio to both digital and out-of-home, Mr Hudak said.

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Phillip Hudak

In recent times, the cost of living in Australia has grown faster than salaries, meaning ‘real’ wages have gone backwards. We believe this is about to reverse as the lagging effect of Australia’s employment regime abates. This should fuel material wage inflation over the next 6-12 months despite signs that the labour market may be softening. As a result, we expect to see Australian small cap companies increasingly divide between those that can cope with rising wages using pricing power, cost cutting and/or productivity initiatives – and those that can’t.

A consistent theme coming through for most sectors across the Australian small cap universe is wage inflation. We believe wage inflation is trending higher, however this is yet to materially show up in official government statistics, which currently show wage growth tracking below the Consumer Price Index (CPI).

Australian wage and consumer price inflation (% p.a.)

Source: Australian Bureau of Statistics – All groups CPI (%), Total hourly rates of pay including bonuses index, June 2023, https://www.abs.gov.au/statistics

In addition, systemic rigidity has contributed to Australian wage growth lagging the rest of the world. The minimum wage / award wage, which impacts over 20% of the Australian workforce^[1], is set by the Fair Work Commission (FWC) and only resets annually on 1 July each year. Enterprise Bargaining Agreements (EBAs), which impact approximately 35% of the workforce^[2], typically lock in wage growth rates for a period of up to four years^[3]. The duration of standard EBA contracts means many Australians are still ‘stuck’ in employment agreements negotiated as far back as pre-Covid. This significant lagging effect stands in contrast to almost every other developed economy, where wage increases have washed through much earlier.

Australian and US wage inflation (% p.a.)

Source: Australian Bureau of Statistics – Total hourly rates of pay including bonuses index, https://www.abs.gov.au/statistics, Federal Reserve Bank of St. Louis – Employment Cost Index: Wages and Salaries: Private Industry Workers, Percent Change from Year Ago, Quarterly, Seasonally Adjusted, June 2023, https://fred.stlouisfed.org

The structure of Australia’s wage negotiation regime means wage inflation is predominantly a lagging indicator. The 5.75% minimum wage decision^[4] announced earlier this year by the FWC applies from 1 July 2023 and we expect this hike will act as a benchmark for EBA renegotiations, and contribute to further acceleration in wages over 2HFY24 and into FY25.

This risk of further wage inflation is evident in the sharp increase in wage rates being set for new EBAs^[5] with employees expecting annual wage increases to be even greater over the next 12 months as cost-of-living pressures persist.

This classic wage-price spiral is happening when the unemployment rate remains close to record lows, although we acknowledge a loosening in labour market tightness, as indicated by labour underutilisation (i.e. unemployment and underemployment)^[6] ,which has recently increased but remains well below pre-Covid levels. In addition, job vacancies remain elevated although below peak levels^[7] and productivity weakness^[8] is raising concerns that more significant wage inflation may be underway.

Recent government policies, including the Secure Jobs, Better Pay Bill^[9], may deliver greater wage negotiation powers for trade unions and employees going forward. A recent example of this policy in action is G8 Education (GEM), a listed childcare operator, which is party to an application made to the FWC for multi-employer bargaining in the middle of both an ACCC inquiry and a Productivity Commission inquiry.

‘Application made to the Fair Work Commission (FWC) for Multi-Employer Bargaining in June 2023, facilitates tripartite negotiations between unions, employers and government, G8 voluntarily consented to be involved, FWC approved authorisation – September 2023, negotiation meeting agreed in November and December 2023’ G8 Education Ltd, ASX release from 2023 Strategy Day Investor Presentation, 26 October 2023.

In addition, the abolition of the Australian Building and Construction Commission (ABCC)^[10], and companies increasingly focused on pay equality^[11] and more flexible working arrangements^[12] is expected to add further upward pressure on wages.

How to play wage inflation in the Australian small cap market

It’s no surprise that service-related sectors have the highest labour cost intensity, including healthcare and information technology. Conversely, commodity-related sectors tend to be less labour intensive.

Earnings Before Interest Taxes Depreciation Amortization (EDITDA) margin vs. Cost of Doing Business (CODB)/Sales forecasts for FY1 for the median stock in each Australian small cap sector

Source: FactSet, MBA estimates, N.B. consensus forecasts and classification in FactSet for different companies can vary.

Going forward, we expect there to be a materially adverse impact on sectors with minimal pricing power and high labour components as a percentage of sales. The notable standouts here are the healthcare and retail sectors.

In the healthcare sector, the listed radiology providers (such as Integral Diagnostics and Capitol Health) have been price-constrained by increases in Medicare reimbursements (approximately 1.6% in FY23 and 3.6% in FY24)^[13] which lag cost inflation by approximately 12 months. This has resulted in material margin compression given labour as a percentage of total costs is high. This impact has been further amplified by increasing interest expenses given the gearing burden being carried by these companies.

‘Clinical staff shortages, particularly in regional areas, and cost inflation have continued into FY24 driving labour costs to be higher than expected, adversely impacting Operating EBITDA. As such we have not seen the expected Operating EBITDA margin improvement in Q1 FY24 relative to 1H FY23. IDX is responding to these pressures by accelerating productivity and efficiency initiatives.’ Integral Diagnostics Ltd, ASX release, 3 November 2023.

We prefer companies with a variable cost base and pricing power. Within the healthcare sector IVF providers stand out. Monash IVF Group continues to be a beneficiary of structural industry drivers including an older demographic, egg freezing and genetic testing. In addition, the company is currently seeing tailwinds from strong domestic industry IVF cycle volumes and price increases which are at or above underlying cost inflation – all of which we expect to result in operating leverage. In addition, we also prefer segments of the healthcare sector receiving additional government funding to support material wage increases, notably the aged care sector via exposure to Regis Healthcare^[14].

In the consumer discretionary sector, CODB/Sales is highly sensitive to like-for-like sales growth with low to mid-single digit sales growth needed to maintain current CODB margins – a target which is becoming an increasing challenge to hit in the current environment. Based on our research and industry feedback, retailers exposed to the youth consumer, including Accent Group and Universal Stores, are experiencing challenging top-line sales growth, coupled with wage inflation expectations of at least mid-single digit percentage growth. As sales growth softens, such firms are having to decrease service levels, including reducing staffing levels during non-peak trading periods, and further implement productivity improvements. Even with such tightening measures, we believe this won’t be enough to offset CODB/Sales pressures.

We are seeing increasing bifurcation in the performance of Australian small cap companies with similar industry exposures. Bapcor, which is skewed to non-discretionary consumer auto-related expenditure, is seeing slowing top-line sales growth which is compounded by increased margin pressure from cost inflatio^[15]. However, high-quality auto-related retailers are handling the current market environment better. For example, Super Retail Group has delivered accelerating FY24-to-date like-for-like sales growth since the release of the FY23 financial results in August, in an environment of CODB/Sales headwinds^[16]. 

Share price performance – Super Retail Group vs. Bapcor

Source: MBA, FactSet, data indexed to 100, 6 months to 6 November 2023. Past performance is not a reliable indicator of future performance.

The information technology sector is typically labour intensive, although this is often more than offset by high operating margins and pricing power. Companies including TechnologyOne and Hansen Technologies typically have annual CPI-linked pricing increases incorporated into their customer contracts which shields them from margin pressure in an elevated inflation environment. Based on our research and industry feedback, we expect margin expansion in select parts of the IT sector given the previous red-hot IT labour market from last year appears to be subsiding, and together with lower staff churn, should drive improving profitability in FY24 and beyond. There are also signs that labour shortages are easing in other sectors and companies, including Kelsian Group^[17].

Summary

In summary, we believe the delayed flow-through of wage inflation in Australia will have a material down-stream impact on the profitability of select sectors of the Australian small cap market over the next 6-12 months – which the market is under-appreciating. Specifically, we expect a material impact on sectors/companies with high labour components as a percentage of sales that have minimal pricing power and are riding abnormal post-Covid sales waves. As the market increasingly appreciates the impact of rising wages we expect to see an increasing bifurcation in the performance of ‘good’ and ‘poor’ businesses going forward. We believe the wage-price nexus creates a great environment for active management in the Australian small caps market and we continue to focus on investing in companies with genuine pricing power to offset lagged labour cost pressures.

By Phillip Hudak, Co-Portfolio Manager, Australian Small Companies

———
Notes:
[1] The national minimum wage only applies to a very small proportion of that workforce: only 0.7 per cent of employees are paid the national minimum wage. As for modern awards, approximately 20.5 per cent of employees are paid in accordance with minimum wage rates in modern awards. The Annual Wage Review Decision 2022-23, Fair Work Commission, 2 June 2023, https://www.fwc.gov.au/documents/resources/2023fwcfb3500.pdf
[2] The proportion of employees covered by enterprise agreements has decreased from its historical peak of 43.4 per cent in 2010 to 35.1 per cent in 2021, Enterprise Bargaining outcomes from the Australian Jobs and Skills Summit Regulation Impact Statement Department of Employment and Workplace Relations OBPR ID 22-03169, https://oia.pmc.gov.au/sites/default/files/posts/2022/10/Regulation%20Impact%20Statement_0.pdf
[3] Enterprise agreements benchbook, Fair Work Commission, https://www.fwc.gov.au/what-enterprise-agreement#:~:text=An%20enterprise%20agreement%20is%20an,from%20the%20date%20of%20approval.
[4] Minimum wages increase from 1 July 2023, Fair Work Ombudsman, https://www.fairwork.gov.au/newsroom/news/awr-2023
[5] Fair Work Commission
[6] Australian Bureau of Statistics
[7] ANZ job advertisements, ANZ
[8] Australian Bureau of Statistics
[9] Secure Jobs Better Pay Act, https://www.fwc.gov.au/about-us/secure-jobs-better-pay-act-whats-changing
[10] Abolition of the ABCC and ROC, Fair Work Commission, 12 December 2022, https://www.fairwork.gov.au/newsroom/news/secure-jobs-better-pay/abolition-abcc-and-roc#:~:text=The%20ABCC%20has%20been%20abolished,have%20now%20transferred%20to%20us
[11] 2022 – 23 Gender Equality Reporting, Viva Energy and Workplace Gender Equality Agency, 13 June 2023, https://www.vivaenergy.com.au/ArticleDocuments/1317/1787_108855_17Jul2023154421_WGEA%20Compliance%20Report%2022-23_Viva%20Energy.pdf.aspx?Embed=Y
[12] Four-day work week gains momentum – Medibank set to launch trial, Medibank Private, 23 October 2023, https://www.medibank.com.au/livebetter/newsroom/post/four-day-work-week-gains-momentum-medibank-set-to-launch-trial
[13] ‘Limited price increases with Medicare indexation of 1.6% well below inflation… indexation of 3.6% announced and applied to all Diagnostic Imaging Services, including MRI items however excluding Nuclear Medicine items, from 1 July 2023, with further indexation of 0.5% expected to be applied from 1November 2023.’ Integral Diagnostics ASX release FY23 Results Investor Presentation, 28 August 2023
[14]  ‘From the first full pay period on or after 30 June 2023, minimum award wages will increase by 15% in residential aged care for workers who are paid under the Aged Care Award and the Nurses Award in relation to the following occupations – personal care workers, recreational activities officers, head chefs and cooks (one FTE per service), assistants in nursing, enrolled nurses, registered nurses (including nurse practitioners)…. Providers must pass on all the additional funding allocated to wage increases to their workers in the form of an increase in wages.’ Aged Care Worker Wages Guidance for aged care providers on the provision of funding relating to Stage 2 of the Fair Work Commission Aged Care Work Value Case, Australian Government Department of Health and Aged Care, June 2023, https://www.health.gov.au/sites/default/files/2023-06/aged-care-worker-wages-guidance-document.pdf
[15] ‘However, we are not immune from shorter-term macroeconomic headwinds facing many organisations, which in the current financial year have so far led to a more moderate growth profile in our Trade and Wholesale markets, and a further deterioration in the Retail sector. This resulted in our overall year-to-date revenue growth slowing down to a low-single digit percentage rate, compared with last year. In terms of bottom line, these challenges are further compounded by increased short-term margin pressures from cost inflation and other external factors such as increasing payroll taxes… As a consequence, our year-to-date Pro-Forma NPAT at the end of September is behind the expectations we had at the beginning of the year, with the shortfall to our plans being in the mid-single digit millions of dollars’, Bapcor, ASX release 2023 Annual General Meeting, 17 October 2023.
[16] ‘I am pleased to report that in the first sixteen weeks of FY24, the Group has delivered sales growth of 4 per cent and like-for-like sales growth of 2 per cent, cycling 20 per cent like-for-like sales growth in the prior comparative period… As previously announced to the market, as a result of continued inflationary pressures on wages, rents and electricity costs, the Group expects its cost of doing business (CODB) as a percentage of sales to increase in FY24.’ Super Retail Group Ltd, ASX release from AGM Addresses, 25 October 2023.
[17] ‘The post COVID pressure of labour has been relieved. The new contracts in Sydney commenced fully staffed and Adelaide has returned to full staffing levels and overtime normalised… This part of the business is therefore on track to normalise temporary overtime costs by the start of the second half… As mentioned, we expect by the end of the first half, all businesses to be back to operating with more normalised levels of overtime following an extensive recruitment and training period.’ Kelsian Group ASX release 2023 AGM, 24 October 2023.

The post Is wage inflation being underestimated? Implications for the Australian small cap market appeared first on AdviserVoice.

Phillip Hudak

According to Maple-Brown Abbott, Australian small cap companies are well positioned for any downturn given balance sheets are flush with cash and limited debt, the majority of stocks in the benchmark are profitable, and many companies have cost levers that can be pulled.

Co-Portfolio Manager for Australian Small Companies Phillip Hudak said despite economic uncertainty the starting point for the Australian small cap market appears more attractive given the strength of many smaller companies and the recent underperformance relative to other equity asset classes.

“Timing the turnaround in relative performance, however, is extremely difficult, and underperformance can persist for significant periods of time. It is likely a catalyst is needed in the form of easing financial conditions by central banks, an improvement in global macroeconomic data, a peak in interest rates, and/or an improved earnings outlook for smaller companies.

“The Fund is currently defensively positioned, including those companies with genuine pricing power and strong balance sheets. We continue to look to pivot into quality cyclicals and value cyclicals at opportune times,“ he said.

Mr Hudak said a constant theme coming through in most Australian small cap sectors is wage inflation, with the recent 5.75 per cent minimum wage decision – which applies to approximately 20 per cent of the workforce – yet to feed through.

“Australian wage growth has lagged the rest of the world given our more rigid regime, although recent government policies may facilitate greater power for trade unions and employees going forward. As a result, we are also seeing a surge in expectations for annual wage increases under enterprise bargaining agreements to be greater over the next 12 months.

“Rising wages will have a material impact on sectors such as healthcare and retail, where many companies have high labour components as a percentage of sales and minimal pricing power. When assessing these sectors in particular we have a preference for companies with a variable cost base and pricing power. In healthcare, for example, we prefer IVF providers with greater pricing power versus radiology providers which are constrained by the level of indexation.”

Matt Griffin, Co-Portfolio Manager for Australian Small Companies said AGM trading updates could see mixed results for the retail sector, as employment and consumer spending holds up better than expected, but are offset by cost of living pressures.

“In retail, our research and industry contacts indicate that performance is diverging by category. For example, apparel is fairly weak due to over-stocking and competition, while less discretionary goods such as auto parts are holding up relatively well. With foot traffic to many stores falling materially, the coming year will be a chance for the quality retailers to shine, as differentiation around product range, price points and customer service drives better sales results.

“Travel stocks have all materially de-rated over recent months, down around 30 per cent, on the expectation that cost of living pressures and the end of ‘revenge travel’ will most likely see travel spend fall in the next 12 months. Despite travel stocks materially de-rating over recent months, we are relatively positive on the sector for a few reasons. Firstly, leisure travel has proven to be extremely resilient in past downturns – provided people have jobs, they will take leave and travel. Secondly, increased airline capacity and falling airfares will draw more people back to longer haul flights, especially families. And finally, many Asian countries have been slow to recover from COVID lockdowns and this will be a tailwind in 2024.

“Our research suggests that travel has held up well in the first quarter of FY24 and forward bookings are strong, and we may see renewed interest in the sector with trading updates being better than feared,” he said.

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Phillip Hudak

Maple-Brown Abbott Australian Small Companies Co-Portfolio Managers Phillip Hudak and Matt Griffin believe the recent market pull-back makes the Australian small-cap sector increasingly attractive for longer-term investors.

With further recent market weakness, the team believes there is an attractive entry point at both the sector level and for a number of individual stocks.

Mr Hudak stated “Australian small cap companies are well positioned for a downturn: valuation metrics currently look attractive versus large caps, balance sheets are relatively strong with low debt levels, the majority of stocks in the benchmark are profitable, and many companies have cost levers that can be pulled.”

The team believes the poor sentiment for Australian small caps, as the market pays up for liquidity and earnings certainty, is typically a positive contrarian indicator for the asset class.

Mr Griffin stated “Our ‘earnings drive share prices’ philosophy means the team typically focuses on companies that have proven fundamentals and are in the right phase of the earnings cycle. This also means we systematically avoid select parts of the small cap market, namely where companies are ‘selling the dream’ as opposed to delivering growing, reliable earnings over the medium term.”

The team believes the approach of constructing a portfolio of undervalued holdings with idiosyncratic exposures is a reliable form of alpha generation. Since inception of the Maple-Brown Abbott Australian Small Companies Fund (the Fund) this approach has delivered significant outperformance versus the small ordinaries benchmark, with lower volatility than the benchmark.

The Fund has selected exposures to segments of the market experiencing medium term structural growth, including electric vehicles, biotechnology, travel and uranium.

The team believes uranium is a key commodity exposure to be involved in over the medium term. Two key reasons for this belief include growing acceptance of nuclear power as part of the future energy mix and increased term contracting activity, driven in part by increased supply shortages. The Fund’s exposure to the uranium sector is currently through Paladin and Boss Energy, both closely tied to the uranium price.

The Fund is currently underweight retailers but overweight in specific stocks with cyclical and structural tailwinds into the medium term such as travel and technology.

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Garth Rossler

A degree of complacency may see some investors surprised by potential features of the year ahead, including uncertainty around corporate earnings and elevated commodity prices continuing longer than expected, according to Maple-Brown Abbott.

Chief investment officer Garth Rossler said investors waiting for signs that monetary tightening had peaked to add to equity positions reflecting the successes of the past decade could be disappointed.

“What happens to corporate earnings is perhaps the biggest uncertainty facing investors in 2023,” he says. “Higher interest rates help to rein in inflation, but at least some of this will be achieved through reducing economic growth.

“At a market level, we see risks among the premium-rated growth and yield stocks where valuations have not yet fully adjusted to a higher interest rate environment.

“There has been little in the way of consensus earnings downgrades for Industrials in Australia, but we are starting to see some movement in the US. Of most interest is what is happening in the Tech sector, which enjoyed an extraordinary uplift in earnings during COVID, though those earnings have started to decline.

“Meanwhile, we see opportunities for investors in the energy and broader resources space over the medium term, albeit with the risk of shorter-term volatility given the uncertainties associated with the re-opening of China. Commodity prices remain elevated and we see potential for this to last longer than expected, with supply constrained by underinvestment and ongoing geopolitical turmoil.

“With the rapid rise in interest rates already observed, and the likelihood of further increases, we see opportunities in companies that benefit from this shift such as insurers and banks. We also see a number of opportunities in out-of-favour companies with depressed earnings or multiples,” Mr Rossler said.

On Australian small-caps, Phillip Hudak, co-portfolio manager of Australian Small Companies, says earnings sentiment is broadly in line with the long-term average, although there is potential for material earnings downgrades to come through over the next 12 months.

“For investors, this means a shift towards companies with predictable earnings or structural earnings growth that are less at risk of earnings downgrades in an economic slowdown.

“Australian small cap market valuations are now looking reasonable relative to long-term averages.

“However, investors need to be selective in the current environment. We see an opportunity for quality cyclicals over the course of 2023 as COVID beneficiaries fully unwind and cyclical earnings expectations are re-based with potential oversold share prices.”

Mr Hudak says Australia is better positioned than many other countries, with the impact on company earnings from higher interest rates and rising living costs likely to be delayed given the RBA has been later with initiating interest rate increases, and more measured in the speed of its approach, opting to see the flow through impacts to the real economy.

“Corporate balance sheets in the Australian small cap market are in good shape at this point in the cycle. In addition, the domestic consumer is in a better position relative to global peers given the still elevated savings rate.”

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Phillip Hudak

The impact of higher interest rates and the rising cost of living is yet to take full effect on the Australian sharemarket, meaning there is likely to be further downgrades on earnings expectations for certain sectors and stocks over the next 12 months, according to Phillip Hudak and Matt Griffin Co-Portfolio Managers, Australian Small Companies at Maple-Brown Abbott.

“We think we are early in the downgrade cycle for certain segments of the market.  It follows a pull back in earnings expectations for FY23 during the most recent reporting season,” says Mr Hudak

“The Australian market is at an interesting juncture, with the shift to the new “post-pandemic” normal well underway; however, the end point is still uncertain.

“In particular, the impact of higher interest rates and rising costs is yet to fully play out, and in this context Australia seems to be 6 to 12 months behind the rest of the world.

“The opportunity for investors is to find those companies with structural growth stories and industry tail winds that are well placed to withstand any future downturn, and we believe that active management will be key to this.”

Mr Hudak and Mr Griffin say there five key characteristics they are looking for in companies in the current environment: pricing power to offset cost inflation coming through; earnings certainty that are trading at reasonable valuations; exposure to industry tailwinds and structural growth stories; cost flexibility – in an environment where growth may slow; and mining services.

Mr Griffin says that some companies are struggling to pass on cost rises which has affected their share price. However, this is not consistent across the board and depends on the company and sector.

“We are therefore looking for companies that have pricing power or that are cost leaders.  Companies that can maintain margins and profitably should continue to perform well for investors.”

He pointed to the retail sector as a good example of the importance of active management.

“The retail sector has been holding up well but we believe this reflects the fact that most people still have a good savings buffer and haven’t started to cut spending.  As a result, the impact of the rising cost of living hasn’t yet flowed through.

“The lead up to the Christmas shopping period will therefore be crucial for the retail sector.  Inventory levels look elevated and continue to rise, as a result of concerns about supply chain risk which has led a number of retailers to order well in advance to have stock on hand.

“However purchasing decisions and forecasts may be based on last year’s Christmas sales which were very elevated.  This means there is a big risk if demand slow, as those retailers with a high inventory level will need to discount heavily which will hit margins and profitability.  We’re starting to see this in global markets already.

“As investors, we are therefore focusing on retailers with good cashflow models, very light inventory models, and scalability.”

Mr Hudak added that travel is a sector with industry tail winds.

“Travel – both leisure and corporate – is benefitting from significant tail winds as we exit the pandemic.  Europe and the US are both well advanced on this trajectory, however there is a lag in the recovery in Asia as lockdowns continue indefinitely in China.

“While the sector looks attractive over the next few years, there are risks to the recovery profile.  However, some companies have emerged from the pandemic much stronger than before and are recovering at a faster rate than the broader sector, and we see material upside to these.

“Overall, we see upside potential for those companies that have sustainable business models and strong medium-term earnings trajectories.  This is particularly crucial in the small cap end of the market, which has experienced a significant multiple de-rating so far this calendar year.

“The pullback, triggered by tightening financial conditions, elevated inflation and higher living costs, has been indiscriminate across many stocks which brings stock-picking to the fore,” says Mr Hudak.

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Sophia Rahmani

Maple-Brown Abbott has launched an Australian small companies fund following the appointment of Phillip Hudak and Matt Griffin to the boutique investment manager in April.

The Maple-Brown Abbott Australian Small Companies Fund is primarily invested in undervalued small companies where the investment team has conviction in medium-term earnings delivery and that are supported by sustainable business models. The fund typically holds 30–50 stocks which score well on combined earnings-based valuation and sustainability measures, with the focus on diversification and stock specific risk management. It aims to outperform the S&P/ASX Small Ordinaries (Total Return) Index, after fees, over a five-year period.

CEO and managing director Sophia Rahmani says the fund is based on the expertise, philosophy and investment approach of two experienced Australian small caps investors, who previously managed the AMP Capital Australian Emerging Companies strategy.

“Phillip and Matt have an impressive track record and a compelling earnings-based philosophy integrating a sustainability focus that we believe differentiates the strategy. They also have a proven and repeatable investment process, focused on in-depth fundamental research.

“Judging by the early market feedback, history of the team and capacity limits of small caps strategies, we expect this will be a popular offering for institutional and wholesale clients. The fund further diversifies Maple-Brown Abbott’s offering to investors, and we have seen early interest in a small caps strategy run as a boutique within Maple-Brown Abbott,” Ms Rahmani said.

Mr Hudak says he and co-portfolio manager Matt Griffin have worked diligently with the support of the broader Maple-Brown Abbott team to launch the fund within a relatively short period.

“Matt and I are passionate about finding undervalued Australian small companies with idiosyncratic exposures, and we are excited to be able to do what we love in our new home at Maple-Brown Abbott.

“The new fund is based on our existing strategy and core philosophy that earnings drive share prices rather than on any particular investment style. We consider the valuation and where the company is in the earnings cycle. We believe this combined with our focus on sustainability and avoiding short-term downgrades can deliver consistent returns,” Mr Hudak said.

Mr Griffin added it was an exciting time to be launching an Australian small caps fund given the current opportunities.

“The recent market volatility has presented more attractive entry points for companies with strong medium-term earnings expectations and sustainable business models,” Mr Griffin said.

“As part of the team’s research, we focus on non-consensus and proprietary insights and expect to hold over 1,000 company-related meetings per year, including management meetings, site visits, industry expert panels and ESG meetings. The team is highly aligned to client goals through a competitive remuneration framework and each team member having invested into the strategy.”

In just over 12 months, Maple-Brown Abbott has broadened its offering from three investment strategies – broad-cap Australian value equities, Asia-Pacific equities and global listed infrastructure – to five with global emerging markets and now Australian small companies.

“Being a privately owned boutique investment manager with a long history of strong client alignment and quality investment capabilities means that when we identify solutions that align with our strategy and our clients’ interests, we can add them relatively quickly and efficiently. We believe the launch of our Australian Small Companies Fund is a good example of this,” Ms Rahmani added.

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They were previously co-portfolio managers of the AMP Capital Australian Emerging Companies Fund for the past four years, and will bring their highly regarded investment philosophy and process to Maple-Brown Abbott. They will report to chief investment officer Garth Rossler.

Maple-Brown Abbott CEO Sophia Rahmani says that the lift-out is a key development in Maple-Brown Abbott’s long-term growth strategy.

“The opportunity to add this sought-after capability through the appointment of two highly experienced investment professionals is ideal for us.

“Our people and our platform allow us to efficiently add and support new investment teams, and we expect to launch an Australian small companies fund soon after Phillip and Matt start.

“Being a privately owned boutique investment manager with a long history of strong client alignment and quality investment capabilities means that when we identify solutions that align with our strategy and our clients’ interests, we can add them relatively quickly and efficiently.

“In the past 12 months, we have broadened our offering from three investment strategies – broad-cap Australian equities, Asia-Pacific equities and global listed infrastructure – to five, with global emerging markets and now Australian small companies. We continue to see institutional and adviser interest in actively managed, differentiated investment strategies,” she said.

Mr Rossler added that Mr Hudak and Mr Griffin are passionate and experienced investors who are culturally aligned with Maple-Brown Abbott.

“Phillip and Matt have a proven investment process with an earnings focus and market-leading sustainability framework, which they will continue at Maple-Brown Abbott.

“We look forward to engaging with the market with this quality offering.”

Both Mr Hudak and Mr Griffin have extensive Australian small cap equity portfolio management and fundamental stock research experience. The AMP Australian small caps strategy was launched in February 2013 and managed by Mr Hudak, then co-managed by Mr Hudak and Mr Griffin from March 2018 to March 2022.

Before AMP Capital, Mr Hudak was a small caps analyst at ING Investment Management and earlier worked as an analyst at MIR Investment Management and an investment consultant with Russell Investment Group. Mr Griffin was Investment Director at IFM Investors where he was integral to the launch of the IFM Australia small caps and micro caps strategy, and a small caps analyst at Macquarie Asset Management.

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