Looking at the economic backdrop over the last 18 months, DNR Capital has observed that small caps significantly underperformed compared to large caps.
But now, valuations are pulling back and a significant number of high-quality companies are being de-rated, according to Sam Twidale, portfolio manager of the DNR Capital Australian Emerging Companies Fund.
As such, the firm has announced its strategic pivot within the small caps space, moving from a defensive bias to embracing more positive positions in this segment of the market.
“But we still need to be selective,” Mr Twidale warned, maintaining that investors should “look closely at what’s under the surface of the market as there are still some areas of overvaluation and speculative activity”.
He said defensive companies fall into this category, which continue to have high valuations as investors flock to the sector to manage recessionary risks and concerns around slowing economic growth.
“However, it is the earnings’ downgrades which is the main catalyst for us to turn more positive. Those downgrades are now coming through.”
“As valuations pull back, there are new opportunities to buy companies on much more realistic valuations and more conservative earnings expectations. This is quite a change from the price for perfection scenario 18 months ago,” Mr Twidale explained.
He added that any apprehension surrounding high-quality businesses continues to cause dislocations between price and value, particularly impacting the consumer discretionary sector.
“That’s now our largest overweight. It’s a more contrarian positioning but I think investors will be rewarded taking a longer-term view for many stocks in this sector.”
According to Mr Twidale, DNR Capital has strategically sought companies that are well-managed with strong balance sheets to get through any short-term market volatility, noting that “they’re not out of the woods yet”.
However, he was optimistic that they will emerge on the other side of this cycle in a stronger position, presenting an opportunity for long-term investors.
“On the other hand, we have been actively reducing our exposure to the mining sector. That’s been a key overweight for us for several years now. But I think conditions have changed and we are not seeing the contrarian opportunities and the mispricings that we saw several years ago.”
As such, Mr Twidale said the Emerging Companies Fund is now back in some of the companies that it sold several years ago, now with a focus on de-rated quality opportunities in consumer discretionary, financials, industrials, and tech sectors.
“For investors willing to look through short-term uncertainty, the small cap sector is now presenting great opportunities to take advantage of,” he concluded.
