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Australian small caps offer 'great' alpha potential, say experts

6 minute read

As the outlook for small-cap stocks appears more hopeful, two experts have emphasised Australian small caps as excellent sources of alpha generation.

Australian small caps are more domestically focused and can be more insulated from global geopolitical events, Mike Younger and Richard Ivers, co-portfolio managers of the Prime Value Emerging Opportunities Fund, said on a recent episode of the InvestorDaily podcast.

Overall, small caps tend to underperform large caps leading into economic downturns but outperform coming out of them, the pair explained, adding that the global financial crisis and COVID are recent examples where small caps saw significant recovery post-downturn.

“What we're seeing at the moment is the economy is slowing. We don't know exactly when the economy is going to bottom, but what history tells us is that equity markets look ahead of that and move ahead of that,” Younger said.

“And whether or not the relative outperformance in small caps we've seen in the last few months is the beginning of that next cycle, we're not exactly sure, but we can see that looking forward the projections are that while small caps have underperformed large cap in terms of price and also in terms of earnings, the next couple of years, the expectations are you're going to see much stronger small cap earnings growth, which will then drive the share prices.”

The pair are quite sympathetic towards Australian small caps, noting that given Aussie small caps are more vulnerable to domestic issues than those taking place on a broader international stage, they can be “great for generating alpha”.

They do, however, come with their own risks.

“You’ve got this great alpha opportunity, but you've also got the high risk that comes with it,” Ivers said.

“Where we play is we play in the lower risk area of small caps, which means that we're still playing the space where you have the strong alpha opportunity, but we're playing the lower risk part of that alpha opportunity, which we would call the sweet spot.”

To circumvent the perils that may be encountered in small caps, Prime Value avoids mining and other high-risk areas, alongside taking a risk-focused approach to portfolio construction. Namely, the boutique fund manager constructs portfolios with big weightings in lower risk, more certain outcome stocks, thereby reducing the risk profile and enabling more consistent returns.

“We remove mining, for example. Mining in the small cap space can be very risky. You know, there's a lot of exploration companies and the like. And we also don't play a lot of the other higher risk parts of the industrials part of small caps, and we rarely invest in loss making companies. So that’s the stock picking part, it’s very much risk mitigation,” Ivers said.

“Our big weightings tend to be the lower risk, more certain outcome type stocks, which also reduces the risk profile of the fund and actually enables you to generate more consistent returns over time, because your stock attribution is more even across the portfolio.”

Regarding preferred stocks, the pair highlighted News Corporation, which has a market valuation of over $20 billion but is considered a small cap in Australia because a majority of its trading volume occurs in the US market.

“The actual free float available in Australia is quite low. So, it's only actually a moderately sized small cap company,” Younger explained.

He elaborated that despite being known for newspapers, which are less than 10 per cent of its earnings, News Corps real value lies in realestate.com.au and Dow Jones.

“When we break it down, about a third of the company's earnings is coming from realestate.com.au. But that accounts for nearly two-thirds of the company's valuation. And so realestate.com.au is listed. We can see the value of that business traded every day. And if we just do a simple exercise to remove realestate.com.au from News Corp's valuation and from its earnings, then there's a very strong discount being applied to the rest of the business,” Younger said.

“And so if we look at Dow Jones, HarperCollins, Foxtel and the newspaper assets, in aggregate, when we compare those businesses to their international peer groups, in aggregate, they trade at about a 55 per cent valuation discount. And so that's where we favour News Corp because there's a very high margin of safety there.

“With any investment, things can go wrong, but there's a very high margin of safety there, because outside of realestate.com.au, the rest of that business is being valued very cheaply. And that's what really attracts us to the business. And we do think that there will be catalysts in the coming years to close that gap.”

Additionally, Equity Trustees is one of Prime Value’s largest holdings. It's been around since 1888, giving confidence in the durability of its earnings.

Moreover, Ivers explained the business is currently experiencing strong organic growth and synergies from a recent acquisition.

“The earnings synergies and accretion that's coming through from that is driving accelerating earnings growth and return on capital. So, when you combine a really high-quality earnings stream with accelerating earnings growth and return on capital, it makes a really attractive proposition,” he said.

“And despite that, the PE multiple of the business has been falling away up until the last couple of months, where it feels like the market is now starting to get a good handle on it and it's starting to re rate. But that's a business that trades below market multiples, and we would consider much higher quality than your average small industrial. So, it's one that we really like.”

To hear more from Younger and Ivers, click here.

Maja Garaca Djurdjevic

Maja Garaca Djurdjevic

Maja's career in journalism spans well over a decade across finance, business and politics. Now an experienced editor and reporter across all elements of the financial services sector, prior to joining Momentum Media, Maja reported for several established news outlets in Southeast Europe, scrutinising key processes in post-conflict societies.