In this video insight, David Buckland and Gary Rollo discuss the underperformance of small-cap stocks compared to large-cap stocks since the beginning of 2022. Gary explains that economic uncertainty has contributed to the recent underperformance, as investors tend to shift from small, less liquid investments to larger ones during such periods. However, he views this as a temporary condition, anticipating that once economic uncertainty diminishes, the longer-term performance characteristics of small caps may come into play.

Gary elaborates on a specific company, using Alliance Airlines (ASX:AQZ) as an example of a stock with strong fundamentals despite a 30 per cent decline in share price since 2022. This is evident through the valuation disconnect compared to historical norms, enhanced business fundamentals resulting from acquisitions during the aviation downturn, improved earnings visibility, and the market’s failure to fully recognize the earnings potential of new assets in AQZ’s portfolio.

Transcript:

David:

Hello, I’m David Buckland, and welcome to this week’s video insight.

Today, I’m being accompanied by Gary Rollo, portfolio manager for the Montgomery Small Companies Fund. Gary, in the last couple of years, the small cap stocks have underperformed the big cap stocks quite significantly. What’s your thesis around this?

Gary:

Thank you David, well yeah you’re right, smalls have underperformed the broader market, considerably since the start of 2022.

Big caps are up about four per cent at this time while smalls are down about 20 per cent. As economic uncertainty arrives, small caps do tend to underperform big caps as investors move money out of small, less liquid investments into more larger ones.

Now that’s what we’ve seen, but those conditions, they don’t last forever and, once that economic uncertainty recedes, the longer-term performance characteristics play out. And this is the backdrop for smalls that we see today. And we see this as a very interesting setup, so the underperformance that’s been driven by macroeconomic factors, stock prices are not following fundamentals of the company, and we’re seeing valuations compressed. And we think it’s a stock picker’s market out there.

David:

Thanks Gary, as Ben Graham once said, “in the short term, the market often acts like a voting machine, but in the long term, it reflects much more a weighing machine.”

Gary:

Well, I think in the very short term, I’d say it’s like a washing machine.

David:

Gary, given that underperformance in the last or since the beginning of 2022, there must be many stocks which are exactly, exemplified by that voting machine versus weighing machine contrast where their fundamentals are actually doing very well. But the share price is doing relatively less well. Did you want to name one or two stocks or just walk us through those fundamentals?

Gary:

Sure, there are a number of examples out there, but let’s pick on just one, Alliance Airlines (ASX:AQZ).

AQZ shares are down over 30 per cent since the beginning of 2022, yet the business fundamentals, the thing that counts in the long run, they’ve just gotten stronger and stronger since then. So, let’s break this down a little first, let’s look at the valuation setup. Historically, AQZ is a business that the stock market has valued at around five times forward looking earnings before interest, taxes, depreciation, and amortisation (EBITDA).

Today, on fiscal 2024, its next EBITDA print, it’s trading on four times EBITDA. And if I look out into fiscal 25 and fiscal 26 and take into consideration consensus expectations. That falls to three and a half and three times.

That’s cheap. So, there’s that valuation disconnect versus history.

Second, let’s consider the fundamentals of the business.

AQZ has a lot more growth today than those businesses had historically. That’s because it acquired aircraft, during the aviation downturn that accompanied COVID, and now those aircraft are being put to work. The outcome of that is a significant contract that AQZ has with Qantas, and that’s going to deliver material earnings to AQZ.

And, we think over time, the extra aircraft they bought will more than double the earnings pool in AQZ. You don’t see that type of earnings uplift happen in markets every day. So that’s the second thing.

Fundamentals are much stronger now than they were, and there is much better earnings visibility now too. That contract is a multiyear contract, up to seven years, and so that’s visibility that we haven’t had in the past. Normally higher growth and better earnings visibility is something that the market likes to pay out for.

And, instead, we’ve seen a significant de rating event rather than the positive rerating that we think should have happened to the shares. So that’s that valuation disconnect versus the fundamentals that we look for.

And, lastly, earnings on these new assets that have come into AQZ’s portfolio have yet to be fully seen by the market.

The last results that we saw from AQZ was the second half 2023 period in August, and they were much stronger than the market expected, and we saw some consensus earnings estimate upgrades. We think there’s more to come in that regard, we think AQZ is at the beginning of its earnings upgrade cycle and that the market hasn’t fully understood the earnings power of all these new aircraft going to work. So that’s an attractive combination in our view, and that’s why we hold AQZ in the fund.

The Montgomery Small Companies Fund owns shares in Alliance Airlines. This video was prepared 10 November 2023 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade in Alliance Airlines, you should seek financial advice.