As we enter reporting season, I thought it would be timely to take a moment and review four key sectors of the small companies market that will no doubt be front of mind for many investors.

At a macro level we continue to see speculation around the trajectory of inflation, the potentially varied responses from central banks, mortgage rate cliffs, and the impact all of this has on economies and consumers. Recently, the base case of a recession in the U.S. appears to have shifted towards a potential soft-landing scenario whereby interest rates are sufficiently restrictive to bring down inflation back to the 2-3 per cent target range without breaking the economy. The stock market rally we have seen certainly suggests that investors haven’t been positioned for this potential outcome. 

With this ever-changing backdrop in mind, let’s take a moment to reflect upon some of the risks and potential opportunities we see in different parts of the market as we enter reporting season.

Retail

In the small cap part of the market, you see very few consumer staple stocks, these are generally found in large cap land. Small cap retailers largely consist of pure retailers that derive their earnings predominately from the discretionary component of people’s spending, which is generally influenced by the economic cycle. Media stocks also tend to get thrown into the consumer discretionary bucket given their heavy reliance on advertising spend which is highly economically sensitive.  

We have already seen a range of profit warnings and earnings downgrades for consumer discretionary stocks hit the market over June and July. The likes of groups like Best & Less who recently provided a trading update from May to mid-June sighting that same store sales had fallen by 13.2 per cent over the reported 5-week period.

We have also seen recent comments from Gerry Harvey discussing the slowdown in earnings as they see consumer spending slowing. In a mid-June market update they advised that they expected a fall in net profit of between 40-45 per cent as compared to the same period last year. 

A key headwind for retailers and consumer discretionary more broadly is higher interest rates and cost of living pressures which are starting to hit household budgets. Furthermore, retailers will be cycling a very strong comparative period this reporting season, a time that reflected the reopening after COVID lockdowns and benefiting from stimulus and high household savings.

Additionally, retailers are facing higher costs of doing business driven by a material step-up in award wages, rising rents and rising power bills. Whilst lower inbound freight costs will help gross margins, they will likely not be enough to offset significant operating deleverage over the near-term. 

We remain cautious on the retail sector in general given negative earnings surprise risks, however the sector could become more interesting on a decent pullback. We prefer the retailers with a global growth story where investor sentiment has likely been way too bearish.

The outlook for media stocks also looks tough given the potential domestic economic slowdown and the high fixed cost nature of traditional media businesses.

REITS

Real Estate Investment Trusts (REITs) are another battleground sector for small cap investors.

At a macro level the headwinds facing REITs are well known. Businesses continue to work to find the balance between maintaining corporate culture, sharing of ideas, and productivity while trying to manage employee demands and expectations around broader work location flexibility.

Tenants are facing the prospect of increasing rents (inflation driven) and energy costs associated with their properties while still struggling to determine their floor space needs given the fluid style of some workforces. This issue is particularly challenging for CBD office space globally, as we are seeing vacancy rates slowing increasing as many companies are opting for less floor space and more flexible working arrangements.

Couple this trend from a landlord’s perspective where the fall in occupancy is being met with the impact of increased costs of borrowing (where the property or REIT is leveraged). Further to the increase in borrowing, this same increase in interest rates is now affecting the discount rate that has been used to value these assets, its fall over the last 5 years has seen valuations soar, which is now starting to unwind given the material increase in interest rates.

So, we are seeing falling valuations being met with increasing interest costs and vacancy rates. This is generally not considered a recipe for success in the REIT market.  

However, not all is lost with REITs when you consider the resilience in residential property valuations and demand. The chronic and structural under supply of housing has set a scenario where demand for all forms of residential shelter be it single dwellings or apartments is far outstripping supply. This has placed resilience in housing valuations and has also fuelled a recent rally is U.S. Building Materials companies and home builders.

Although at a high level we remain cautious of this sector, share prices have fallen materially to reflect the above-mentioned risks. This will make REITs an interesting sector to follow over this reporting season.

While we remain underweight, we will watch this part of the market with great interest.

Resources

One could argue no matter what point we are at in any economic cycle the resource sector is always an action-packed place to be. We have had a very interesting year unfold in the resource sector. For the first time in sometime the extreme movements in some commodity prices have not been fully reflected in the share prices of those companies.

At a headline level we have seen Resource stocks being heavily bid up on continued expectations of Chinese Stimulus. Chinese authorities have hinted at more stimulus being delivered but at this stage there is very little specific detail on the matter.

If we take look at some of the commodities that make up this sector, we have had some interesting results.

Starting with what was likely the most topical sector over the year in Lithium. In November 2022 we saw a peak in the price of Spodumene Concentrate delivered to China on the Shanghai metals exchange of USD$S6,100. Over the ensuing period to June 30, we saw this price fall to an average of USD$4030 representing a 34 per cent drop in the commodity price.  

Over the same period, we only saw share prices across the sector move on average around 10 per cent. The resilience of the share prices of these companies was surprising particularly given the underlying volatility of the commodity price.

Alternatively, Copper has generally been weaker over the last 12 months with the price peaking back in January and effectively from there the price has moved sideways or down. Off the back of this and the continued debate on where the economy will land, we have seen this part of the resource sector underperform. Which from our perspective makes it very interesting.

We are all aware of the growth of Electric Vehicles (EV) globally and Copper is a key commodity in their construction, yet the market tends to still consider it an industrial metal rather than part of the EV thematic. For this season we think it is an interesting commodity to have exposure to in a portfolio.

Finally switching to gold stocks which have materially underperformed their peers in the resource sector. Like many resource companies they have had production challenges mainly linked to labour costs and availability. This has seen them miss production expectations at times and be harshly punished by the market.

The headline price of gold has also been weak relative to the performance of other metals. This is in part because an environment of changing inflation and fast-moving interest rates are generally not conducive to the price of Gold. It generally performs better in periods where inflation is more consistent, predicable, and steady (but still increasing).

Also given the weakness in the Australian dollar local gold producers with a reasonable cost of extraction are rather interesting given the strong cashflows they can generate.

Technology

To finish I would like to touch on the Technology sector. For us this is made up of names like Macquarie Technology Group (ASX:MAQ), Megaport (ASX:MP1) and Technology One (ASX:TNE) (plus many more). For the first three quarters of the past Financial Year tech stocks were under pressure.

The market felt that they would continue to burn cash (not in all cases) while they were on a journey to a brighter future. The market didn’t believe it would see earnings improve any time soon so many investors walked away from these names.

Furthermore, in the event these companies didn’t hit the earnings expectations the market had for them, or they had a miss below the line with their costs they were further punished and shown little mercy.

Then from the beginning of the year we saw global tech leaders lay down the play book. Firstly, they would look to manage some of the excess costs that were linked to more speculative long term growth ideas (as opposed to trying to grow any way they could at any cost). They want to keep the optionality for growth there but just push it out a little further into the future.

This cost management then allowed them to address their bottom line much sooner and, in many cases, beat market expectations. As this playbook has unfolded since January we have seen the top global tech companies rally significantly dragging much of the market up with them.

Having watched this unfold, their smaller cousins here in Australia (and all over the world), have looked to make the same changes to their business processes and priorities, putting cashflow management and shareholder returns ahead of the grow at all costs mentality we have previously seen.

We have seen this firsthand in the last quarter in a stock like Megaport, which has moved off its recent lows of around $4.00 back in April to today where the share price is well over $9.00 and even trading into the low $10.00 range.

This sector would still be our largest exposure in the fund in aggregate, and we have maintained this position due to the exceptional growth prospects these companies provide. Also given the share price performance of many of them over the last 12 months we have also seen exceptional value being made available to investors who were prepared to jump in and stay the course with these types of companies.

The Montgomery Small Companies Fund own shares in Macquarie Technology Group, Megaport and Technology One. This article was prepared 04 August 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 these companies you should seek financial advice.