‘Terrible’ sentiment creates small-cap share market bargains

Rising interest rates and looming tax changes have crushed sentiment towards Australian small-cap stocks, creating potential opportunities for investors prepared to bet against the market’s retreat into banks, miners and other dividend-paying blue chips

The S&P/ASX small ordinaries index has tumbled 11 per cent this year, compared with a one per cent gain for the benchmark S&P/ASX 200, as investors abandon smaller growth companies in favour of larger businesses offering income and perceived safety.

The ballooning disparity has left parts of the small-cap market looking unusually cheap, while Australia’s major banks remain overvalued and vulnerable to further falls, according to Regal Funds Management investment director Charlie Aitken.

‘Sentiment is terrible’

“Sentiment is terrible in Australian small caps, price action has been similarly weak, but value and growth are abundantly available,” Mr Aitken said.

The massive underperformance of smaller companies has been blamed on the Labor Government’s capital gains tax changes, which will lift effective tax rates for share market investors to between 30 per cent and 47 per cent.

Smaller companies typically offer a greater proportion of their returns through capital growth rather than dividends, though they also expose investors to larger potential losses.

The proposed tax changes have encouraged some investors to seek dividend income from larger companies, where returns may be less reliant on capital gains.

The Reserve Bank’s three interest rate increases so far this year - taking the cash rate to its equal-highest level since 2011 - have also encouraged investors to favour cash, fixed income and dividend-paying stocks over riskier growth assets.

Data from exchange-traded fund giant Betashares, shows retail investors more than doubled the amount of cash they funnelled into low-risk income-focused strategies from $494 million in May to $1 billion in June.

Rates and earning wobbles

Dean Fergie a small-cap investment specialist and Cyan Asset Management founder and small-cap specialist Dean Fergie said the sector’s poor performance reflected more than tax changes and higher borrowing costs.

“There’s also been a lot of volatility in commodity prices which doesn’t help,” he said.

“Investors I know are also unsure about which way interest rates are going next - up or down. There’s also some trepidation about August and earnings season, people are worried smaller companies’ (profit) forecasts might not be where they want as the economy isn’t great.”

The sell-off has swept through gold and lithium miners or explorers, which are particularly exposed to sharp swings in commodity prices.

Technology and software stocks have also been dumped as investors weigh the threat posed by artificial intelligence and the impact of higher discount rates — in stock valuation models — on the value of future earnings.

Mr Fergie pointed to traffic enforcement technology company Acusensus, whose shares have fallen about 50 per cent over the past six months despite the company announcing several large contracts.

“We think there’s been some serious sell offs in businesses that should be going really well, so of course it brings opportunities,” he said. “But perhaps people are also becoming more conservative, the decline in speculative assets like Bitcoin could be a reflection of that.”

Drive in a different lane

According to Regal’s high-profile investment boss Charlie Aitken, the rush into blue-chip and dividend stocks is a mistake.

The Sydney-based hedge fund and investment group, which is one of Australia’s fastest growing and largest, consistently tells investors to “drive in a different lane” to beat the market.

That means reducing exposure to bank stocks, which make up around 24 per cent of the S&P/ASX 200, according to Mr Aitken.

“I can’t stress enough how cautious I am on Australian banks,” he said.

“While bank equity has de-rated a little this year, it remains expensive on any traditional value of bank equity, and that’s also assuming that current consensus earnings forecasts are accurate. Credit growth has stalled, bad and doubtful debts are rising, net interest margins are falling and competition is intensifying.”

The investment boss also blamed the Australian Prudential Regulation Authority’s Your Future, Your Super performance tests for encouraging large superannuation funds to remain close to their benchmarks by favouring large index stocks and avoiding smaller companies.

Under APRA’s rules, superannuation funds that persistently underperform their benchmark may be restricted from accepting new members.

“That basically means the current Australian bank valuation premiums are a function of regulatory and passive flow dynamics, not fundamentals, which I continue to think is a dangerous set up,” Mr Aitken said.

Regal estimates Australian small caps in the ASX small ordinaries currently trade on average profit multiples of 16.4 times, with earnings forecast to grow 32.9 per cent on average.

This is significantly cheaper than the average profit multiple of 17.5 times for forecast average earnings growth of 19.2 per cent for the larger S&P/ASX 200 Index.