SGH Australian Small Companies Fund update with portfolio manager Shawn Lee

Shawn Lee: SGH Australian Small Companies Fund Update

18th Oct 2024

SGH Australian Small Companies Fund Performance*

The SGH Australian Small Companies Fund outperformed the benchmark by 2.5% net of fees over the September quarter. The fund delivered net returns of 9%, outperforming the Small Ordinaries Accumulation Index, which delivered returns of 6.5%.

Many of you have heard us discuss our barbell approach to portfolio construction, where we balance high-quality, high-growth stocks on one end of our barbell with more mature, defensive companies on the other end. The September quarter actually saw both ends of this barbell perform very well.

On the high-growth side, we saw a resurgence in market risk appetite, driven mainly by a larger-than-expected 50-basis-point cut in U.S. cash rates. This benefited our holdings in this category, such as Pro Medicus, which reported a strong set of results for the fiscal 2024 year and a robust pipeline of future potential contract wins. Other stocks in this group, like Hub24 and Pinnacle Investment Management, also performed well in a positive market and inflow environment, benefiting from high fixed costs and strong operating leverage when conditions align.

On the other end of the spectrum, our more mature and defensive holdings also performed well over the September quarter. There has been a broadening in the market, benefiting underpriced stocks and those offering defensive attributes. One standout is the New Zealand Stock Exchange, a long-term holding that is now being recognized for its upside potential in the emerging wealth business. This business has been growing revenue for years and is now approaching the free cash flow break-even point—a milestone closely watched by market participants.

Two other companies in this more mature category, Centuria Capital and residential developer Cedar Woods Properties, also performed well in the September quarter. The potential for future interest rate cuts is boosting transactional activity, combined with low starting valuations, resulting in mean reversion that has benefited these names.

Current Opportunities

We see clear opportunities in REITs. Some of the headwinds that have challenged this sector, particularly rapidly rising interest rates and increased borrowing costs, are beginning to subside and, in some cases, may soon turn into tailwinds.

The REIT sector faced significant challenges, as rising interest rates reduced free cash flows and, in some cases, led to cuts in distributions. In the most recent reporting season, however, many REITs reset their effective interest costs to current market rates, which could reduce future headwinds for distribution growth.

Additionally, cap rate expansion appears to be peaking, signaling a potential trough in asset values. Increased property transaction activity, along with potential future interest rate cuts, also adds positivity to the REIT outlook. As a result, we’ve moved from a slightly underweight to a slightly overweight position in REITs.

Outlook

While we are generally optimistic about the market outlook, we continue to monitor risks. One primary risk is the potential for an economic slowdown sharper than what the market currently prices in. Though this isn’t our base case, traditional economic indicators are weakening, with labour markets softening as well.

Additionally, rising tensions in the Middle East present another risk we closely monitor, as does the potential for policy destabilization tied to the upcoming U.S. elections in November, particularly regarding tariffs.

These risks have some offsets, such as recent stimulatory actions from China and central banks globally beginning to exercise their “put options” in terms of monetary policy. However, the combination of these factors is likely to contribute to ongoing market volatility. As a result, we maintain a balanced barbell approach to portfolio construction, ensuring sufficient portfolio insurance and capital preservation should a downturn occur.

Outlook for Small Companies

Returns for small companies have significantly lagged behind large caps, particularly over the last three years. In fact, over the past three years, the Small Ordinaries Index has underperformed the ASX 100 by more than 30% cumulatively. However, we believe we are approaching an inflection point, and the outlook for small companies is brightening.

There are three main reasons for this optimism.

First, interest rates appear to have peaked globally, and with the onset of an easing cycle, we believe this is likely to benefit small caps more than large caps. Small caps are often better positioned to capture the stimulatory effects of a cutting cycle due to their smaller size and agility. Additionally, small companies typically carry lower levels of fixed debt, meaning their interest expenses decrease more rapidly as rates fall.

The second reason for optimism is the evidence of market broadening. In recent months, we’ve seen the Russell 2000 in the U.S. (a proxy for small companies) outperform the broader cap index. Similarly, in September, small caps in Australia significantly outperformed the ASX 200 benchmark. We expect to see a similar broadening in the domestic market here, with mean reversion in relative performance as small caps start to fill the liquidity vacuum that has persisted over the past two or three years.

Finally, IPOs and secondary market activity indicate positive sentiment. Although the IPO market remains soft with limited transactions, we’ve seen a resurgence in secondary market activity over the past 8 to 10 weeks. Boards are more willing to greenlight transactions, and companies are increasingly tapping equity markets for secondary capital. Most of these deals have been well-supported by the market and have led to strong aftermarket trading, suggesting additional liquidity may return to the small-cap space, helping close the performance gap.

CLICK HERE TO FIND OUT MORE ABOUT THE FUND.

*The text has been edited for clarity.


The document contains general information only. Reference to either individual securities or other investments should not be considered as investment advice. We strongly encourage you to obtain professional advice before making an investment in securities that have been mentioned. Documents you should consider prior to making an investment could include the relevant Product Disclosure Statement and the accompanying Target Market Determination. If you would like further information on financial products that SG Hiscock & Company Ltd (AFSL 240679) is the investment manager for, contact the Client Services team on 1300 133 451, visit the website www.sghiscock.com.au or contact your financial adviser.  Any investment is subject to risk, including possible loss of income or capital invested.