Home / Small caps / Downgrades and dislocations: Reporting season creates opportunity in small caps

With reporting season already revealing earnings misses, valuation pullbacks are creating opportunities in high-quality small caps, according to DNR Capital's Sam Twidale. Investors should look through short-term risk and select from sectors where fear and uncertainty prompt mispricings.

After a period of underperformance, the outlook for Australian small caps is looking brighter in the second half of 2023, as earnings downgrades lead to more realistic valuations and exploitable market dislocations. But investors seeking quality still need to be selective, according to DNR Capital.

For the past 18 months, small caps significantly underperformed large caps, Sam Twidale, portfolio manager for the DNR Capital Australian Emerging Companies Fund, said in a recent market update. But valuations are now pulling back, causing a number of high-quality businesses to undergo “quite a derate” and creating a new opportunity set.

“We are changing our view of the sector and moving from a defensive bias to embracing more positive positions in this segment of the market,” Twidale said. “For investors willing to look through short-term uncertainty, the small-cap sector is now presenting great opportunities to take advantage of.”

The catalyst for the improved outlook has been a volatile start to reporting season, he said, as earnings downgrades help bring valuations back down to earth. The small-cap sector – companies with between a few hundred million and $2 billion in market capitalisation – is more inefficient than larger-cap sectors, creating more opportunities from mispricing.

“As valuations pull back, there are new opportunities to buy companies on much more realistic valuations and more conservative earnings expectations,” Twidale said. “This is quite a change from the price-for-perfection scenario 18 months ago.”

According to Twidale, opportunities are likely to arise in high-quality small-cap businesses in sectors where fear and uncertainty are causing dislocations between price and value. “For us, this shows up as a concern around the economy, especially impacting the consumer discretionary sector,” which is now the fund’s largest overweight, he said.

“It’s a more contrarian positioning, but I think investors will be rewarded taking a longer-term view for many stocks in this sector.”

Select opportunities emerging

Looking through short-term risks will help investors identify long-term opportunity in quality small caps. Twidale pointed to DNR Capital’s recent investments in Breville Group and Lovisa, industry-leading and high-quality companies that generate high returns.

“These companies are well managed with strong balance sheets to get through a bit of a trickier period in the short term,” he said. “They’re not out the woods yet. However, we think they will emerge on the other side of this cycle in a really strong position.”

A less attractive exposure at the moment is the mining sector, where “conditions have changed and we are not seeing the contrarian opportunities and the mispricings” that created opportunities several years ago, he added.

The Emerging Companies Fund – an actively managed strategy offering exposure to a concentrated portfolio of high-quality Australian small-cap listed equities – has identified derated quality opportunities in sectors including consumer discretionary, financials, industrials and technology. It has also reinvested in some companies it previously exited that have since derated, Twidale said.

But as even falling tides may not sink all ships, investors still need to be selective and avoid stocks with still-inflated valuations. For example, Twidale noted, investors have been pouring money into defensive stocks in the face of recessionary risks and concerns over slowing economic growth, inflating prices in that sector.

“Investors need to look closely at what’s under the surface of the market as there are still some areas of overvaluation and speculative activity.”