Australian Small Caps: "Dodge, duck, dive, dip and dodge"

Small Talk
"Dodge, duck, dive, dip and dodge"
by Marcus Burns, Senior Portfolio Manager, Australian Smaller Companies


“Just remember the five D’s of dodgeball; dodge, duck, dip, dive and dodge” - Patches O’Houlihan in Dodgeball: A True Underdog Story

The quote from Dodgeball pretty much sums up our feelings on the market at the moment. I could have quoted Shakespeare, Horace or Dickens but the raw simplicity of the message above captures it. September was a poor month for the Australian market and the small cap index wasn’t spared in the selloff. Surviving a market selloff is about ducking, diving and dodging and trying to keep a sense of where your true north is. If you needed any more glaring example of market sentiment in September you only had to look at the photographs of Jack Ma, Asia’s newly minted second richest man and founder of Alibaba, smiling at the camera with his thumbs up. Alibaba was the largest IPO in history and opened up a lazy 38% after reportedly waiting 2 hours for the first trade to occur … for lack of sellers.

Does anyone think we are in a lukewarm market? We are old enough now to have seen a few market cycles and lost money in some cases (and the pain of losing always teaches you more than winning). There are just too many bells ringing around us to be comfortable at the moment. A 7-year old company called ‘Rocket Internet’ (I kid you not) is about to IPO in London with a market cap of €6.2bn. It owns minority stakes in a bunch of fast follower internet companies which lost many hundreds of millions of Euros last year. I suppose it’s all in the name. ‘Damp Squib Internet’ hardly has the same allure of riches and would have struggled to garner the same investor enthusiasm. Of course, saying that the overall market is expensive is different to saying there is no value anywhere in the market but as we’ve remarked previously, it’s getting harder to find.

Rather than adumbrate the number of small bells ringing which cumulatively add up to market clangs to us, let me focus on what we are doing with your money to keep the boat righted, should there be a market correction. Investors in Schroder funds will know that we focus on mid cycle earnings and have a preference for good businesses that earn above average returns on capital. Whilst we are finding it more difficult to find value in the market, we are focussing on three ways to maintain a reasonable outcome for investors and keep our powder dry for potential opportunities. These are:

1. ensuring our investments earn good cashflows – a good mantra for most markets but essential in bad times; 
2. ensuring balance sheets are not overstretched and thus our investee companies are unlikely to be the ones doing emergency capital raisings at half the current share prices (Arrium anyone?); and 
3. adhering to valuation disciplines. We don’t consider holding a portfolio of good businesses but at super expensive valuations a good way to make or preserve wealth (you pay a high price for a cheery consensus). This has meant that we have sold some of our longer term holdings over the past few months on concerns that the businesses have been over priced and reflect more than a cheery consensus. 

Against our cautious intonations, the M&A market remains frothy as does IPO activity. These are the two areas we feel could continue to be potentially profitable for investors for a period. A number of our holdings have been or are in the process of being acquired. It seems like a reasonable bet to us that whilst interest rates remain low and management teams remain confident that this trend has some distance to run. We should add that owning a stock purely as a takeover candidate does not form part of our mantra but it’s a nice side angle and one that is likely to continue to catalyse value for our investors over the course of the next year.

The other end of the spectrum is the IPO market. We would have made more money over the past 6 months blindly shutting our eyes, holding our noses and wading in deep to every IPO opportunity presented to us. But you need to have a process and back it and ours has been to be fussy about IPO’s. The IPO’s we have participated in have on balance been very profitable for our investors but the rules are changing. It now feels to us like everyone is trying to game everyone else. The vendors and bankers are trying to game us (the institutional investors), while investors are trying to game other investors – hoping that they will be able to shift on their IPO stock at even higher prices to the next patsy down the line.

Normally there is some pretence around the IPO process with management teams solemnly laying out well thought out and vaguely plausible growth plans. More recently however, even the veneer of sincerity has peeled off. Normal questions around business duration risk, management quality and experience, regulatory risk and sustainable margin structures for instance have been tossed out the window in favour of who can game the next person down the line and shift the stock on at a profit. Second guessing how other investors are going to react is aptly called ‘the greater fool theory’. It’s fine whilst greater fools exist but when they don’t it’s you who is caught holding the over-valued IPO scrip in a business you ought to have known better about. Playing in this arena is candidly moving from the rational to the irrational and going from something we know something about – business evaluation – to something we don’t – the fickleness of human psychology.

Outlook
The correction to world markets in September had no obvious catalysts. Equity market valuations are broadly at the upper ends of their ranges and this makes the asset class more vulnerable to profit taking. Against the backdrop of extremely low interest rates and investors’ impatience to earn returns on capital it doesn’t seem obvious that markets will fall a great deal given the limited alternatives. The prolonged period of low interest rates however is beginning to create other mischiefs – property bubbles, junk bond rallies and other risk taking behaviour that may have poor long term consequences unless central banks dream up other creative ways to save investors from themselves. Such an environment continues to warrant a degree of caution and our focus on cashflow and valuation disciplines should ensure reasonable outcomes for our investors.

Disclaimer
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. For security purposes telephone calls may be tape