By David Rogers
QVG Capital co-founder Tony Waters sees a better year ahead for small to mid-sized company investing as inflation peaks, but prefers defensive growth companies as inflation is expected to stay relatively high and most of the impact of aggressive interest rates is yet to be felt.
Small-mid market cap stocks were out of favour last year as rate hikes caused an exodus of investors from the less-liquid end of the market. Sectors dominated by large cap companies – financials, materials and energy – got much of the attention.
The small-mid cap exodus was magnified by the fact that fund managers had flocked to smaller stocks in search of outperformance in recent years. But liquidity became more of a priority in 2022 as central banks lifted rates from record lows and some began quantitative tightening.
Banks and resources enjoyed tailwinds from surging net interest margins and booming commodities.
The Small Ordinaries index fell 9.3 per cent in the year to February, but the ASX 100 rose 6.9 per cent. In the past two years, the Small Ords fell 4.5 per cent and the ASX 200 rose 17.7 per cent.
“For the last 12 months there’s been two macroeconomic reasons for large caps to outperform,” Waters says. “When it comes to small-mid caps, the space is filled with what you’d call long-duration growth-type stocks, so the past 12 months have not been great for them.”
But after a resurgence in value stocks in 2022, a flatter trajectory for inflation, interest rates and commodities is leading investors to refocus on growth stocks for sustainable earnings potential, particularly as still-high inflation shows the importance of strong nominal returns.
Large caps pushed the ASX 200 Energy sector up 49 per cent in 2022 as Woodside Energy surged 52 per cent. Materials rose 145 per cent, with BHP up 24 per cent.
Value jumped 15 per cent, tech dived 32.7 per cent and growth lost 27.5 per cent.
But while the ASX 200 rose 7.4 per cent in January-February, energy fell 7.7 per cent and materials fell 10.7 per cent. Tech rose 2.1 per cent, growth rose 2.2 per cent and cyclicals rose 4.8 per cent.
Waters and co-founder Chris Prunty are in their sixth year at QVG Capital.
QVG also invests pro bono for Future Generation Australia, the country’s first listed investment company to provide both investment and social returns.
For seven years before QVG, Waters and Prunty ran the successful Ausbil Micro Cap Fund.
They have delivered returns almost three times above the market over the past 13 years.
QVG runs a concentrated long-only fund and a long-short fund, mainly in small-mid caps outside the ASX 100. The opportunities fund looks for founder-managed companies with compounding free cash flows, healthy balance sheets and high returns on invested capital.
It typically has more exposure to the consumer space, services and tech businesses.
In the year to February, QVG’s Opportunities Fund returned 4.8 per cent after fees, versus minus 8 per cent for the fund’s benchmark Small Ords Accumulation index. Since inception, the fund has returned 12.7 per cent per annum after fees, versus 5.8 per cent for the benchmark.
QGB’s top five shareholdings are Johns Lyng, Hansen Technologies, HUB24, Index and Lovisa.
Small-mid cap investing is one of the few categories where active fund managers in Australia tend to consistently beat their benchmarks. Moreover, the “demarcation” between the valuations of small and large cap stocks potentially gives a “great entry point”, according to Waters. But he’s cautious about the overall outlook for shares over the next 12-18 months.
“The main reason for that is we still haven’t seen the full effects of the recent rapid interest rate increases on consumers,” he says.
“As a big chunk of fixed-rate mortgage settings start to come off and reset at much higher rates, you’re going to see an ongoing impact to the consumer in the latter half of this year.”
Waters says there were “no disasters” for the fund’s shareholdings in the December half.
Industrials companies saw the most “misses” in 25 years. Good results were “rare”, yet sharemarket outperformance versus expectations on earnings was “just as likely to be sold as bought” as negative sentiment dominated amid rising bond yields.
A lack of inflows into equities probably goes a long way to explaining this phenomenon.
“There’s little we can do about this but can report that we have a high degree of confidence in the current operating (if not share price) performance of our holdings,” he says.
But in light of the valuation gap that has recently opened up between small and large caps, he’s convinced that small caps will return to favour in 2023.
“Whenever we’ve seen such a demarcation in terms of small cap underperformance, historically there have been great entry points, whether you look back at the GFC or the dotcom bust,” he says. “We’re already starting to see a little bit of a swing back towards small-mid caps. But it’s not just about picking stocks, it’s understanding what to avoid.”
