2018 outlook: Australian small to mid-caps

1. What is your investment outlook for Australian small to mid-caps next year?

The outlook for Australian small to mid-cap equities for 2018 is positive with the benchmark EPS growth expected to be around 10%, PER ratios around 16x and free cash flow yields between 4-5%. 

Currently, the positive bullish drivers of the market are winning over the more cautious bearish drivers. Points for the bull are well supported by data and sentiment including a synchronised global recovery, a continued boom in infrastructure spending and a rise in capex across a range of industries. In addition inflation is negligible, stock correlations are low and commodity prices are generally rising.

Counter to this, points for the bear include high asset valuations across a number of markets, low top line growth world and record global debt levels. The price of risk is also very low with junk yields in line with treasuries -a sign for many of a coming bubble.

Another sign that liquidity and price momentum has been very favourable is the ‘Toddler index’ which signifies the proportion of each index where companies have been listed less than 3 years. Once again the index is at its highest levels (around 50% in micro cap and small cap) which are similar to other periods of high valuations, liquid debt and high liquidity such as 2000, 2007 and 2016. A word of caution is warranted if history is any guide.  

2. What do you think could most surprise investors next year? 

2018 will likely be the year of inflection and change and only time will tell if markets are able to facilitate an orderly adjustment phase. Volatility and the cost of debt are likely to rise, inflation may be pushed higher by commodity prices and wages could also rise due to higher employment growth. Finally market liquidity, the great facilitator over the last decade may fall as the major governments shift from qualitative easing to quantitative tightening while the price of risk rises from a very low base.

A number of years ago there was discussion that if the equity risk premium was zero it had a dramatically positive effect on valuation. Today, the real cost of debt is zero and if the Global Financial Crises proved anything it was that debt is not an everlasting source of growth. The key is not to extrapolate the status quo on the cost of capital into perpetuity. “Interest rates are gravity” Warren Buffett stated in a recent CNBC interview, with others have also commented that interest rates close to zero have lifted all asset values on a global scale.  As investors we need to anticipate what may happen next. Next year is likely to give some strong indications of what’s to come in the next decade which is likely to be very different from the one we’ve just lived through. 

3. How do you plan to capture the best opportunities and add value for investors? 
In order to maintain a balanced approach, I’m maintaining some exposure to those themes mentioned in the bull points above but am cautious as well. As liquidity declines, the cost of capital rises and inflation lifts the importance of fundamentals such as viability and sustainability.

Here are some of my key thoughts on opportunities in the current environment:

  • Positive on sectors that benefit from synchronised global growth such as industrial cyclicals and energy.
  • Positive on themes that are likely to continue medium-term such as mining services, infrastructure, construction services and electric vehicle industry participants.
  • Positive on technology - Personal and business productivity is going to remain a structural theme going forward and I therefore view software, artificial intelligence, robotics, internet of things and technology leadership as critical facilitators. 
  • Cautious on liquidity beneficiaries such as loss-making companies especially in software, technology and micro caps.