Australian small caps: Insights from James Abela

Over the last couple of years the small cap market has remained pretty stable with good growth and a high degree of certainty. However it’s not prudent to expect that these conditions will continue forever. Lately both volatility and valuations have been increasing and investors need to be aware of this as we look forward to the next 12 months.

What are the lessons from reporting season?

Valuations that have been too exuberant have tended to disappoint and we saw some corrections in the last reporting season with a number of sectors reporting lower than expected growth. Some companies in aged care, retail, outdoor media and telecoms fell by 20 to 30% largely thanks to increased competition, a greater investment requirement to generate sales in our low growth world, and in the case of aged care potential changes to regulation.

On the other hand stocks which have been out of favour recently such as Ansell, Flight Centre and Fortescue performed better than expected, reported single digit growth and good share price performance due to more reasonable valuations. 

It’s important for investors to be mindful of growth rates and whether they’re sustainable and pay close attention to the market structure companies are operating in. Expectations need to be reasonable - if companies disappoint, especially companies perceived to be high quality or exhibit strong momentum, then significant devaluations can follow.

> Watch video: To learn more about what’s happening with Telcos   

What characteristics do you look for in stocks you like to own?

I do look for certain stock characteristics.  I look for businesses that have:  high returns, a high level of sustainability and very credible management and accounting practices. I call these my three pillars of success and if a company has all three, it certainly has my attention. 

On a sector level, I tend to focus on consumer, healthcare, technology and selectively resources. This is where I think you find the truly great companies in Australian small caps. 

> Watch video:  To find out more about where James is investing 

Will Australian small caps continue to outperform?

The performance outlook for small caps remains strong with around 15% earnings growth forecast for the next couple of years. However investors need to realise that the cycle of easy money is coming to an end and now is very much a bottom-up stock pickers market.