Small and mid-caps: What are the signals telling us?

Andrew

Well, welcome to the March episode of Fidelity Soundbites, a straight to the point monthly podcast where some of Australia's leading portfolio managers will share with you what's happening in markets, how they're positioning their portfolios, and the outlook ahead. I'm your host, Andrew Dowling, and James Abela joins us once again as we look back on March and discuss some of the key signals in markets right now. So let's now get James to decipher some of it.

 

Andrew 

So, let's face it, a somewhat tumultuous month for US and European financials. What does it mean for us here in Australia?

 

James 

There's a lot going on in March. There's M&A, there's obviously the blowups of the US financial system and then Europe got involved as well. So SVB, Credit Suisse, I mean all of this was very damning for confidence for the whole world. I mean the financial system people were worrying about taking our minds back to the GFC. I guess for Australia it's very important to realize that our financial system is very very strong.

So the US financial system is a very different two-tier system. Regionals are now in a very difficult position and Europe is also very difficult positions right across the board, were the weaker ones. But Australia is very strong, very well capitalized. We don't have many exotic activities taking place in the Australian financial system. So it's just good to know that our at least our Australian system is going quite well. And I think you know we're in a good spot, so you know a lot to worry about as they do offshore.

 

Andrew

Right and so we have we have big banks and well not so big banks or smaller banks that doesn't make any difference in terms of?

 

James

Well there's a big five obviously. The big four banks plus Macquarie, and then you've really got the two regionals which is in my world. And the two regionals will be affected by funding, but I haven't obviously held them for a long, time as a subscale and things like that but it's just not a lot of impact I guess for our system because we don't source capital offshore in a way that will be affected by this big liquidity crunch. And that's really, I guess, where the comfort comes from.

 

Andrew:

Good to hear. And certainly another interesting month, after too many interesting months with rate rises. A pause this month - What does that mean for your world?

James

Yeah, it's big. I mean, 10 months we've had rate rises upwards and now we're finally having a pause, and people have been calling for the pause for quite a while. And now it's finally come, thank goodness. Because people are being affected by cost of living increases anyway without rates going up as well. What does it mean in terms of stocks? That really people are pausing and having a think now that rates are going to be at this high level and kind of hold there for a while, but they're not going to keep going up. So the panic I think is now starting to subside, but the reality of earnings needing to be there is what's happening. So as that rate rises started to lift, the value style really worked and the momentum obviously was the opposite. It didn't work at all, because the cost of capital was rising. Now you're getting really quality working. So quality names are really working. Companies that have earnings, companies that have growth, companies that have duration is what's really happening now. So with rate rises being continuous, people's duration has actually been very short, because they got very worried about the future. And they started to really discount anything that was very long dated. So now it's kind of becoming a bit more balanced because the market's moving their duration out, and they’re happy to think that they kind of can see what's happening over the next few years. And that's why quality I think is now starting to work well. But also transition names, which are called turnaround names or self-help names, they're also going quite well. And those momentum and value styles are not working as well because the market's in fear or greed mode, and we’re in reality mode and that's where the signal really sits. It's more real earnings, real cash flows and that's where you need to really go towards now. And that's what I think has worked during results, but is certainly during March as well.

 

Andrew

And just on that front, I see companies that have a positive outlook, some of them have certainly hung on to those share price gains that are on the back of reporting season. Can you talk us through just a few of those companies that stand out?

 

James

Yeah, I think the ones that have continued to do well are ones that there are earnings growth. That's what has worked during results, but it's certainly during March as well. And just on that front, obviously companies that have a positive outlook, some of them have certainly hung on to those share price gains that are on the back of reporting season. Can you talk us through just a few of those companies that the ones that stand out as? Yeah, the ones that have continued to do well are ones that bear our own as well. So pretty much insurance, technology, some  healthcare names, they’ve done quite well. And also resources has done quite well. So gold has done quite well because it's become a bit more of an anti-market kind of theme. Didn't really work during COVID but has worked. But it really is earnings, in those areas where there is earnings growth. That's really where it's been rewarded and continues to be rewarded.

 

Andrew

And is that getting harder to find?

 

James

It is getting hard to find. That's the thing, as quality names have already run up quite hard. So a lot of those healthcare and tech names have run quite hard, so I guess the bifurcation in high quality, high growth, and then your lower quality, lower growth names. That spread became very short, say six months ago. And now it's sort of started to move out. You got companies like Wisetech on 60, 70 times, Altium's on 30, 40 times. And I think that that's the concern now. It's starting to get harder to find opportunities. And that's where you talk to traders ad trade volumes are down, and they're a lot lower than used to be say six months ago. Because you got to a point where it’s now harder to find opportunities.

 

Andrew

Increasingly so and one area that did pick up also for the quarter was M&A activity. Something that’s been somewhat scarce in recent times. Can you talk us through some of the drivers behind that? What's that signaling to you and also you know what are the risks and opportunities that come from M&A waves?

 

James

So it was definitely huge. I mean Liontown got bid for, United Malt also Helios. So those three are quite different, one in healthcare, one in malts, which is beer related, and then Liontown which is resources. So M&A is coming up because growth is getting very scarce. It's getting harder to find growth. So I think the balance sheets, which have been in a good position during COVID, are now being utilized. Also, it's a low growth road. So you kind of buying growth as well. And the other thing is also going down the value chain to secure supply, or going up the value chain to either get leverage or lock in consumers and that sort of movement up and down the value chain has also been an important thing. And then the last one is really just leveraging and costs, and getting bigger scale. When you've got this environment of high inflation, tight supply, nervous customers, and increasing cost bases, scale becomes much more important. So I think companies are also going for scale. So a lot of those M&A trend I think will continue during 2023. All those drivers underneath them and the signal that it tells you, that is going to be there for the whole of this year. It's in a whole different range of areas: resources, materials, healthcare, technology, and you're seeing them not just domestically but globally. I think those trends is a signal of lower growth. I do think they will be there through the year.

 

Andrew 

And just on that point about gold, record prices?

 

James

Yeah, gold's near record prices and had huge, huge performance during March, just massive. So some stocks were up 50%, 60%. The average is around 20% to 25%. Evolution, which we own had a good run and was up. So I think gold is now being seen as a safe haven that it traditionally was over the decades. But during COVID it wasn't seen as because money was very cheap. But now you've actually got financial system fears of the system. And that's why people are going towards low beta stocks and also gold. And gold has now become the safe haven, which its core, I guess, is when you have fears about the financial system, which is where it's going well now, especially during the month of March. People say we may be getting towards the end of that rally, but gold has been a massive theme during the month of March, which was, you know, it makes a lot of sense now. And it's surprising that it hasn't. I have clients asking me through the whole of the whole of the COVID crisis, why hasn't Gold gone up? Why hasn’t gold worked? Why aren't the stocks going up? And then you had that for three years. And in the last three or four months, it was we had cost blowouts, capex upgrades, so they're not working. But then in the month of March, all that was pretty much changed. And it became one of the strongest sectors right across the mid-cap space.

 

Andrew

Right. And materials, what, nearly 30% of the index?

 

James

Yes.

 

Andrew

We're living in a material world. We're likely to continue in a material world to that degree

 

James

<singing>

It really is a material world. I mean, materials as a percentage of my universe, it's only been at 30% in 2008, 2011, and just only towards the end of last year 30% of the index. That's just huge. Normally it’s been at 10-20% really over history. And you've got so many factors happening. You've got lithium being a huge theme in Australia. We are a big producer of lithium, and have a huge number of lithium stocks. We also have rare earth stocks, and other related transition metals. And also gold is still a pretty big part of the index in mid caps and small caps. And also all the copper and nickel and lithium names from transition, and there's also M&A.

So there’s a lot going on in resources. We've actually got a special bonus episode including the analyst here, Sam, will be getting involved and giving you an update on Australian resources because there's a lot of exciting things happening. We've got a lot to offer the world. We export a lot of resources and it's a big part of our market and I do think it's it is definitely this month especially it's been a material world. But the whole of last year became very much dominated by resources and materials.

 

Andrew

And James, speaking of signals, there continues to be a major mismatch in consumer sentiment data, sort of back to GFC levels, and actual consumer behavior. What's your take on this?

 

James

Yeah, I find it quite phenomenal. I mean, look at the Reserve Bank chart pack, I put together every month. It's back down to 70, which is back to GFC levels. It's very, very low. But if you look on the streets with your eyes, what you can actually see, you look at roads, schools, airports, cafes, hotels, shopping centers, holiday destinations, rental accommodation inspection, business trips, or preparing for a family gathering, everything is busy. Everyone is busy. And so it's really a big mismatch. And retail sales are still very strong. The analyst here is saying that the discounting is broadening and deepening in terms of retail. But there is a big mismatch. And you don't know if people are just shifting their spending from buying things to buying moments, and buying experiences. That's what it feels like. When you look at where the wallet is going, that seems to be what is happening. And the signal is definitely people are shifting towards moments and memories and moving away from things and household goods. So I think that's something you need to keep in mind when you're investing in certain stocks. But I do think it's quite a big mismatch between what the data is telling you and what you can see with your eyes out there in the streets.

 

Andrew

 Well, we'll continue to see how that plays out. Well on that note, thank you, James. Much appreciate you joining us again today.

 

James

Thanks Andrew

 

Andrew

And if you've enjoyed this episode, please share it with a friend and subscribe to the podcast via your favourite streaming platform. And we look forward to having you join us next month.

 

James

Thanks a lot.

 

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