• Small caps have underperformed over the past 18 months
  • But Brittany Isakka from Spheria Asset Management says the tide could turn soon
  • Isakka tells why she likes or dislikes some small cap sectors

 

Over the past few years, there has been substantial divergence between large capped and small capped stocks.

On the ASX, micro cap and small cap indices have underperformed over the last 12 months and also in the last three years relative to large caps.

Brittany Isakka from Spheria Asset Management explained that small and large cap have diverged in the past year or so mainly because of the inflation effect.

“We are in a risk-off environment. And that’s been the case over the last 18 months, and has been brought about by this rapid rise in inflation,” she told the ASX’s Ideas Exchange podcast.

“So there’s been a lot of sentiment and talk about rising interest rates, and that’s roughly the period where small caps have underperformed large caps.”

Isakka also says smaller companies tend to have less diversified businesses, hence they tend to be more volatile operationally, particularly in the face of rising interest rates, than larger ones.

Another important aspect that investors may not understand is liquidity in the market.

“This is really important for small caps, because when there’s a risk-off environment, liquidity tends to dry up, and this can create really big dispersions between prices from day to day,” she said.

Isakka however thinks there is evidence that some sectors have now started to show signs of convergence.

“We believe this part of the market should be mean reverting; in other words, the liquidity should return once the macro picture improves, which will be supportive for small caps.”

 

Profitable vs unprofitable stocks

At the conclusion of the last reporting season, Isakka says there was a super big divergence between those companies that were really well loved, and those that were unloved.

“People want earning certainty, whereas the cheaper companies just continue to get sold off, and it’s almost like investors are only looking at the six-month period,” Isakka said.

“They’re only looking at the short term as opposed to considering the long term outlook for these companies.”

In general, Isakka said the Spheria fund doesn’t like to invest in unprofitable companies.

“Because at the end of the day, we’ve done the back tests and studies on negative cash flow companies, and in the long run it matters, and they do underperform.”

 

Investment views on three small cap sectors

Isakka says the biggest divergence of small to large caps has been in the consumer discretionary space, where stocks are more exposed to the macro environment.

“We’ve heard in general conversations that investors are steering clear of the [consumer discretionary] sector, but for us, we don’t think excluding a sector makes sense.

“At the end of the day, we think everything has a price, and some of the selloff in that space are stocks that are trading at single digit EBIT multiples, so they’re cheap.

“When we do invest in the retail space, we will look at the balance sheet, and we prefer to own these retail names that have a good balance sheet, because it means when times get tough, they’ve got cash to support the trough in earnings,” she said.

For tech companies, Isakka said those that are loss-making are now refocusing on cashflow and earnings, and are trying to get to cash flow breakeven.

“The markets are no longer paying these tech stocks to grow at any cost now with interest rates rising, so there has been a shift in mentality, and I think some of these companies have bounced off their lows,” said Isakka.

“So people are getting excited on tech stocks because maybe the tide is turning.”

With regards to mining and commodities stocks, Isakka said Sphere doesn’t really invest in speculative exploration companies.

“A couple of reasons – firstly these explorers are trying to find deposits of some copper, gold or lithium but they’re not sure [if they can find them] yet. And that means they tend to burn a lot of cash.

“And secondly, for companies that do make a profit and have moved from exploration to development, they tend to have shorter mine lives in the small cap end of the market.”

Issaka adds that when her fund does invest in the small cap mining companies, it typically wants to buy those that have a long mine life so they have lower risk.

“We also want mining stocks that have a good balance sheets, in other words they’ve got cash and very little debt.”

 

The views, information, or opinions expressed in the interview in this article are solely those of the interviewee and do not represent the views of Stockhead.

Stockhead has not provided, endorsed or otherwise assumed responsibility for any financial product advice contained in this article.

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