MoneyTalks: Why Tribeca believes the tide is turning for ASX small caps, and their top three picks

MoneyTalks is Stockhead’s regular drill down into what stocks investors are looking at right now. We’ll tap our extensive list of experts to hear what’s hot, their top picks, and what they’re looking out for.

Today we hear from Tribeca Investment Partners portfolio manager Simon Brown.

What’s hot right now?

For Brown it’s all about small caps. He said as an asset class, domestic small caps have had one of their worse periods of relative performance versus large caps in the past two decades.

“This is very much an outlier result in respect to previous interest rate hiking cycles and value rotations,” he said.

Brown said firstly make-up of the index hasn’t helped, with relative small cap overweights in sectors such as building materials, discretionary, tech, REITS and financial services which have performed poorly and been hit hard by higher rates and tighter financial conditions.

“Secondly, small cap earnings revisions have been more negative compared to large caps, as they struggled to pass on input cost inflation as well as their larger peers, who often operate in highly consolidated industries and thus possess stronger pricing power,” he said.

“Thirdly, small caps have historically underperformed in periods of depreciating AUD, with large caps having more exposure to foreign currency denominated earnings while small caps are more domestically focused on imported goods and services.”

However, Brown believes the tide is due to turn and sees attractive opportunities in some of the more beaten down sectors where expectations are low, and where valuations are now comparably very attractive.

He said inflation appears to be in the process of normalising and the AUD has bottomed, both of which should bring some relief to small cap margins just as larger names begin to cycle their pricing power benefits.

“We believe that tactical exposure to the domestic economy should be beneficial moving forward as the housing market bottoms, resumption of immigration helps ease labour shortages while generating additional demand and the global push towards deglobalisation and decarbonisation stimulates capital investment and demand for our commodities,” he said.

Top picks

Integral Diagnostics (ASX:IDX)

Brown said corporate activity is heating up in the bombed out traditional healthcare services sector. Recent bids include Estia Health (ASX:EHE) and the proposed Australian Clinical Labs (ASX:ACL) and Healius (ASX:HLS) merger.

“The diagnostic imaging sector has experienced an enormous amount of disruption over the past three years,” he said.

“Lockdowns, surgical restrictions and constrained access to health services have driven industry volumes well below the long-term trend.”

He said in recent months this has been unwinding with industry imaging volumes rebounding strongly, growing 10% in January and February, which is well ahead of the long-term average of 3%.

“Diagnostic imaging is also experiencing a structural shift towards more complex, higher fee modalities,” he said.

“IDX which has a greater exposure to MRIs and CTs versus ultrasounds and X-rays is benefiting.

“A mix shift combined with selective price rises and a better Medicare indexation outcome will drive strong growth in average fees per exam.

Brown said given IDX’s cost base is largely fixed, revenue declines drove significant margin contraction. However, he said operating leverage works both ways.

“The strong rebound in volumes and higher average fees will flow straight through to IDX’s margins, supporting material margin expansion and strong earnings growth,” he said.

“The stock trades on 23x 12 months forward price earnings (PE) with +20 per cent earnings per share (EPS) growth and 3 per cent dividend yield.”

Home Consortium (ASX:HMC)

Brown said HMC  is a fast-growing alternative asset manager with around $7.5 billion of external AUM, up from just $900 million at IPO in October 2019.

“The group has defied a tough environment for the real estate segment over the past 12 months, with rising debt costs and expanding cap rates putting downward pressure on valuations, to maintain its rapid growth,” he said.

“The recent $1.2 billion acquisition of the Healthscope portfolio of hospitals is testimony to management’s ability to execute complicated deals in a tough environment.

“We expect further news flow on deals in the near term, with management guiding to $10 billion of AUM by the end of calendar 2023.”

He said despite operational progress the stock has halved from its peak in early 2022 and now trades at a discount to the sector despite a significantly higher growth profile.

“On a 12-month forward PE of 15x with 15% EPS growth and a 3.2% dividend yield we think HMC is a buy.”
 

Kelsian Group (ASX:KLS)

KLS is a public transport and tourism operator that has grown out of the original SA-based ferry operator Sealink.

With a history of operating public transport, charter and tourism ferries, Brown said KLS has embarked on several acquisitions that included additional ferry operations and also adjacency in buses.

Today, the group operates ferries and buses in metro and regional Australia and select international locations.

“Operations such as KLS’s are all about scale, and while public transport can be low margin, modern contracts are structured to reduce patronage or fare box risk,” Brown said.

“After some recent misses, KLS landed new contracts in the Sydney metro market adjacent to existing operations, enabling a degree of cross utilisation.”

He said additional tenders are on the horizon in areas where their capability is strong and are well regarded.  The group also continues to make small bolt-on acquisitions that fill out capability in the corporate and education sectors.

“A recent bus acquisition in southern USA provides a beach head for further growth, with opportunities for organic expansion within the existing US business while also enabling KLS to bring their operational expertise to extract efficiencies and drive new tender activity,” Brown said.

“We view KLS’s business operations as relatively defensive and well diversified, while the recent tender wins and acquisitions provide an attractive multi-year growth profile.

“Digestion of the recent capital raise is providing an attractive entry point in the shares, trading at a 12-months forward PE of 13.7x with 15% EPS CAGR and a 4.3% yield we consider the shares great buying.”

The views, information, or opinions expressed in the interviews in this article are solely those of the interviewees and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article