Prime Asset Value's three tips to manage volatility in the ASX small cap market

Prime Asset Value has three tips for investors to avoid volatility in ASX small caps
Companies with high amounts of debt tend to fall more during a market downturn
Equity markets tend to lead the economy so are expected to rise well before economic recovery

It’s been a tough time for investors in ASX small caps as continued economic uncertainty, geopolitical tensions and now bank collapses take a toll on global markets.

But Prime Value Asset Management portfolio manager Richard Ivers told Stockhead there are ways investors can reduce volatility in the ASX small caps market.

Ivers said the Prime Value Emerging Opportunities Fund has one of the lowest volatility factors of any small cap fund in Australia.

So what are Ivers’ three ways to avoid volatility in a small cap portfolio?

1. Diversification

Ivers said you are trying to get a balance between having a positive impact of your best stock and ideas with having diversification.

“You want stocks which are ideally uncorrelated with each other,” he said.

“We have about 40 stocks in our portfolio but they are uncorrelated and across different industries with different earnings drivers.

“If something goes wrong it will only affect a small part of the portfolio.”

2. Avoid loss-making companies

Ivers said companies which are highly leveraged and have a high level of debt tend to fall more when markets fall.

He said in small caps there are a lot of companies which are yet to turn a profit and are loss-making.

“They are earlier stage but their costs are higher and they are burning cash,” he said.

“Investors get nervous because if the earnings come off then the debt becomes a bigger problem.

“If the share price is falling they may need to raise more equity and issue more shares, which means you can have a dilutive equity raise which causes a big loss in capital.”

He said the ability of loss-making companies to fund themselves during bearish markets or harder economic times becomes harder.

“When times are tough being loss-making is not a good situation to be in for a company,” he said.

Ivers said a good example of a loss-making company whose shares have been impacted over the past 12 months includes Zip (Z1P.ASX).

“Concerns over Zip’s ability to fund these losses has caused the stock price to fall, along with some other issues,” he said.

Ivers said a company with a low debt profile means less risk but also provides the ability to use their stronger optionality in tougher times.

“So if you have a strong balance sheet there are a few things you can do, like make acquisitions,” he said.

“Or, say, if the market falls a lot a company with a strong balance sheet could buy back their own shares which is highly accretive and create value for shareholders.”

3. Avoid cyclical businesses

Ivers said companies exposed to the economic cycle of highly cyclical industries can also add to volatility.

“We don’t look at the volatility of stocks but we focus on what is less cyclical and when you do that the outcome is you have lower volatility in the portfolio,” he said.

“Consumer discretionary retailers or residential housing construction – they are notoriously cyclical industries.

As the old saying goes – Nothing is certain except for death and taxes. Ivers said one company Prime holds is one of the largest funeral operators in Australia – Propel Funeral Partners (ASX: PFP).

“No matter what happens to interest rates, inflation people will still die and there are still funerals happening,” he said.

“It’s highly profitable and growing so that business will do well in any circumstances.”

Ivers said another example of a business not tied to economic cycles is insurance broker AUB Group (ASX:AUB), which comprises insurance brokers and underwriting agencies operating in ~520 locations around Australia and New Zealand.

“If you think about insurance it’s something you have to pay and can’t risk not having so its a non-cyclical business,” he said.

“The key thing is insurance premiums are going up and that benefits them and if we get to a point when insurance premiums go down that could be negative so there’s a little bit of cyclicality in that but it’s prolonged and unlikely in an inflationary environment.”

Prime outperforms its benchmarks

According to the SPIVA Australia scorecard produced by the S&P Dow Jones Indices, 58% of actively managed Australian equity general funds underperformed the benchmark S&P ASX 200 during the full year of 2022.

However, in a tough market Prime Value Emerging Opportunities Fund was able to outperform its comparable benchmark of the small industrials and small ordinaries.

“We have outperformed both of those indexes for the last five years,” Ivers said.

“There’s a measure of risk, which is a standard deviation and volatility of returns and over that five years the small industrials and small ordinaries are both around 21% and ours is 17%, which means we are less volatile.

“We are beating the market but also doing it with less risk, which is very unusual.”

Ivers said that the true measure of risk is the permanent loss of capital, which you can’t mathematically measure unless you look at performance over time.

Equity markets and small caps primed to rebound first

Ivers added that we’re going through a choppy period in which big macro economic issues are driving markets. And that makes it hard to know how things will play out.

“The positive in small caps is the market has already fallen a long way so it means there is a fair bit of bad news priced in – so when things turn they will turn fast and hard with significant upside,” he said.

“Equity markets tend to fall first and rebound first so we started falling a year ago but house prices only started falling six to nine months ago.

“Equity markets tend to lead the economy in and out so we’ll start rising again well before the economy starts improving.”

Ivers noted there are some great companies attractively priced at the moment.

“I can see the value in these businesses and I look out a few years and I’m confident that they will be worth a lot more than they will be now.”

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.