The global macro headwinds shifted in August – should small cap investors be worried?
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By most measures, August was a pretty rocky month for ASX investors.
And while June reporting season was in full swing on local markets, it was a suite of global factors — both economic and geopolitical — that weighed on risk appetite.
Another round of US-China trade tensions was the catalyst for a sharp selloff at the start of the month, and stocks struggled to recover from there.
That was accompanied by a further re-rating in global bond yields, which has Aussie 10-year bond yields now sitting below 1 per cent, while the US yield curve inverted — historically a fail-proof indicator of pending recession.
Amid all that, the ASX200 fell by 3 per cent while the local Small Ordinaries index slumped 4.2 per cent.
Speaking yesterday at the 2019 ASX Small and Mid-Cap Conference, Morgan’s equity strategist Andrew Tang explained why that discrepancy wasn’t all-together surprising.
“Small caps typically have a high beta so when the market goes up they tend to go higher, and when the market falls they fall sharper,” he said.
Tang also pointed to the correction in the December quarter of last year, when small-caps were down 14 per cent while large caps fell only 10 per cent.
Incidentally, that sell-off was driven in part by a macro development, after US Fed chair Jerome Powell made bullish comments in October which got markets spooked about the pace of future Fed rate hikes.
So, should small cap investors be wary? Can shifts in the macro environment pull the rug out from smaller companies, just as their share price is gaining traction?
Dean Fergie, director and portfolio manager at small-cap fund manager Cyan Investments, had a pretty succinct response to that gloomy question.
“The short answer is no,” Fergie said.
“We think in terms of the important factors to look at in small caps, the macro environment is further down the scale.”
“I guess the way you conceptually look at it is that any small business usually operates in a narrow niche of the global macro environment.”
“So while broad figures like GDP and consumer confidence do influence the picture overall, it tends to be micro factors that usually influence how stocks trade.”
He highlighted the latest reporting season, where the evidence suggested that moves in the stock price of a given company were driven by the earnings results, rather than macro factors.
So in terms of where the Cyan investment team spends its time, individual earnings metrics take higher priority. And importantly, investing in small-caps requires a different risk profile to begin with.
“We’re operating in a fairly high risk, high reward section of the market,” Fergie said. “People invest with us because they want to make double-digit plus returns.”
And to be an effective small cap money manager, Fergie said it’s important to maintain a capital base that allows for flexibility.
“If we have a good year we’re going to be up 30-40-50 per cent,” he said.
“And it’s to do with the fact that we’re not managing a lot of money — we’re running a fund with $50m in it so we can generate great returns for our clients.”
“You can’t do that if you’re managing a $100 billion super fund — so if we’re switching out of bonds because we want to add 20 basis points to our running yield, it’s just not relevant.”
Fergie said the main area of macro factors Cyan keeps an eye on is where they affect currency moves and changes in the Aussie dollar.
But he added that companies generating revenue outside of Australia are largely skewed towards mining and resources — a sector which Cyan doesn’t have a strong focus.
However, “if you look at the decline of the AUD in the last few months, that can move the dial. So that’s probably the broad exception”.
Back on the home-front, Australia’s domestic macroeconomic picture hasn’t been looking too rosy lately.
Wednesday’s GDP print showed annual growth of just 1.4 per cent, a 10-year low. It followed a two-year housing slowdown in the major east coast markets, combined with chronically low wage growth and the end of the residential construction boom.
In response to a consumption-led economic slowdown, the RBA has also cut interest rates twice this year to a record low of 1 per cent.
And Morgan’s Tang said that macro factors could present an opportunity for nimble small-cap investors.
“I think one thing we saw in reporting season is some green shoots starting to emerge in the retail space,” he said.
Perhaps evidence that “low interest rates and the federal government’s tax cuts are funnelling some money back into the consumer side of the economy”.
“Tying that through, consumer discretionary stocks make up around 15 per cent of the small cap index. So if you’ve got exposure to that sector, there’s indications that a lot of these retailers are showing signs of a turnaround,” Tang said.
In summary, it probably pays to keep at least one eye on the macro environment as a useful way to frame an investment idea or spot a trend.
But good small-cap investors also combine that with an ability to assess the individual metrics of a given company on a case-by-case basis.