Criterion: With rates cut looking a sure bet, small-cap stocks are biggest winners

• Small caps generally fare well when interest rates fall, because they tend to be exposed to cyclical domestic sectors
• Rates are heading south to prevent the economy from overheating, rather than avoiding recession
• Yarra Capital Management names four preferred ASX small-cap plays

This week’s benign inflation figures have fired expectations that the Reserve Bank will announce an interest rate cut on Tuesday week.

It would be amazing if the central bank did a BACO – Bullock Again Chickens Out – and maintained a neutral stance for the second month in a row.

Along with mortgage holders, small cap investors will cheer on what’s expected to be a series of cuts over the next 18 months.

That’s because of a strong correlation between lower rates and the health of small caps.

“Smaller companies tend to be exposed to the more cyclical elements of the economy, so benefit from reduced rates which stimulate demand,” says Yarra Capital Management’s small caps portfolio co-manager Michael Steele.

Wilson Asset Management’s Oscar Oberg refers to the “inherent leverage” of small caps, in that they typically carry more debt.

“This means that even the slightest economic tailwind can fall to the bottom line quickly and drive earnings upgrades.”

Lower rates also mean a lower Australian dollar, as foreign investors seek better returns elsewhere.

Rates are falling for the ‘right’ reason

Steele says investors should consider why rates are reducing.

The current round is more about inflation slowing – and the economy not overheating – rather than the nation falling into recession.

That’s why investors applauded the jobs numbers showing an uptick in unemployment (not that the affected workers will be cracking out the bubbly).

In contrast the rate reductions during the global financial crisis and the pandemic were more about avoiding disaster.

Steele adds the rates benefit not just discretionary retailer, but other exposures including construction and real estate income trusts (REITs).

Driving higher returns

Steele cites Eagers Automotive (ASX:APE), the nation’s biggest car dealership, as one of the biggest interest rate beneficiaries.

“Over the last two years, industry profitability has dramatically reduced with selling new cars,” he says.

“But we are now at the bottom of the cycle, with reduced industry inventory volumes.”

Lower rates tend to have an instant knock-on effect on new car sales. That’s a plus for Eagers, given its franchises include the fast-growing Chinese brand BYD.

But about half of Eagers’ gross profit comes from servicing, which creates durable annuity income.

Steele adds that freehold property accounts for about one-quarter of Eagers’ enterprise value.

The REIT way to invest in property

About half of the property fund manager  Centuria Capital’s (ASX:CNI) share price is underpinned by it stake in related entities including Centuria Office and Centuria Industrial.

Centuria also co-invests in other unlisted property assets.

“About 75% of assets under management are in closed-end vehicles or listed entities where it has effective control,” Steele says.

“That means there’s a low level of outflow risks.”

Lower rates benefit the overall REIT sector, which is seeing improving asset valuations after years of decline.

But Steele says funds management REITs reap extra benefit.

“When [the property] cycle turns up, they will get upside from fund management fees and property development,” he says.

“Those earnings streams are at zero currently.”

Construction group’s rare appeal

Steele describes construction materials play MAAS Group Holdings (ASX:MGH) (pronounced Mars) as a “really interesting business”.

MAAS operates regional quarrying operations (such as asphalt and aggregates) and has civil construction/plant hire and residential property development arms.

The company’s land bank of 8000 residential plots supports its $1.5 billion market cap. These are in high-growth lots locales such as Dubbo, Orange, Bathurst and Rockhampton.

“MAAS has a diversified business across three markets and all of them are attractive at the moment,” Steele says.

MAAS also is an ASX rarity, given buyers swooped on building material plays CSR, Adbri and Boral.

Judo moves deftly in SME market

Pure-play small business lender Judo Capital Holdings (ASX:JDO) has blipped on investor radars, given the Big Four banks’ elevated valuations.

By not aligning itself to the hotly competed home loan market, Judo generates superior net interest margins.

Of course Judo doesn’t have the inherent security of a mortgage, so its risk managers need to be on top of their game.

To date, Judo’s delinquencies have been low – and risks should only moderate as rates come down.

Steele says investors price Judo at book value.

“This is a very attractive valuation compared to the big banks which are trading at significant premiums.”

This story does not constitute financial product advice. You should consider obtaining independent advice before making any financial decision.