Weekly update: The Impact of COVID-19 on Australian Small Caps
With Phillip Hudak and Matt Griffin from AMP Capital.
Paul O'Connor (POC): Welcome to the Netwealth Portfolio Construction Podcast series. My name is Paul O'Connor, and I'm the Head of Investment Management & Research. The investment management and research team looks after both the investments we make available to you through our super and non-superannuation investment platforms, but also the managed funds and managed accounts that we issue. So we naturally spend a lot of time interacting with the fund managers.
The due diligence we undertake provides lots of insights into the views on the global economy, financial markets, and the investment strategies offered by fund managers. Today, we have Phillip Hudak and Matt Gryphon from AMP Capital, who were the co-portfolio managers of the AMP Australian Small Company Strategies.
They're both responsible for co-managing the AMP Emerging Companies Fund, which includes the fundamental stock research they undertake across all of the small-cap sectors. Given the roles of Phil and Matt, you're both really well-placed, I guess, to provide insights and comments on the Australian small listed company segment, and also the impact that COVID-19 has had on the sector. Good morning, Phil and Matt.
Phillip Hudak: (PH): Hi, Paul. Thanks for having us on the show.
POC: And historically, the small-cap benchmark has outperformed the large-cap benchmark, although the caveat is that the higher returns typically come with a certain higher level of volatility or risk. The outperformance of active small-cap funds has, I guess, really interested me over the years. And I guess there's probably two underlying drivers behind it, and that's essentially the skill and the ability to be able to pick the stocks that will outperform the small-cap benchmark, but it's also the fact that the benchmark does contain a number of companies that effectively aren't making any profit and not paying any dividend. So, perhaps to start with, Phil and Matt, how did the two of you come to be involved in managing Australian equity small-cap portfolios?
PH: I've always been interested in equity markets, in particular Australian small-caps as I see it, as a segment of the market that you can really add value. I've got over 18 years investment experience, and focus on Australian small-cap since 2007, which was just before the GFC hit. During this period, this instilled in me the importance of earnings sustainability in valuing companies, which has followed me throughout my small-caps career to date.
As you mentioned, both Matt and myself are co-portfolio managers for the AMP Capital Australian Small Cap Strategy, and it's got over seven years track record with delivering returns in excess of the benchmark, and doing that with a lower volatility, which is in line with our investment objectives.
Matt Griffin (MG): Yeah, and I've been in the industry for 12 years now. Similar to Phil, started just before the GFC, which was very much an interesting time to learn about the market, and it was sort of a baptism in fire into small- and micro-caps. I started out at Macquarie for three years. Three of us who went over to, to start a small-cap fund there. And then I've come across AMP and joined Phil just over two years ago. So it's really, I've been in the market 12 years now, but small- and micro-caps is really what I love doing, and that's what's kept me in this segment of the market.
POC: Yeah, well, you've certainly both got a lot of experience in the small-cap space, so you're both well-placed to provide the insights on the market and how it's performed in recent months. So, since the outbreak of COVID-19, we've seen equity markets fall significantly in March, but then recover spectacularly in April and May. So how's the Australian small-cap sector performed relative to the other parts of the market since late February?
MG: Yeah, it's been quite an amazing couple of months, actually, Paul. We had the record fall in March in terms of size and speed, and then we've had a record recovery over the next couple months. So looking to the Small Ords, which is the index we track and is a small-cap index in Australia, that peaked on the 20th of Feb. Over the next month, we saw 41% decline. And since the lows, we've actually had a 50% rally from the bottom. So where we're sitting today is just about a 10% below where the peak in February was. So it has been quite a wild ride and very strong recovery, which has probably surprised most people in the market.
What we've seen over the past few months can probably be broken down into a few distinct stages. I guess the initial self-off was pretty indiscriminate. Everything was going down in unison, investors were just looking to liquidate any sort of asset holding they had. What we saw next was focused on the most COVID-affected stocks, so those with bad balance sheets, those in the travel industries, leisure, tourism, finance companies, retailers. They were all very hard-hit towards the middle, end of March.
Then once the market had bottomed, we actually saw quite a strong rally of names, which people began to think were benefiting from COVID. The tech stocks, work-from-home-related stocks, gold, and the quality end of the spectrum. Following that, the next phrase was the reopening trades. There we were looking at stocks leveraged to the economy reopening a bit quicker than what people thought. So we almost saw the reverse of the previous month, where the retailers, the finance companies were rallying pretty strongly and recovering quite well.
Most recently, what we've seen probably over the past few weeks is markets turn to value. People are just looking at what's fallen a lot, what hasn't recovered, and this has really led to the low-quality end of the market lifting quite strongly. Typically, this is fairly dangerous phase of the market, as investors are just buying names purely based on value, and just in a lot of cases ignoring structural and earnings issues at finance companies.
With small caps specifically during this rebound, they've actually outperformed large caps. Part of that is compositional. Small caps does have a much higher weighting to gold and tech stocks, versus large caps, which is quite heavily in financials and banks. There's a bit more of a domestic bias in small caps as well, so I guess with Australia being one of the better-positioned countries coming out of COVID, you'd expect that these names probably recover quicker and return to business a bit faster than those who have large international operations in countries which may be a bit slow to open.
One of the things which is really great about the small-cap universe we see is the breadth of stocks available for us to invest in. In our universe, outside of the top 100 stocks and down to about a 100 million dollars market cap, there's 600 stocks in that universe. That's sufficient. We typically only invest in about 40 stocks, so we can be very selective and just invest based on high-conviction ideas we have. And regardless of what's going on in the world, there's always companies which have their own internal growth drivers, or their own ways of growing which don't rely on the economy or the consumer in general. And we've certainly seen that with certain names, particularly in the tech space, stocks leveraged to cloud, AI, work-from-home thematics. You have the likes of NexTec and Megaport, Appen, Kogan all being big beneficiaries from COVID, and they've really rallied quite strongly. Most of them are well above where they were pre-COVID.
POC: It's interesting, the comments you make that the recent rally in the value sector of the market. Maybe perhaps, for the benefit of listeners, the stocks that are viewed as value-type stocks are typically the ones that are perhaps going through a restructure, a rebuild, and they don't have the same growth story that perhaps some of the star stock performers in the index have had. But do you think the rallying value has been attributed to the fact that a lot of the better-performing growth stocks are so fully valued?
MG: That is a fair comment. I'd probably say there is an element of FOMO, fear of missing out, going on in the market at the moment, where people are just scanning across, going, "Well, market's had this record rise. We're almost back to previous highs, so let's just see what hasn't performed well and pile into those," regardless of what the story is. I think a lot of people have read the story about, and I heard this in the U.S., which is in Chapter 11 bankruptcy and the stock's up a couple hundred percent, despite the fact that an equity, you'd probably get nothing out of that company. That's just been a huge rally. So there is this element of just looking at while stock's down, let's just buy now. And I think that that is very dangerous because people are ignoring what the company's specific drives going on are, and whether that stock, whether the business will recover, and will it be the same size as pre-COVID. It's a lot of questions going on which are being ignored.
The growth side, yes, they are trading on record valuations. In some cases, that's warranted. Like I mentioned before, a few of the cloud guys, the work-from-home thematic stocks, they've actually had this structural acceleration in the business case where NexTec, who own a bunch of data centres, will say that they've seen 10 years of demand in one year. And for a lot of these guys, that's permanent. So despite the they've had, it's probably going to be justified across a lot of those growth stocks.
Coming back to what we do, we're very focused on earnings and the sustainability of that earning. So the value rally does worry us a bit in some of these stocks where we don't think earnings will support that share price rise.
POC: We've seen numerous ASX-listed companies undertaking capital raisings over the last couple of months to strengthen their balance sheets. So what's been the experience of small-cap companies? And what sort of companies have been coming to the market seeking further capital?
MG: Yeah. I'll give you the stats, Paul, because it's quite amazing. Since mid-March, we've seen 77 capital raisings. There's been 21.5 billion dollars of new equity raised. The average discount company's been-... dollars of new equity raised. The average discount companies have been raising money at been 18%. And the average gain has been 40%. We're seeing, yeah, it's quite incredible how well these capital raises have been going. 85% of these raisings have been in the small cap part of the market. So has been this rush of companies.
In the initial stages, it was to recapitalize balance sheets. The first couple raisings, I can remember were Carbon Revolution and Webjet, which were towards the end of March. It was a very tough market environment. There were a few re-pricings in those raisings, a few nervous moments about whether they got done, but as we saw, Webjet, in particular, performed very well coming out of that, market really opened up and was very receptive to the idea of companies raising money.
I think initially, this was very much reminding us that the period coming out of the GFC in 2009, back then, companies had a lot of debt. They were looking to recapitalize their balance sheets and get the banks off their back. In the initial stages in March and April, it was very similar that there were companies coming out going, "Let's repay debt, fix any cashflow holes we have and just make sure we survive."
I think what we've seen more recently is the pace of capital raisings has continued. So we're still seeing at least a handful every day coming through, but now it's very much companies looking at, well, let's take advantage of high share prices. A lot of them have bounced pretty hard. Let's raise some money to look at acquisitions, see if there's any distressed competitors out there, support reopening of business operations, and potentially growth as well.
So the reason for raising this kind of change, it's been across the board, across different industries. I mean, industrials, resources, real estate, everyone's raising money where they can. I think the rules around capital raisings where ASIC allowed companies to undertake placements at a high percentage of their share base, and share purchase plans getting increased to a $30,000 limit has helped certainly, and we're seeing raisings being treated a lot more fairly in terms of existing investors getting priority and retail getting a chunk.
And I think really, what's the period showed us is the benefit of companies being listed in terms of having access to equity quickly in times of need. Companies who have a good business model, people can see recovery coming, people trust management, they will have that equity available if they need it. And that's been valuable for some of these guys to move quickly on opportunities and maybe take advantage of buying up some smaller unlisted peers who have been struggling.
POC: Maybe a question for Phil now, the technology sector has been such a strong-performing part of the market. So what sort of tech companies do you guys invest in and how do you view their prospects?
PH: Yeah, look, Australian small-cap technology companies have been strong performers over the past few years. The secular growth companies have been well sought after by investors given the low-growth environment we have been in and continue to actually be in. And you just have to look at the recent performance of the commonly-referred to WAAAX stocks here in Australia, which has significantly outstripped the performance of the FANG stocks in the US over the past few years. So far this year, we've been surprised with the strong performance that we have seen for Australian technology stocks versus the broader market, even in the face of COVID. What is particularly interesting is the recent strong performance has been driven by strong revenue growth and a multiple re-rate, which broadly has been in the face of consensus forward earnings downgrades for many, but not all, of the stocks in the sector.
In this episode, Måns Carlsson-Sweeny from Ausbil joins us to discuss the latest trends in Environmental, Social and Governance (ESG) investing. Our conversation covers how to make ethical investment choices using ESG research, how rising geopolitical risks may impact ethical investing, the effect of the modern slavery act in developing nations and his investment tips for navigating the current market uncertainty.
PH: There's a couple of reasons for this here is why this is happening. Firstly, the accelerated technology adoption by users we're seeing during this period so far this year. The shift to cloud, increased data consumption, artificial intelligence, work-from-home beneficiaries, and online shopping. There's definitely a structural shift that's been accelerated recently. Secondly, the lower-for-longer interest rates, meaning lower cost of capital, which justifies the high valuations which we're currently seeing.
We agree with many of these factors. However, we are cautious, pockets of the sector at the moment. We prefer exposures to the genuine earnings upgraders where we actually see a long runway for growth that can support these higher multiples for these companies. Companies exposed to artificial intelligence and the accelerated cloud adoption, we expect no slowdown in the demand profile. In addition, companies exposed to positive industry tailwinds in the enterprise financial software sector space, we also like. We are somewhat concerned though about a number of technology companies that are exposed to the SME segment of the market, given the expected flow-on impacts from COVID once government stimulus starts to roll off. And from a valuation perspective, valuations are extremely high and there is very little room for disappointments. There is definitely a long-term structural shift that has actually happened as part of COVID that has accelerated the progress by a few years. And the market has effectively priced that ahead of time.
In addition, as we mentioned before, it's getting harder and harder to ignore the size of the extreme valuation gap we actually see between growth stocks and included in that, technology stocks, and that of value stocks, which are more leveraged to an economic recovery as we come out of COVID.
POC: It's interesting there that I guess a lot of investors may not realise that the small cap benchmark has such a large number of tech stocks actually making a part of that benchmark. And historically, I've heard a lot of comments saying... Investors saying they may have an overweight to USA equities to get a tech exposure and a reasonable tech exposure in their portfolio. But I think, as you were talking there, Phil, I was thinking to myself that you can certainly get a good tech exposure in your portfolio by allocating to Australian small caps there. So from a portfolio construction perspective, it's interesting there. And I think it's probably a point that isn't that well-understood by the market as a whole.
Maybe for Matt, as there's a large gold weighting in the small cap sector, how do you guys view gold stocks as an investment from here? And given that gold's had such a strong run over the last, I guess, four years or five years.
MG: Yeah, gold's been a very interesting one over the last few months, and is actually one of the best opportunities that we saw that was thrown up by COVID and the turmoil in the gold market in March.
So it's interesting to get a bit of context around where gold stocks are held. ETF and asset investing has become huge part of gold stocks registers over the past few years. So if you track the GDX and the GDXJ, which are the two main global gold ETFs, stocks which are included in part of those ETFs can have anywhere between five and 15% of their share registers held by those ETFs. There's a bunch of other ETFs, a bunch of other passive investors as well. And typically, these guys have daily applications of redemptions, so that they're sort of forced to trade, regardless of what the market's doing based on applications and redemptions into the funds.
So as we saw the early stages of the market fall in March, I said before, people were just looking for liquidity and selling everything they could. This included gold. And despite the gold price in Aussie dollar terms actually holding up and not really missing a beat at around the 2,500, $2,600 an ounce level, some of the better quality, Aussie small cap gold stocks like Saracen, Regis, St Barbara, they all fell by more than 30%. So there was this huge disconnect to those, in the early stages of COVID, where the physical gold price was actually holding up and almost pushing record highs every day, in Aussie dollar terms, and the Aussie stocks had fallen quite a fair bit. So there's this big gap that opened up. We took that as an opportunity to actually take quite a big overweight to gold, which paid off quite well over the next couple of months.
From here, we've actually seen that gap eroded now. So the gold stocks have largely caught up to where the gold price is. They've made up a lot of that loss. Some of the small cap gold stocks are trading well above where they were pre-COVID. And I think if you look at the macro outlook for gold, it is positive. All the liquidity being pumped into the markets by central banks does raise a fear of inflation over the medium term. And I think there's no denying that gold should be pretty well-supported.
But what is worrying us is this feels very well-captured now in valuations and gold price forecasts. It makes us nervous to see every single commodity strategist out there have gold as their top pick for the next 12 months. And given where valuations have been and they've sort of caught up now, we actually think that we've taken a fair bit of gold off the table in the last couple of weeks. Rationale a bit underweight. Let's wait.
What we've done is we've really consolidated our gold holdings into a couple of stocks where we have high conviction in the ideas. We see either production upsides, mine life extensions, or a big valuation discount relative to peers. And I think, over the past few months, you've been able to make a lot of money in gold just by owning anything. I think we are now back to very much a stockpicker's market in gold where you're going to need to separate the winners from the losers and see who can actually deliver on forecasts and upgrade and do well in the exploration. Find first those who have just disappointed potentially, lag the index.
POC: What sort of correlation do the actual Australian gold miners have to the price of gold?
MG: Yeah, it's interesting. In aggregate, the correlation's quite high over the longer term. In the short-term, it does get distorted by things like flows into ETFs, just general market sentiment. So there are these opportunities opened up where gold stocks will outperform or underperform the gold price significantly in a short period of time. And that particularly reverts over time. I say, in aggregate, because there's about 15 gold stocks in the small cap index, but there is a huge amount of variability in terms of how some of those performed. We typically see a couple of those go to business every year. There's a few new enter every year on new discoveries. And if you're in the right gold stocks, you can make multiples of your money in a few years time. Whereas if you pick the wrong ones, you can basically wiped out. So there is a high element of-... There is a high element of stock picking necessary if you're going to play individual gold stocks, rather than just invest in the gold ETF, which will own a bucket of stocks.
POC: I guess it also then highlights the importance of active management in the Australian small cap space, again, to our earlier comments there, Matt?
MG: Yeah, absolutely. That's something we spend a lot of time on, when we can travel before COVID, I'm sure when restrictions are eased, we were out at a different mine sites pretty regularly, every couple of months. So actually getting up close and personal with the operations does give us a lot of insights into how things should perform.
POC: Maybe a question for Phil, now. Are you guys seeing more investment opportunities in the large cap or the small cap segment of the Australian listed market?
PH: We see more investment opportunities at the smaller end of the market, and that's driven by two main drivers, both from a structural perspective, but also from a cyclical perspective. From a structural point of view, there are a number of key drivers, which we've actually touched on so far during our conversation. Firstly, select Australian small caps offer high earnings and return potential. Key reason for this here is the greater exposure to emerging thematics that have accelerated growth profiles.
Secondly, is Australian small caps offer exposure to one of the few remaining inefficient segments of the markets. The ability of investors to consistently beat markets is becoming increasingly challenged with advances in technology and improved company disclosure. Just you have to look at the median US equity manager that has struggled to beat their benchmark over extended period of time.
The median Australian large cap managers struggled to keep their head above water and Australian small cap managers have a track record of consistently delivering significantly higher alpha. The key reason for that there is there's less investment research at the smaller end of the market. We expect this inefficiency to be exacerbated going forward given the increasing shift we're seeing to passive investments.
Another key driver from a structural point of view is Australian small caps offer exposure to exciting early stage growth areas. Typically, you see many large cap companies are old world, being mature businesses, with lazy duopoly industry structures, which are facing potential disruption and run the risk of being left behind in the fast changing modern world, which we're actually seeing at the moment. Particularly small caps offer leadership and innovation that has the potential to transform industries and deliver significant capital appreciation, particularly those structural growth companies and technology companies, included in that there.
Finally, from a structural point of view is small caps offer investors a greater level of sector and stock diversification. The large cap index is very financials focused and small caps are a lot more diversified and give investors exposure to some of the more exciting areas of the market, including technology.
Looking at it from a cyclical point of view. Small caps has some interesting characteristics at the moment. Firstly, small caps are more leveraged to a cyclical recovery. We're seeing global PMIs are currently bouncing, albeit off extremely low levels, as there are signs of the massive fiscal and monetary stimulus combined, starting to actually come through. Small caps typically have a higher beta and out-performance in such market environments.
Also, Australian small caps has more exposure to domestic cyclicals and consumer discretionary stocks. This includes housing, retail, auto and media. They're expected to recover a lot faster, versus the rest of the world's coming through there. Then also other positive indicators like the increasing Australian dollar and commodity prices are also favourable for small caps there. I mean, finally, valuation of small caps looks reasonable on a relative basis versus large caps. It is interesting to see small caps has significantly outperformed large caps since the market bottomed in late March, which there's scope for that to continue going forward.
POC: It's interesting your comments, they fill around the impact of passive investing. I guess I've thought that as well, that as you get an increasing amount of passive investors in a sector or in a market, is that creating more opportunity for the active managers and is it more distorting prices? I guess given the earlier comments we'd made about small cap certainly being a fertile ground for quality stock picking, it's reinforced my view that the opportunity to add value in small caps isn't diminishing in any way. In fact, it's possibly getting greater with the increased prevalence of small cap strategies.
Your investment philosophies earnings drive share prices and I guess you both, Matt and Phil, you've spoken to that in our conversation this morning, numerous times. Back to my earlier comment too, that there is a large portion, well, a certain portion of stocks in the small cap universe that don't make any earnings at the moment. So what's your outlook at the moment on corporate earnings over say the next 12 months? Do you have any outlook on corporate earnings given the extraordinary times we're living through?
MG: Yeah. Fair questions and just to provide a bit of background as to our investment philosophy on earnings drive share prices. We've actually done a lot of work looking at small caps returns in the Aussie market for the past 20 years. The main thing we found is that by far the most important factor driving performance of stocks has been earnings. So companies which can actually set earnings targets and deliver on them, they're valuation is far less important consideration.
So just putting stocks based on value over longterm hasn't worked, you've needed to see those earnings come through to support them. That's been the background for us. I guess we'd try and find companies where we have conviction to the earnings growth profile and look at the sustainability and persistence for that earning stream going forward. Like you say, the current environment hasn't been great for forecasting earnings. We've had the vast majority of companies on the ASX actually come out and withdrawal any sort of earning guidance as to not give any comments around trading updates.
We've had a couple of CEOs of different companies tell us that earnings forecasts have been removed as a board agenda item in short term, just given the volatility. The fact that the main thing that matters or has mattered over the past few months has been liquidity and banshee. So the risk really has been over the past few months that information has been changing so quickly, that what you believe one day may not hold true the next. It's very hard to make medium-erm investment decisions based on that information.
I'll give you an example of it, in mid-April, we were talking to a few players in the auto industry and a couple of car dealers and service centres and the like, and it was just dire for them really. There was no one around them, no customers, things were looking awful and making people redundant and there was no idea when things were going to bounce back.
Talking to the same people just a few weeks later in the middle of May, they had a huge bounce, car sales are through the roof. They couldn't get a and used cars, valuations going up, people were getting services again. It was just amazing to see how quickly that information changed in a couple of weeks and how that frames management's perspectives but then also our perspectives on investing in certain stocks in their sector.
Having said all that, I think earnings will start to matter again. And what we've actually seen increasingly over the past couple of weeks is companies come out and start to reinstate guidance. Now that things are reopening, retail is getting stores back online. People are getting back out and buying things. It is giving companies confidence to say, "Well, we're through the worst. We can now pin some numbers on how this year's looked."
In general, the trading updates we've seen so far have actually probably been better than what the market's expected and stocks have done pretty well in the back of that. There's certainly an argument to say that the consensus numbers, which have seen a 20 to 30% cap for earnings over the next 12 months as potentially bottomed down, and maybe we start to see, at least a flattening out or maybe an uptick in certain sectors. So increasingly we think earnings will start to matter again, while the market's being driven by liquidity lately, we think companies are going to have to come out and start delivering on earnings to sustain a rally and to keep going. It is very important to, I guess, distinguish how important near term earnings are for some companies at the moment and how unimportant they are for other companies.
So certain stocks where the market's perceived them to be COVID beneficiaries or very defensive, they can't afford any slip ups on earnings. They've trading at big multiples, and are actually expecting growth they're going to get hurt. Whereas, on the other hand, companies for instance, in the travel industry, or leisure industry, people know the numbers are going to be a disaster for the next six months. It doesn't matter how bad the short term, as long as those companies can survive. And what the market's doing now is trying to look forward to FY '22 or FY '23 earnings and say, "Well, how the things look on a recovery basis? Does this company get back to the same size it was? How quickly does it get there? What sort of evaluation metric do we apply?" So there is a bit of distinction there as to how much earnings actually do matter right now for certain stocks.
The Australian market is highly skewed towards large stocks. For investors looking to maximise their returns from a rich and diverse opportunity set, small cap stocks can be a good alternative.
POC: Makes sense to me that having perhaps a longer timeframe, in terms of forecasting corporate earnings would be more rational at the moment, given all of the volatility and I guess unknown how deep the recession actually plays out in Australia there. So maybe for Phil, what are you key sector and stock picks in your portfolio at the moment?
PH: Yeah, look, it's interesting time at the moment. At a broad level, we believe that market should be well supported given the ever-growing amount of fiscal and monetary stimulus that is supporting assets in the absence of an external shock. Although, we need to acknowledge that we are in unchartered waters at this present time and there are a number of unknowns, including a potential second COVID infection wave or escalating trade tensions coming through. So we would advocate a diversified exposures at this time.
Some of the interesting sectors include consumer discretionary at the moment, household income is strong, despite higher unemployment, given it's being inflated or supported by Job Keeper at the moment. It's interesting to note that there are many Australians that are receiving more from Job Keeper, then what they would otherwise be paid in a pre-COVID when they were working. So this means sectors like-] when they were working. So this means sectors like retail and the auto sector continues to be strong for at least the next quarter or two, until it rolls off. However, recent discussions of job-keeper benefits, potentially being tapered earlier than the September deadline may dampen retail sentiment over the next couple of months. So that's something you need to look out for there.
The other area, which is quite interesting is housing. You know, the recently announced $25,000 federal government incentive for new housing is expected to be supplemented by many of the state government incentives that they're expected to come through, which should be positive for housing related companies. I mean, just last week, we just actually saw the WA government announced an additional $20,000 incentive on top of the federal government scheme. Stamp duty exemptions, and if you incorporate a first home owners grant of $10,000, you can potentially get up to a $70,000 benefit in WA.
Many of the building material and housing related retailers have run ahead of the expectations of these incentives coming through, but where we do see value is in property developers, notably those exposed to the West Coast, where we expect to see fewer job losses, once job-keeper rolls off post September this year.
I mean, the other key area is domestic leisure. They're expected to be a beneficiary with international borders being shut down. So caravan parks and companies exposed to a lot more driving, like the aftermarket auto parts, should do well in such environment.
Another interesting sector is the agricultural sector. The sector is cycling some very, very easy comps following droughts, which now we're starting to see a lot more favourable weather conditions so far this year. So we expect to see earnings upgrades come through for that sector there. Particularly post-COVID food security has become increasingly important thematic. Although, the key sector risk here is escalating China trade relationships. And then...
POC: It's interesting your comments around tourism, because, I guess, given about half of Australia chooses to go to Bali once or twice a year. Yeah, there'd be a lot of, I guess, beneficiaries in the Australian leisure and holiday market there. And I would've thought well beyond caravan parks as well, the hotels and domestic air travel when that picks up, because I think it's going to be quite a while before we can freely travel globally there. We've mentioned a couple of times about the more volatile nature of small cap stocks over large cap stocks. So how do you guys actually manage this volatility in your portfolio?
PH: We adopt a multilayered to risk management within our investment process, and we are in to outperform the benchmark for term over a long term. Although what is just as important to us is to achieve this with a lower absolute volatility as compared to the benchmark or the small ordinaries index. Our investment philosophy is governed by three core beliefs, which has a track record of delivering strong risk adjusted returns that is designed to outperform in most market environments.
Firstly, we are focused on medium term earnings delivery. You know, we don't invest in concept stocks like biotechs or mining exploration companies, that are never going to generate earnings. Secondly, sustainability is a core part of our investment process, which is recognised as being an important longterm driver of value. And thirdly, what we try and do is look to minimise exposure to companies with short term earnings downgrades that're expected to come through.
We typically find a company that downgrades earnings will continue to do so in the future, given the serial correlation of earnings, that does come through. I mean, during the COVID period and the significant market pullback we saw in March, we had the ability to, what I would say is high grade the portfolio with companies that are pulled back just as much as the market, and coming through there.
Most recently we've been looking at selective cyclical companies that are expected to benefit from fiscal stimulus in the recovery, with the expectations of those earnings coming through. We utilise a rigorous bottom up fundamental stock recommendation and portfolio sizing process. And we adjust our position sizes for stocks held in our portfolio, for those which have downside earnings surprise and earnings risks. In addition, a liquidity factor is also applied to further reduce positions sizing for those companies that are less liquid.
What is key though in small caps is we place significant importance on company management and governance with a particular focus on three key areas, being management alignment, management tenure, and independence levels. And this is particularly important for successful in investing, coming through there. I mean, since the strategy's inception in early 2013, we've been able to generate returns, above the benchmark, but have done that with lower absolute volatility, which is in line with our investment objectives coming through there.
Typically what we find is, based in our core investment beliefs, is that we will typically outperform in down markets, and in up markets we'll look to be in line or slightly outperform in those environments there, but there's a significant focus on capital preservation, particularly in those down markets.
POC: Oh, I guess it's fair to say there, Phil, that you, the portfolio, it holds stocks that are considered better quality than the market as a whole, the whole small cap benchmark, I'm assuming.
PH: That's correct. And typically what we do find is the beta of the portfolio is typically below that of the market there, which means that we typically should have lower volatility versus the market over the longer term.
POC: We usually finish with asking a guest for any personal investing tips that you've applied through life and is really central to your own personal investment philosophy. So have you got one or two tips you might be able to share with the listeners?
MG: Yeah, absolutely. I think, look, personally in the fund, the process is and the philosophy is a very structured process and that's what we stick to. So what I say is, look for companies with good management teams, good industry structures that can deliver on earnings growth. That's really key. Keep an eye on risk, always think about position sizing, volatility, and know when to sell.
I'd say to your listeners, don't fall into behavioural traps in terms of anchoring, and "I've lost a bit of money. I'll just wait until it gets back to even to sell." Try to take the emotion out of investing. I think I'll give finally, maybe just one more plug to active management, I'll say this end of the market in small caps, given the amount of opportunities out there with 600 stocks to look at, you really need kind of dedicated professionals doing all of that work and being across all aspects of the market.
And as Phil mentioned before, this is one part of the market where active managers do significantly outperform year after year versus benchmark. And the fees are sort of well compensated for by performance. So if people have a particular thematic they want exposure to, or just want to a market return, ETFs are very good tools for that. But if you want good capital growth in the small cap part of the market, it does pay to use active managers just given the track record, the sort of access to management companies. We have, I guess, in times like we've seen recently as well, capital raisings and IPOs can add quite a lot of value as well.
POC: Absolutely. You know, I guess the other point that in my mind is both yourself and Phil have been talking through the small cap market this morning with us is how important it is to understand the investment philosophy of the active managers that you're engaging in your portfolios. And I'd certainly encourage all listeners to really have a good look at the investment philosophy of the managers that they're considering. And ultimately then to make sure that ongoing, I think, that you've just got to make sure that that manager continues to run a portfolio that is true to that philosophy there as well.
So now to Matt and Phil, I think you very much for your time this morning, it's certainly been an enjoyable and an insightful conversation around the small cap sector of the market. And I'm sure our listeners will have taken a lot out of the discussion there.
To the listeners, thank you very much for joining us this morning and I look forward to joining you in the next Net Wealth Portfolio Construction podcast.
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