Value in small caps – patience will be rewarded

Cash is certainly attractive in the present volatility – and the RBA is likely to make it more attractive – but beware missing the sharp bounce in equities later this year. So warns Carol Austin of Contango Asset Management.

After the worst month for Australian equities since 1987, many investors are feeling battered and bruised. Keep some powder dry for this battle, but the biggest losers now could be those who belatedly try to cut and run.

Austin started her career as a Reserve Bank economist and continues to keep a close eye on what the central bankers are up to. She predicts the US Federal Reserve will keep cutting rates until the US housing market bottoms. With rates low enough, there will be a mortgage refinancing surge later this year that should be the turning point for US financial confidence. The equities bounce then could be very sharp indeed.

Domestically, though, she sees the Reserve Bank as conservative and more likely to lift rates again in response to our inflation pressures. Despite the sharemarket wobbles, the Australian economy remains strong, the China story remains solid.

Contango Microcap has been a top-performing listed investment company throughout the bull market. As its name suggests, it specialises in small companies, a sector that tends to lag the large caps in time of uncertainty. Austin argues it is the quality of the companies that count most and patience during the present rough ride will be rewarded.

Michael Pascoe: A lot of people suspect that the micro-cap sector will be hit harder than most in the market. Contango specialises in micro-caps. What’s your story?

Carol Austin: Certainly the micro-cap sector will be volatile and we understand that. It happened in August 2007 but importantly share prices ultimately reflect the fundamentals for companies and we think there’s still a lot of value in the micro-cap sector. They will be volatile and they may fall during this turbulence, but we’re encouraging people to take a long-term view and we still think there’s a lot of value from the long-term perspective in micro-caps.

Now about 40% of your portfolio is in the resources sector, plus another percentage on top of that servicing the resources sector. Is that the nearest thing people can hope for as a safe haven?

I don’t think there are any safe havens in the current market. Unfortunately there is wholesale selling and it’s complicated because there’s selling induced by margin calls. But we think that the China story is still intact. We think global demand for resources is structurally strong and that a number of these small companies are still on valuations that make them very attractive, so once all of the volatility moves out of the market we can still see these companies generating good returns over the longer term and we certainly see that they’ve got good assets.
What should investors be looking for now? What are the telltale signals of where the market’s going to next?

We are optimistic about the medium-term outlook for commodity prices, so we have a good company, good resources, well managed and it’s looking cheap on that basis; it’s a great buying opportunity. It may go down a little bit but it also may spike up quite sharply, so buy good quality companies and buy them at attractive prices and they’ll make good long-term returns.

Have Asian and Middle East economies decoupled from the US? Is that still the case?

It’s a little bit more complicated at the moment. What happened originally was the US had its housing recession and that had an impact domestically, but really the rest of the world was pretty well isolated from what was going on. When the housing crisis spilled over into the financial sector and became first of all a liquidity crisis and then a more broad-based credit crisis, it affected a whole range of industries in the US. Importantly, it’s affected the global economy, so we’re starting to see Europe slowing. We’re starting to see slowdowns in the UK off the back of a global credit crisis. Now with so much of the developed world slowing it will have an impact on China and India – a modest impact. And it will, in broad terms, cause a slowdown of the global economy, certainly to a greater extent than was anticipated when it was just a US housing crisis.

The IMF has just downgraded its forecast for world growth from 4.4% to 4.1%… still above 4%. Isn’t anything above 4% still pretty much guaranteeing the Australian economy will be all right?

The Australian economy will be fine. The question for most investors is about the consequences for the equity market, and one of the problems is that we have done so well for so long and now we’ve seen a pull-back. Despite the severity of the falls that we’ve seen, particularly over January, our market is still above the levels that it ended 2006. So we’ve had several years of good performance and what is happening is that prices are being pulled back on the realisation that growth isn’t going to be as strong as people thought a couple of months ago.

Is there an argument on that basis for domestic-oriented Australian stocks being more attractive?

I think the whole market was bid up on the back of the strong growth out of China. I mean what it did is it boosted profitability, it enhanced government revenues, which allowed governments to be generous in tax cuts and in their hand outs to the general community because they had a big surplus. So the flow-on effect of a strong China and a strong resources sector affected the whole of the Australian economy. As the world recalibrates its expectations for growth, we have to recognise that Australia won’t grow as strongly as it would have and the beneficiaries of that buoyant outlook are being derated.

Does that also mean that the Reserve Bank can have a bit of a rest – they don’t need to keep their hand on the monetary lever?

Unfortunately, I think that the next rate increase looks fairly certain. The Governor of the Reserve Bank has made it clear the bank thinks China and the rest of Asia will continue to grow at a rapid pace and that as a consequence we’ll see ongoing inflationary pressures in this country. I think the new Government will be tighter in fiscal policy than is generally expected.

The outlook for resources stocks, particularly the small resources stocks that Contango specialises in? Will they find it harder to get capital?

Most of the resource companies have had no difficulty in getting capital. They’re cash-rich and looking to acquire, so I expect to see quite a bit of consolidation taking place as we move forward because there are a number of companies that have a lot of capital – free capital – that they can utilise for acquisitions.

Companies have not had any difficulty getting access to equity capital or debt capital because at the current high commodity prices. The good producers are making a lot of money so I doubt whether raising finance will be a problem going forward for these companies. It’s more a question that companies, that individual investors, aren’t certain about the outlook and traditionally have seen mining companies as more volatile than the larger-cap, conservative companies; and so you might see some selling as people look to cash out their high earning stocks and move to a more conservative portfolio structure.

What in this present climate is more conservative than resources?

Cash. When Australian cash rates are 7%, cash is attractive. In other countries, certainly in the US as cash rates are coming down rapidly, if you do move out of equities into cash you are going to be looking at returns of, I suspect, 2% in the not too distant future – but at 7% in Australia cash is not an unattractive option.

So the Reserve Bank could have a double whammy for the Australian sharemarket if it does lift rates again?

That’s right. The problem with going into cash is working out when to go back into equities and what you’ll find is the Australian economy is fundamentally sound. We will see, I think, very substantial cuts in interest rates coming out of the US and we’ll see follow-on easings in Europe and the UK. Those developments will re-ignite interest in equities and we’ll see a bounce back in many of the areas that have been beaten up in the sell-off, and the problem with going into cash is that there will be very attractive returns when some of these markets bounce and some of the areas that have been sold down sharply; if you’re in cash you may miss that very strong rally.

Final question, the impossible one: When do you think that’s going to happen?

I think we’re seeing a lot of volatility and I don’t expect that to be resolved in a matter of days or weeks, but certainly by the middle of the year I think there’ll be a lot more clarity. I think we will see significant cuts in interest rates in the US which will help to stabilise the housing market. Once that happens we’ll see greater clarity in bank balance sheets. They will be able to price their assets like CDOs [collateralised debt obligations] and securitised instruments because they’ll know how far the housing crisis is going.

They’ll see a bottom, and once that happens, once we’ve got clarity to balance sheets, I think that you’ll start to see a lot more bottom fishing as people start repricing assets and certainly that will be the start of an upturn in the equity market. But I don’t think we’re there yet and I think we need to see further interest rate cuts in the US before we get there.

The story first appeared in The Eureka Report.