Christine St Anne: Today I'm joined by Andrew Smith from Perennial Value Management to talk about some of the companies he likes in the small cap space. Andrew, welcome.
Andrew Smith: Thank you.
St Anne: So, Andrew, what sort of opportunities are there in the small companies sector?
Smith: Well, the valuations for the index as a whole are not particularly attractive at the moment, but we are able through quite a lot of due diligence and a lot of companies managed to uncover a portfolio which we think is terrific value still, about 12 times earnings versus about 16 times for the market at the moment.
The sectors we particularly like, housing would be one of those sectors where there is obviously clear momentum, stocks like AVJennings, Capral, Brickworks. We haven't really seen the impact of development coming through yet. We've seen the approval numbers come through and it's really down to the last few months we've seen those commencements hitting the ground. So, the building intensity, the land getting sold; for example, Capral provide windows, aluminum windows getting manufactured. So, we think that's one sector in the Australian economy that's got clear momentum.
Outside of that it's very stock-specific. We think stocks that are going to benefit from a falling Australian dollar, we've positioned the portfolio that way for probably a year now and it's good to see the Australian dollar coming off recently. Exporters like Matrix which export 100% of what they do. Their competitors are in the U.K. and in the U.S., so obviously a falling Aussie dollar is a clear advantage for those companies.
St Anne: Of course, resources and energy is a big part of the small cap market. So, Andrew, what sort of opportunities are you finding there?
Smith: Okay. So, what we are doing at the moment, we are slightly underweight materials and we're overweight in energy. So, we are seeing more value in energy at the moment, particularly over in the U.S. some of the shale plays, shale oil that is, differentiating from gas, obviously where there is a bit of an oversupply. Sundance Energy is one stock that's been in the portfolio for a few years now, performed very well, but we still see value there, generating very good returns and an excellent management team and Eric McCrady.
Another stock we've just recently added is AusTex. There has been some management changes there, very straightforward asset, vertical drilling, so it's not very complicated and starting to produce some quite good numbers. That's a new stock we've added recently.
In the material space, copper is probably our preferred. We see the market moving to deficit probably by 2016. Hillgrove is a good example of a stock we like there. It's an asset down in South Australia, very well managed, produces good cash flow, not particularly exciting in terms of exploration or anything like that, but just produces good cash flow and they've just recently said they are going to start looking at paying dividends which we think is a good sign of their maturity. So, we're seeing some good value in copper, to a lesser extent gold. Iron ore is something we're actually quite negative on for some time. We've sold out of all our iron ore names back in December last year and only recently have we started buying back in and in a small way into BC Iron and that's the only iron ore stock we hold.
St Anne: Some of the risks in the material sector seem to be in the iron ore market with China cutting back and then of course, some of the bigger players upping big volumes. So Andrew, what are the implications for the smaller players?
Smith: We really want to focus on companies that are low-cost producers and in small caps it's really only BC Iron that meets our metrics at the moment. So, other players like Mount Gibson have a good balance sheet but very short mine life, so we are not seeing the same value there. So, BC Iron is really the only player we have there.
In terms of the Chinese regulations, obviously a big shift we're seeing is in the coal market, particularly the sulfur and ash content. That really impact Australia. Our only holding in coal is Whitehaven Coal. They currently sell zero to China and they do actually have high quality coal. So they are actually now starting to get enquiries from China because their coal unlike a lot of their other Australian competitors makes the quality criteria. And I think it's a sensible thing for the Chinese to do and to reduce pollution and ultimately, that will drive up the price of coal as it cuts out lower quality supply. So, we are a bit more positive on coal, but you got to be very careful to make sure the companies that you're producing have low cost and also provide the right quality of coal and Whitehaven is a good example there that is providing the good quality coal.
St Anne: Andrew, as a value manager, how are you seeing valuations playing out in the market?
Smith: So, I think if you look purely at the index, it's not looking like terrific value at the moment, around that 16, that's actually close to the 17 times P/E one year out. So, you definitely have to look a bit harder to find value, potentially looking at stocks that are too small to be in the index or have some other reason why – major shareholder means there is not enough liquidity that is outside the index. So, that's where almost half our portfolio now comes from is outside the small cap index because we are not really seeing much value in the more traditional small cap names. So, I think you've just got to look wider and harder to find value. But as I said, we put together a portfolio on 12 times, so we've found – and that's made up of 50 stocks. So, you can do it, but it certainly not easy at the moment to find good value.
St Anne: Your portfolio is relatively high conviction. How do you overcome some of the risks in that approach?
Smith: Yeah. So, liquidity risk is something we focus on a lot. So, we might think a stock is absolutely terrific, but it's only $100 million market cap. That's really only I think going to be 1% of our portfolio. If we had the same conviction in a stock that's $0.5 billion market cap, then it might be 3 per cent or 4 per cent of our portfolio.
The other thing that we really focus on risk is the balance sheet. We don't want to take any risk with the balance sheet. So, we want a company ideally to have net cash on their balance sheet. But if they do have debt, we want it comfortably covered. I think on average our portfolio is over 20 times interest cover. So, that's something we really focus on. So, liquidity risk and balance sheet risk are the two areas we focus on.
Also, we don't want to be too overweight in any one sector. So, not only do we look at the GICS sector levels but we have our own classifications if the sector is behind that. So, we'll break it down even further and just make sure we are not taking too big a bet in any particular sector.
St Anne: Andrew, thank you so much for your insights.
Smith: Thank you.