Key points: 

  • Yarra Capital Management portfolio manager Katie Hudson manages the gold-rated UBS Australian Small Companies fund, which aims to identify undervalued small cap ASX stocks.
  • She says the current environment marks a turning point for equity markets after more than a decade of falling interest rates.
  • This interview was conducted on the sidelines of Morningstar's International Women's Day event in March, where Hudson was joined by Elizabeth Kumaru from Australian Retirement Trust and Laura Ryan from Ardea Investment Management.

1. What is your approach to picking small-cap stocks? 

Katie Hudson: So we're a style-neutral manager. So we're open minded about whether we are buying or investing in growth or value companies or somewhere in between. So we're really looking for the best companies that we think are really with strong industry characteristics. We really love companies that generate free cash flow and we really focus on having companies with good boards and management. So collectively we're trying to find the best companies that we can find that have those characteristics.

2. What sectors are you holding at the moment?

Hudson: So for small caps, which is what I look after, 2022 was a big sell off year. The sector ended down 18%. And that's meant there's been a big valuation gap that's opened up between small caps and large caps. And so from that perspective, we think the small cap sector looks really interesting.

Amongst that there was particularly a growth and technology part of the market that sold off even harder and there are some really interesting companies within those cohorts that we think have, maybe have had some short term missteps. Maybe have been overvalued, but the retracement has created some really good opportunities, particularly in that sort of growth and technology part of the market.

3. Were markets too optimistic heading into the February reporting season?

Hudson: Yeah, well, they certainly were going into reporting season earnings were clearly too high on the back of reporting season, earnings growth expectations have come down about 8%, which is quite a big step on balance.

About 50% of companies missed earnings expectations and their numbers were downgraded. So I think numbers are much more realistic now, particularly for some of the case of industrial and financials areas, but clearly it's going to be a challenging environment.

What reporting season really told us was that volume growth has been okay, price growth has been strong, largely as people have passed through cost inflation, but margins have been coming under pressure.

Cost inflation's now starting to bite in terms of margins, and that's creating a pretty significant headwind for earnings as we go through 2023.