High growth potential with small caps
In this week’s video insight, Gary Rollo and I engage in a discussion about the remarkable performance of the Montgomery Small Companies Fund and its implications for investors. With a backdrop of significant outperformance by the fund against its benchmarks, portfolio manager, Gary Rollo, unpacks the recent success stories of specific companies and the broader economic trends influencing small cap stocks. Spotlighting companies such as Life360 (ASX:360), Megaport (ASX:MP1), Superloop (ASX:SLC), and Audinate (ASX:AD8), we explore the underlying factors driving an average uptick of 45 per cent in just the initial weeks of the year.
Transcript:
David:
Hello, I’m David Buckland, and welcome to this week’s video insight. Today, I am accompanied by Gary Rollo, portfolio manager for the Montgomery Small Companies Fund. For context, the Montgomery Small Companies Fund has been operating for nearly four and a half years and has outperformed its benchmark by 5.2 per cent per annum after expenses. Gary, recent months have been quite exciting for the Montgomery Small Companies. I noticed that four of our stocks—Life360 (ASX:360), Megaport (ASX:MP1), Superloop (ASX:SLC), and Audinate (AD8) — calendar year to date, for the first approximately nine or ten weeks of this year, are up on average about 45 per cent. So, many of them have obviously responded very positively to the reporting season and 45 per cent in nine or ten weeks is not something to be sneezed at, on average.
Gary:
Yeah, I’ll take your word for all that. But the reasons why these things are happening is the most interesting context. What we’ve got to do is bring it back to what we call the setup. The setup here is that small caps have underperformed big caps for just over the past two years now by around 25 per cent. And that’s not normal. What we’re seeing is the market responding to the earnings results of these companies to say these businesses are in good shape and let me tell you why. These four businesses that you’ve identified, they are growth companies.
A couple of years ago, the stock market was looking at growth almost at any cost as being the right way to go. We had the inflation shock in 2022, and the stock market changed its mind on that. It took these companies some time to adjust their cost structure and get themselves back in business. So, what they all did is they raised prices, cut costs, and reduced capital expenditure (CapEx). From that, they’re able to demonstrate that these are viable business models with great profitability. And now you have that optionality on growth being observed by the market. So instead of having growth at any cost without regard to earnings, you’ve now got a profitable business that’s growing, and the stock market likes that and has responded to that accordingly.
David:
It’s interesting that a number of them have moved into a position of positive cash flow relatively recently.
Gary:
Yeah, that’s right. The stock market essentially told these companies, ‘Show us your earnings power, show us your cash flows, and then we’ll come back and discuss what valuation regime you should be on.’ The stock market was surprised by just how profitable these businesses can be without sacrificing any of their growth opportunity or optionality. And that’s what we’re seeing now. These businesses are being re-rated as profitable growers. And that’s worth more to the stock market than what we were before.
David:
And relative to big caps, it’s interesting that many of them have an incredible runway of growth. And I’m not talking about ten or fifteen per cent per annum for the next few years. I’m talking twenty-fives and thirties type numbers, which is an exciting place to be, Gary.
Gary:
Look, that’s right. We look for businesses that are small and more early stage and what we’re doing is we’re looking for them to face off against larger end markets, with the ability to go and take market share. What you get in combination, if they’re successful, is a small business growing fast into a large market. And the market likes that. That gives the opportunity for significant profit growth. And like you say, we’re not trying to find businesses growing at GDP-like rates. We’re trying to find businesses that can grow at many multiples of that for a long time. And those are the types of businesses the market wants to rate highly.
David:
In terms of that setup, to what degree has that enormous discount of small caps to larges—I think at one stage, it was approximately a thirty-percentage point discount—to what degree has it begun to narrow in just the recent month or two?
Gary:
Look, if you look back over the last decade, the returns between small caps and bigs have been relatively consistent. In the last two years, we’ve seen a significant deviation. The extent of that deviation was somewhere around twenty-eight, twenty-nine per cent when it was at its max and now it’s about twenty-five. And the reality is that the stock market is responding to these growth companies having the future that they should have. And as a result, you’re starting to see small caps catching up with big caps. A couple of stats: In the last twenty-six months, big caps have outperformed small caps eighteen of those months, and small caps outperformed big caps, eight. In the last six months, it’s three-three, and in the last three months, it’s two-one in favour of small caps. So, I think the implicit question to ask is, are we starting to see the returns of small caps move to more normal levels? It’s impossible for us to tell, but we think that event is starting to happen now as investors appreciate the quality of the business model and the growth optionality in small caps as undervalued.
David:
Thanks very much, Gary. Ladies and gentlemen, as you’ve heard it straight from the horse’s mouth, that discount is certainly starting to narrow. And as inflationary pressures slow and pressure on interest rates dissipate, it certainly looks like a very good probability to us that small caps have a wonderful runway, particularly in the growth area of the small cap index.
That’s all we have time for this week. Please continue to follow us on Facebook and X.
The Montgomery Small Companies Fund owns shares in Life360, Superloop, Megaport and Audinate. This blog was prepared 8 March 2024 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Life360, Superloop, Megaport or Audinate you should seek financial advice.
Chief Executive Officer of Montgomery Investment Management, David Buckland has over 30 years of industry experience. David is a deeply knowledgeable and highly experienced financial services executive. Prior to joining Montgomery in 2012, David was CEO and Executive Director of Hunter Hall for 11 years, as well as a Director at JP Morgan in Sydney and London for eight years.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
