Pockets of good news and opportunities aplenty for small caps stocks

The Australian small cap market has performed strongly this reporting season.

Investors had subdued expectations with a spate of earnings downgrades leading into the period, but a better-than-expected start buoyed sentiment, before company results waned by the end of the month.

For small cap industrials, the number of companies seeing downward earnings revisions outweighed upward revisions but despite this, average company share prices delivered positive absolute returns, likely helped by the Reserve Bank of Australia's dovish tilt and strong offshore markets.

The outlook ahead appears challenging – forward-looking guidance statements remain particularly vague as companies grapple with the prospect of a slowing Australian economy, the possibility of a significant credit squeeze and further house price falls.  

The housing slowdown hits

The key theme from reporting season has been the impact of the slowing housing cycle reverberating across many sectors. Construction related companies, along with other stocks with exposure to housing, have provided challenging outlook statements partly caused by the faster-than-anticipated softening in multi-dwelling residential construction activity.

The housing market slowdown coupled with ongoing low wage growth is seeing household budgets remain under pressure which is threatening to take consumer spending with it.

Consumers are delaying the purchase of big-ticket items and we saw this with companies exposed to the automotive sector continuing to underperform with depressed motor vehicle sales impacting car dealerships, which has had flow on impacts to the car leasing industry. Interestingly, companies exposed to the auto aftermarket parts sector underperformed with slower than expected organic growth as consumers also delayed servicing their vehicles. However, one cannot delay servicing indefinitely, so we expect a bounce back at some point.

The implications of weaker consumer sentiment were far ranging with other small caps stocks such as listed fertility services providers continuing to be impacted as consumers look to more affordable alternatives. The big question for investors is how far will the ripple effects of falling house prices extend?

Discretionary retailers
For discretionary retailers, investor sentiment was bearish with subdued consumer confidence and a spate of downgrades leading into reporting season, although the sector delivered better-than-expected results. Investors remain cautious given unpredictable sales patterns, slowing sales growth and a lack of detailed guidance.

Many of the retailers experienced strong online growth but muted, and even, negative instore growth, which impacted those retailers which are heavily reliant on shopping centre foot traffic which has declined.

In addition, the lower Australian dollar is expected to impact margins going forward. Nevertheless, there were bright spots with some small retailers demonstrating that opportunities to grow earnings remain, including those with a cost-out strategy and exposure to a positive thematic.

Mining services
Another key theme during reporting season has been the relative strength of the mining services companies’ earnings. Global markets have been focused on the resolution of the trade wars which has seen the resources sector perform strongly. Whilst there are emerging recession risks, we believe a safer way to play the resources thematic is via the mining services companies that provide equipment and services to the miners, given years of underinvestment and the need to replace depleting reserves.

Growth stocks

As seen in the previous reporting season, the market has been willing to pay up for companies that deliver on strong earnings in the current low-growth environment.

Many structural-growth and technology related companies continue to exceed the market's lofty growth expectations; however, any high growth company that missed market expectations was punished. Once again, we are seeing disparity emerging between current valuations and fundamentals as the market increasingly pays for long-dated earnings although we believe quality companies that can continue to exceed market expectations will outperform despite elevated valuations.

Insurance brokers provide a pocket of opportunity for investors with the improvement of premium rate hardening across commercial insurance classes which should be a key source of leverage.

So, despite the challenging domestic environment, we continue to see plenty of opportunities in the Australian small caps market.