AFR – Sarah Jones
After two years of pretty dire performance, Perennial’s Andrew Smith is starting to feel vindicated.
The Smaller Companies Trust that he co-manages with Julian Guido is up 17.2 per cent after fees over the last 12 months, almost double its benchmark.
But it’s the fund’s three-year performance – down 5 per cent versus the benchmark’s 1.5 per cent decline – that hints at the pain small-cap fund managers have endured.
Back in 2022, Perennial’s $1.3 billion small-cap team that Smith oversees spotted what he says was a “once in a generation” opportunity to buy up some of the best companies on the ASX at bargain prices as they were being dumped by industry superannuation funds in their droves.
Changes to legislation meant that the big super funds had to benchmark their performance to the S&P/ASX 300 Index, making them forced sellers of companies valued at less than $500 million.
Perennial went on a buying spree, allocating a large chunk of the fund into less liquid micro caps, and in some cases taking 15 per cent stakes where the fundamentals had become detached from the share price.
It was all good in theory until the Reserve Bank started raising interest rates in May 2022 to contain rampant inflation, adding to the selling pressure that would continue for 12 months.
“Sometimes you have to be early to get a good-sized position in these companies,” Smith tells The Australian Financial Review, before conceding they were probably a year too early.
“We’ve got some very supportive institutional clients who actually topped up during that time,” he adds. “They’re looking very smart now, putting in a lot of money in the middle of last year, and they’ve done really well.”
It was investments in stocks like Qoria (up 46 per cent in 12 months), Medadvisor (up 143 per cent), Dug Technology (up 66 per cent), Veem (up 324 per cent), and Superloop (up 120 per cent) that has driven the fund’s recovery which Smith is tipping will be “multi-year”.
He attributes much of that performance to a pivot in strategy during the downturn to double down on so-called “active engagement” to help get the companies they owned in the best shape possible for when the market finally turned.
This saw Smith bulk up the investment team to six people to help manage the day-to-day running of the fund, freeing him up to be more hands on with the portfolio companies.
Active but not activist
This includes getting Perennial-recommended directors on the boards of 16 listed companies so far, along with recommendations for debt advisors, investor relations, and even bringing in co-investors.
“It’s all about helping these companies get noticed by the market to get rated properly because if that doesn’t happen a logical outcome is they probably get taken over,” he says.
Some wins include Veem appointing Angus Murnaghan as a non-executive director last month. Smith says Murnaghan will be “really helpful from a capital management point of view”.
He also points out the strong re-rating in Dug Technology’s shares after helping the company put a debt advisor in place to avoid a capital raising. And it introduced a director to Qoria last year, which helped the cyber safety company grow from a micro cap to a small cap.
The strategy means Perennial is now a substantial shareholder – owning at least 5 per cent – in about half of the 60-odd companies that the strategy is invested in.
“Obviously if they don’t want to hear what we’re talking about, or they don’t want to engage with us, or they don’t agree on strategy, well then we sell,” Smith says simply.
“We’re not activists, we’re engaging with the companies in a collaborative sense as co-investors to try and get the best outcome.”
In the last few weeks Perennial has been taking profits in its more successful trades and stockpiling cash to the highest level in the portfolio since 2022, ready for the next big market opportunity: the August reporting season.
“It’s been great to see these companies starting to get noticed by other investors,” Smith says. “Once the herd arrives it means we can take some capital out to try and find the next one. We are in a much better environment to start recycling some of that capital as well, which is handy.”
At the end of June, the Smaller Companies Trust held less than 1 per cent in cash, and is now closer to 5 per cent, thanks to improved investor sentiment for small caps, bolstered by the prospect of imminent rate cuts in the US.
Markets are now fully priced for the Federal Reserve to start cutting rates by September, which has triggered a huge rotation out of the US tech giants into the smaller end of the sharemarket. In just three weeks, the US small-cap benchmark – the Russell 2000 Index – has rocketed almost 12 per cent versus a 3 per cent decline for the S&P 500 Index.
Australian small caps have lagged that performance, with the S&P/ASX Small Ordinaries down around 2 per cent over the same time frame, but is still up 5 per cent from the lows in January. Smith’s gut feel is that the Small Ords will lag the US by about six months, given the RBA is not expected to start cutting rates until well into 2025.
Perennial has been “banging the table” since the middle of last year to get investors interested after the selling pressure on the microcaps finally came to an end.
“That’s still the case today,” Smith says. “But it’s probably an easier argument now because we actually are seeing signs of that capital coming back into the space – I’m still very, very positive, but I would say that,” he adds wryly.
The earnings season is expected to be “volatile” and that will throw up some good opportunities if the team can move quickly.
Stockpiling cash
“You’re going to see some genuine surprises on the up and the down during August,” he says. “That’s the sort of environment we like, where, if you’ve done your homework you should get rewarded.”
The fund is most underweight in commodities and sectors sensitive to higher interest rates like real estate, which the small-cap team have been doing their due diligence on.
“It’s why we’re going to be very busy,” Smith says. “We haven’t made any firm views yet, but we’re certainly doing the work and are prepared to move capital if we can get to them at the right time.
“Whether it’s next month or six months from now . . . that’s the sort of window for those sectors.”
And while the big risk remains interest rates – the market is still pricing in around a 20 per cent chance that the Reserve Bank may raise interest rates at its August meeting – Smith says he was never banking on rate cuts in 2024.
He and Guido have positioned the fund to have a heavier exposure to sectors where they don’t have to worry about the macro too much, such as healthcare, education, and infrastructure, where the spending is locked in.
He adds that a surprise rate hike from the RBA won’t derail his expectations for returns, but rather just slow the recovery. He is expecting a few good years of “double-digit” performance.
“You’ve got that rotation that you’re starting to see in the offshore market, but I think the story is even more interesting in Australia,” Smith says. “We’re coming off a lower base with a lot more sort of multi-year recovery ahead.”
Read the original AFR article.
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