3 small caps in prime place for the next phase of the economic cycle

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Some small caps have been re-rating recently, as investors have started to once again appreciate the quality and value on offer outside the ASX top 100. This wasn’t the case last financial year however, when many small caps struggled as investors migrated to large caps looking for lower volatility and greater liquidity. While this is changing, trading conditions remain mixed for businesses, so investors need to be careful which stocks they choose.

There are two main factors driving this mixed performance:

1. Pricing power. Quality businesses with pricing power have been able to maintain their margins to account for the impacts of inflation, without significantly impacting volumes. This resilience has proven attractive to a market looking for defensive growth.
2. Balance sheet strength. With interest rates much higher, companies with high debt levels have struggled to maintain profits given higher interest costs. Businesses with strong balance sheets, or those that have worked to improve them over the past year, are being rewarded by investors.

Here are three companies that we think are high quality, with strong balance sheets and pricing power that look very well positioned for the next 12-24 months. All three stocks have very good growth potential as well as attractive dividend yields, and so are likely to deliver growing, and less volatile, total returns for investors.

GUD Holdings (ASX:GUD) is Australia’s leading aftermarket automotive parts and accessories company. While it has seen its share price strongly appreciate this year, investors have had three question marks over its outlook. GUD answered all three questions convincingly during reporting season.

The first was the level of debt on its balance sheet, which at 2.5x net debt/EBITDA at the company’s first half result in February, was simply too high. GUD saw its net debt fall materially through a combination of strong cash generation in the second half and the disposal – for an attractive sum – of the non-core Davey Water business.

The second question was whether GUD could maintain its operating margins amid tough market conditions. In fact, GUD’s margins, particularly in its core auto parts business, were stable, demonstrating pricing power and robust end market demand for its products.

Thirdly, there were doubts around how the recently acquired Auto Pacific Group (APG) – supplier of towing and trailing accessories into the 4WD and SUV market – was performing. GUD reported that APG is now on track to deliver to the earnings expectations held by management when they acquired it in 2022.

In our view GUD passed all three tests with distinction. The quality of the business has improved since it bought APG, with its earnings base now more diverse and resilient. GUD will also benefit from two ongoing dynamics. Firstly, the large backlog of new car orders outstanding which should improve as Covid-disrupted supply chains normalise. Secondly, the increasing sales of SUVs and 4WDs as a share of new car sales overall, as demand for passenger sedans and station wagons declines. GUD stands to benefit from both trends and is likely to grow strongly for the next few years. It’s currently priced at around 14 times FY 25 earnings and has a dividend yield of more than 4%. So, while GUD is already up more than 50% this year, we think it still looks cheap.

Regis Healthcare (ASX:REG) is the last listed aged care operator in Australia. It has, along with the aged care sector more generally, struggled in recent times due to staffing shortages, funding shortfalls and declining occupancy, all of which were accentuated during Covid. These issues all combined to eat away at profitability. This is now starting to turn around. At its recent result, Regis reported spot occupancy was close to 94%, which for all practical purposes, is close to full utilisation. Occupancy is likely to remain stronger from here as the average age when someone moves into assisted living is 84, and the massive wave of Baby Boomers are just starting to reach that age.

Regis is also set to benefit from deregulation. Previously, companies were limited in where they could build aged care facilities by the need for bed licenses. This is changing as governments have abolished bed licenses and introduced greater flexibility to help providers meet the expected increase in demand. With its strong balance sheet and improving company fundamentals, Regis is very well positioned to be able to build new facilities to meet that demand. Funding issues are also resolving as additional government funding flows into the sector over the next few years. Regis is currently trading on just over 8 times FY 25 operating EBITDA and with a dividend yield of 5.6% we think it looks very good value.

Kelsian Group (ASX:KLS) is Australia’s largest listed provider of public transport bus and ferry services. The market was underwhelmed by its recent result, with bus driver shortages in Adelaide, Sydney, and Singapore impacting its ability to meet service requirements under each of its contracts. However, those bus driver shortages are now abating. Kelsian is also fully staffed up to service its recently won bus contracts in Western Sydney. Moreover, its recent US acquisition All Aboard America looks like it will be transformational. All Aboard had 40% EBITDA growth in the six months to June 23, which provides a great starting point for Kelsian. The acquisition also gives Kelsian a great platform for further growth in the US. This future growth potential will also be boosted by the steps it has made in introducing electric vehicles into its fleets, which should help maintain its competitive advantage and contract economics. Kelsian is trading on 12 times FY25 earnings, with a fully franked dividend yield of 5%. We think that, when you include the increased US earnings for next year, it looks very cheap for the defensive and low risk earnings growth on offer.

Strong balance sheets and healthy dividends will be critical for returns

We have found the recent outlook commentary interesting from many companies. While many are understandably cautious, there are a good number of quality companies trading at reasonable prices that are positive about the next 12-24 months.

Many analysts and investors were caught out by higher interest rates in the recent reporting season, underestimating the impact they would have on company earnings. With interest rates unlikely to come down any time soon we think balance sheet strength will again be a key investor consideration in the coming financial year.

Also, with economic growth challenged, and trading conditions mixed, we think dividends will provide a significant proportion of investor returns this financial year. As well as the boost to returns dividends offer, we think that paying consistent, growing dividends over time is a strong disciplinary tool for management teams – it prompts management to carefully consider the best use of a company’s scarce capital.

People often overlook dividends in the small-mid cap sector, but there are many smaller companies paying very attractive dividend yields – if you look!

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