Small cap update – FY 2024

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Join IML Senior Portfolio Manager Simon Conn to discuss the performance of IML’s small and mid cap funds for financial year 2024, as well as key stocks and market movements.

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Lightly edited transcript

Jason Guthrie: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers Australia, where we bring you insights from our global collective of experts to help you make better investment decisions.

I’m Jason Guthrie, Head of Wholesale, and today I’m joined by Simon Conn, who is a Senior Portfolio Manager at IML providing his regular quarterly update on the small and mid-cap strategies at the firm.

Now Simon has been managing capital for over 25 years at IML. He’s a highly regarded investor in this space and has many of Australia’s top executives on speed dial. The rough agenda will include a market update for the quarter, how the funds have performed, some of the more recent opportunities, and the outlook from here. Please enjoy the conversation.

Simon, welcome to the podcast.

Simon Conn: Thanks, Jason. Thanks for having me.

Jason: So Simon, end of the quarter, also end of the financial year. Hard to believe another 12 months done. It’s been another strong quarter for global indices, maybe less so here in Australia. I think the ASX 300 was off around 1.2% and small caps a little bit more down some 4%. Can you maybe start by running us through some of the main developments you were watching over the quarter?

Simon: Yeah, look, I think we’ve had quite a strong 18 months in small cap industrials when we had more certainty around interest rates. And so I think over the last quarter we’ve sort of seen the market run out of steam a little bit and the broader market’s been weighed down, particularly in the small caps by the softness in the consumer. So we saw a few of the retailers warning companies like Eagers and the like warning of a slowing consumer environment and that’s weighed on the consumer discretionary sector in smalls. Then also the REITs in the index have been weak. Obviously that inflation print during the quarter was a lot hotter than the market had anticipated and that’s led people to surmise maybe the interest rates here have to go up, which has weighed on that interest rate sensitive sector of the small cap market.

Jason: And maybe if we turn to the 12 months to the full financial year, is that similar, the same sectors driving things over the 12 months?

Simon: Yeah, look, over the 12 months, the index has done 10% so it’s had a good 12 months. But yeah, a lot of the heavy lifting, all the gains were made in the first two and a bit quarters. But clearly as the financial year has come to an end, it’s been a bit softer in terms of the outlook and I think people sort of weighing more on the outlook for ’25 and ’26 and where the economy goes to from here.

Jason: Well congratulations to the team. I can see it’s been very solid outcomes over that period across the three main funds that you’ve managed between 18 and 24%. And I know that’s been delivered, from my understanding, in a much less volatile way as well, which is a hallmark of IML. So congrats to the team.

Simon: Thanks, Jason.

Jason: What were some of the main companies that were really driving things over that period?

Simon: Yeah, we’ve had a range of really good performances. I mean obviously we talked before about the takeovers we’ve had in the fund, but it’s not just that. It’s come from a broad range of gains across the sector. One stock that’s been a really strong performer for us is SG Fleet, which has been one that we’ve owned for some time and really got sold off quite heavily through the COVID period and that’s rallied quite strongly over the last 12 months.

Still looks very cheap on 11 and a half, 12 times, but very solid business in fleet leasing and novated and we think still got a very strong future given that it’s got a contracted nature to its earnings in terms of the fleets that they manage. Other stock that’s been strong for us is Integral Diagnostics and it was a good gainer over the last quarter as well. And so that’s posted good gains. And they just announced a scrip-based merger with Capital Healthcare, which is a listed peer in the radiology sector.

Jason: And I think we were talking a bit earlier, GDG is another name that’s been quite good. There’s been a bit of action there and they’ve been in the media lately.

Simon: Yeah, GDG, Generation Group, has been the one that’s held in the Smaller Companies Fund for some time and they’ve really had a really good run of it in terms of insurance bonds and their flow there. Grant Hackett, the CEO, has done an outstanding job in getting growth and sales in their insurance bonds, but it was their purchase of Lonsec Consulting, which has really helped fuel up the growth and through the quarter they bought the balance of that business that they didn’t own for circa $200 million and that’s seen them move to a hundred percent of Lonsec. That business has been growing very strongly and your listeners are probably well aware of the strong growth in managed accounts.

And this linked Lonsec business is one that’s really invested and being able to scale very rapidly in that sector and as a real leader in that field. So the market’s obviously very excited about the outlook for that business. It is generating good growth and I think the team at Lonsec and GDG have got a good track record in terms of selling products. So we are quite excited about the outlook for the business. Obviously not as cheap as it was before, so the other placement was a good opportunity for smalls and caps to increase their weight, but these prices are looking fairly full. But for Future Leaders at $1.95 it was a great opportunity to get set for that fund and we’ve initiated a position there. So one we think can continue to do well through time.

Jason: Fantastic, thanks Simon. Look, not all companies always deliver. What have been some of the more disappointing holdings over the quarter?

Simon: Yeah, look, I think we’ve had two disappointing ones over the last quarter and obviously the reason of having a diverse portfolio is that you do get some disappointments. So SkyCity obviously had a disappointing update where they announced that they weren’t going to pay a dividend for the next three halves to prioritise debt reduction, which is frustrating because they’re just getting to the end of these regulatory issues that they’ve had. They settle the Austrac matter, which has been a big handbrake on the stock. Also announced a new CEO who’ve just met recently. He seems like a strong candidate, but disappointing they had to cancel the dividend, issued some earnings guidance which was softer than the market anticipated for FY ’25. Clearly the consumer is weighing on the stock in terms of gaming activity in New Zealand.

So look, that was disappointing. It’s got a strong asset backing at the current price. Looks very reasonably priced, got a strong asset backing, good management team. And I think once they get through these issues, there’s a real low-priced option in the business in terms of that online casino. And so the new Liberal [centre-right NZ party] government there has been talking about licensing and regulating online casinos. Sky has been operating a casino in that environment for some time and if they can get that licence regulated, they could have a strong market position and a good earner I think potentially. So that gives you some upsides to that business and I think the new management team will always bring a guise and look at the asset base.

Maybe some of the assets don’t fit. Just last quarterly or so announced the sale of an online casino called Gig or online casino developer, Gig, which they were sitting on their books for a low value. They’ve crystallised some cash to pay down debt. So I think it’s always an opportunity to revisit the portfolio. And then the other one that was weak between the quarter was Mayne Pharma. Bizarrely gave a reasonably positive update at a conference earlier in the quarter, was taken negatively for a range of reasons. There’s been a cyber attack on one of the pharmaceutical distributors in the US and I think people surmise that the impact had been greater than it was, company’s continued to reiterate guidance but it’s seen the stock drift off quite a bit. So that’s one we have been adding to on weakness just given how cheap it looks.

Jason: Okay. And I can see a number of names coming out over the more recent period. You’ve had some takeover activity, you mentioned. Maybe some of those names.

Simon: Yeah, look, we’ve had a lot of takeover activity. Clearly Namoi Cotton in the Smaller Companies Fund continues to bubble away. We’ve got two bidders for that. Probiotec was taken off the boards, through the quarter and it’s a good outcome for the small funds. Adelaide Brighton, or Adbri as it’s now known, obviously taken over. That was a good outcome and it went… And then the other one that’s been a big holding in the fund and a good performer over the last 12 months is QuantM. So it’s the smaller peer in the listed intellectual property law firm sector. IPH is obviously the large player in the market, but QuantM owns a very high quality intellectual property firm in Melbourne called Davies Collison Cave, it’s a leader in its field.

The stock’s been much maligned. I think liquidity was an issue, but it was trading at a very cheap multiple prior to Christmas. They’ve actually had two profit upgrades since Christmas, which saw the stock initially move from like 95 cents to a $1.10. But then there was a bit of a bidding war broke out between a UK private equity firm and a local private equity firm called Adamantem. And through the quarter, we finally saw Adamantem declare successful in that bid. So they’re taking the company private at a $1.81 and hopefully they pay another 7 cents fully franked dividend when the scheme’s implemented in early August. But again, really good outcome for the fund, strong performer. It’s actually quite a big weight in the fund, so it’s been pleasing outcome.

Jason: Great stuff. So maybe one last question before we wrap up. More broadly, got reporting season coming up, late August kicks off for small caps. What are you hearing from management teams in general and how do you see things playing out in the second half? Crystal ball, eh?

Simon: It’s never easy, Jason, in this game. Look, I think the market’s had a reasonable run, but the valuations in smalls are still very reasonable. I think balance sheets are okay, but I think most CEOs are pretty cautious and it’s hard to get a good read on the economy. I think people can see growth, but it’s harder to get. The one consistent theme is costs, whether it’s higher rates because bank interest rates are now resetting to higher rates, whether it’s labour or insurance, electricity. There’s just this constant battle for CEOs to continue to maintain margins because of cost. But today, we’ve actually seen most companies been able to perform quite well. The Australian market’s not heavily exposed in smalls to manufacturing. And I think manufacturers in Australia are the ones that are really struggling. But most companies seem to be-

Jason: Don’t have a lot of exposure there today across the-

Simon: No. Well, there’s not much exposure left in Australia manufacturing.

Jason: It’s all been sold.

Simon: It’s mostly a service-based economy. But there is pressures and I think navigating that environment, it makes it tricky. So I think the outlook for earnings growth is muted, but I think good companies can continue to still eke out some good growth. And I think that M&A in that environment, Jason, comes to the fore again. I think that’s going to be an ongoing theme where particularly something like an Integral Diagnostics where we’re seeing unlisted operators trading at much higher multiples than the listed market is this multiple arbitrage. And I think we’ll continue to see companies getting taken private because of that valuation disconnect.

Jason: Well, thank you Simon. As always, great to chat. We appreciate the insights and thank you to all of our listeners joining us today. If you enjoyed the episode, please don’t forget to click follow on your favorite podcast platform. You can also click the bell icon to be notified of future episodes. And please tune in again very soon to hear more from our global collective of experts.

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