Small caps big bounces: reporting season update

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IML portfolio manager Lucas Goode talks to Jason Guthrie about the excellent reporting season for many small cap companies. The small cap index was up around 8% at the time of recording, despite extreme volatility. Lucas and Jason also discuss:

• His three main takeaways – volatility, momentum and overheating
• The performance of key holdings including Tabcorp, Kelsian, Hipages, ReadyTech and Cuscal
• The value he is still finding in small caps, despite the big rally

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Lightly edited transcript – Recorded on 28 August

Jason: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers, where we bring you insights from our global collective of experts to help you make better investment decisions. I’m Jason Guthrie, and today I’m joined by Lucas Goode to talk about the reporting season, which will wrap up over the next couple of days here in Australia.

Now, Lucas is a portfolio manager on IML’s small mid-cap funds, co-managing with Marc Whittaker, and he’s always full of energy. He is actually one of our more popular guest speakers on the pod. So, Lucas, welcome back. Thanks for coming on the pod today.

Lucas: Thanks for having me back, Jason.

Jason: So, look, we had a couple of your colleagues last week, Hugh Giddy and Daniel Moore, on the pod last week talking about some of the large cap names, which looked to have been quite positive in terms of performance over reporting season. There’s always some big moves, often overreactions off the back of some of the results, but markets continue to touch fresh highs from some of the strong results that we’re seeing. Lucas, turning to small and mid-caps, I understand some companies are still yet to report here, but how has confession season been for your part of the market?

Lucas: Yeah, we’re still right in the thick of it, Jason. Three more results out this morning, and a bucket load of company meetings still going on. It’s interesting hearing you say that Hugh and Dan were talking about the broadly positive reporting season for large caps because if they think that’s been positive, well, the small ordinaries are up nearly 8% for the month. I think that gives you a good indication of where the market’s at in terms of sentiment, but also the fact that results in general have been pretty positive.

Jason: So with that as a bit of a backdrop, that’s probably one of the stronger results we’ve seen over recent years through reporting. What have been some of the main observations that you’ve seen? What are some of the key sectors or themes that have stood out or maybe surprised you as the team goes through reporting?

Lucas: Yeah, I mean, look, the three key call outs for me, Jason, would be, number one, volatility; number two, momentum. I mean, momentum probably is actually the number one theme rather than any specific sector during reporting season. And then just a broader market that is probably starting to show signs of overheating.

On the volatility point, you might have seen in the press that a former colleague of mine, Jason Swinbourne at Barrenjoey, has noted this is the most volatile reporting season on record based on result day moves. I can tell you that it absolutely has felt that way, although at least for us, the majority of the big moves have been in the right direction. So we don’t mind seeing big moves as long as they’re up.

Just as a way of example, you look at Coles and Woolies; there was a 25% divergence in their result day moves. Coles was up 10 on, I think, 4% like-for-like sales growth, and Woolies was down 15 because it only reported 2% like-for-like growth. So, a 2% divergence over seven weeks of trading drove a 25% difference in their share price reactions. And these are two large cap defensives, so imagine what it’s like at my end of the market. Just incredible the kind of volatility that we’ve seen.

In terms of markets that I think probably are looking a little bit euphoric, listeners might be familiar with the famous CNN Fear and Greed index. It’s safe to say that, at the moment, the needle is firmly pointed into greed territory. To highlight that further, if we look at factor attribution for what’s driving returns, the number one factor by far is momentum. That is often a sign of an overheating market, where you see already crowded stocks continue to push higher. Just to give you examples, we’ve seen in small caps already very well-owned stocks trading way above historical averages, like Codan (CDA) or Generation Development (GDG). They put out good results, but it almost doesn’t matter now what the valuation is. If they put out good results, they attract even more money flowing into the stock, which is already expensive by any valuation metric; it doesn’t matter. Stocks get pushed way higher. I mean, Codan’s up, it’s doubled in like the last six weeks.

Jason: Incredible. Maybe turning to some of those key names in your portfolios— I know our listeners will be keen to hear about those names and the movements. Can you talk us through some of the standouts? What have been the primary drivers, outside of this maybe momentum factor, in some of these quality industrials that you’re holding in the portfolio?

Lucas: Yeah. Well, obviously when it’s our stocks going up, Jason, we’ll never say it’s because of momentum; it’s because of great stock picking. Thankfully, when I was preparing for this, I figured you might ask me a question like this, so I actually had to cull the list, which is a good position to be in, because we had so many to choose from that have put out positive results and seen a great share price reaction.

Some that I would call out include a company called Cuscal (CCL), a payments infrastructure provider, recent IPO, that we cornerstoned. Not only did they exceed prospectus forecasts, but they also announced a highly accretive acquisition of the number two player in the market. Indue at least the 30% accretive acquisition. Once they fully integrate it, shares reacted strongly in response to that, and we think they’ll go further higher.

There’s a bit of an overhang at the moment created by the stock coming out of escrow, but we think that’ll get soaked up here from brokers; there’s a lot of demand for that stock. So that’s one that we continue to like and has had a very good reporting season.

Kelsian (KLS), also one that has been a bit of a serial offender for us in previous periods, has actually been our largest contributor this month. They’ve hit guidance, and the new management team’s just executing extremely well. They’ve got upcoming catalysts from the announced sale of their tourism assets, solid guidance, and a really positive outlook into FY27 in both the Australian and US bus businesses. So Kelsian has been a good performer for us.

I’d call out Tabcorp (TAH) as well, a stock that really was under-owned heading into their result a couple of days ago. I’ve got to say that Gil McLachlin is doing a great job there—strong profit performance on cost-out and the execution of the strategy, which is very clear. It’s for Tabcorp to focus on areas where it has a competitive advantage; something it has probably struggled with for a long time. They’ve been a bit of a “me too” to Sportsbet, and they can’t match Sportsbet’s product innovation given how deep-pocketed that competitor is. Instead, they’re focusing on where they’ve got competitive advantages like tote and retail. As you say, we know positioning plays a large part when the market is so volatile and liquidity’s not great, and Tabcorp was really under-owned heading into that result, so another strong performer for us.

Another one I’d like to flag is HiPages (HPG). It’s another stock that we’ve owned since its IPO, unlike Cuscal its IPO was actually quite a long time ago—pre-COVID, in fact. But we’ve finally seen that strong free cash flow generation come through, demonstrating the great operating leverage that these marketplace businesses have. Listeners are obviously more familiar with those longer-standing platforms like CarSales, REA, and Seek, but HiPages really is following that well-trodden roadmap of generating a lot of incremental free cash flow as they keep growing the top line.

Jason: I know some of those names like Kelsian and Tabcorp, you’ve held for a number of years, and they maybe haven’t been the strongest performers. So, it’s nice to hear that the patience is being rewarded. How about touching on anything that’s been a bit disappointing over the last couple of weeks?

Lucas: Yeah, I was afraid you’d ask me that, Jason. Look, nobody bats a thousand, as they say in the States. Probably the one to flag is local government and education software provider, ReadyTech (RDY), which is a key holding of ours. But yesterday, announced the latest in a series of small profit misses and downgraded its medium-term revenue guidance. Pretty disappointing.

We remain big believers in the long-term opportunity, particularly in higher education and flipping their existing on-premises council clients into the cloud. We actually think the company’s done the right thing in ripping the Band-Aid off and setting more conservative goals that it can then exceed. It’s always better to under-promise and over-deliver in every aspect of life, but particularly when you’re a listed company giving guidance, Jason.

The funny thing is, Ready Tech’s growth over the journey has actually been very good; it just hasn’t been quite as good as the goals that they’d set. So, I think it is good for them to come out with these more conservative goals. We remain supportive of the company. We’re firm believers; founder-led, great story. I think we’ve been through a similar situation with Kelsian in the past couple of years, as referenced earlier. Kelsian is one of their big winners of this reporting season, where they finally delivered a result ahead of expectations and the stock’s up almost 30%. Hopefully, touch wood, we might see something similar from ReadyTech in February.

Jason: Fantastic. Obviously, you’ve mentioned a number of pretty big moves in share prices. Has this created any trading opportunities where you’ve been able to put some important capital to work for clients?

Lucas: Yeah, look, we are conscious that the market as a whole is looking pretty toppy. That follows the US lead, where even Trump attacking the Fed’s independence doesn’t seem to rattle markets anymore. It’s almost concerning how little impact these things that you would have assumed would freak the market out are having. So, I think underneath the surface, things are probably a little bit more volatile than what we’re seeing.

As a result, we have been pretty active in trimming some of those winning positions that have run hard. Luckily, in small caps, there’s always value to be found somewhere if you look hard enough, and we have initiated a couple of new positions during the month. I maybe won’t let listeners in on them just yet, but hopefully, they’ll be hearing about them in the not too distant future when they’ve, you know, hopefully delivered some alpha for the fund.

Jason: Yeah, maybe on the next pod, Lucas. In finishing up, I know in a number of recent meetings and presentations, there’s been this persistent valuation gap in small and large caps, particularly now going back to early 2022. Clearly, they’ve had a really strong run through this reporting season, and you’ve mentioned that the valuations are looking quite full. What’s the portfolio trading on today, and how are you feeling about things going into the end of the year?

Lucas: Yeah, I mean, as you mentioned, Jason, the small caps have outperformed large caps by around 5% for the month. However, if we zoom out, you have to view that in the context of three years of material relative underperformance—around 30% or so since the start of 2022. We still think there’s a more attractive opportunity set outside the top 100 than there is in the top 100. Mind you, obviously, I would say that! But, look, we’re always finding undervalued stocks in small caps. That’s the beauty of having such a large universe to choose from. Particularly at the moment, given yes, headline multiples are now looking a bit stretchier, even outside the top 100, valuations at the index level, excluding mining, are actually pretty similar to the top 100. But beneath the surface, as I mentioned, there’s a lot of crowding into a pretty small number of names. You look at the top 10 holdings of a lot of our small cap brethren, and they look very similar. We still think there are plenty of unloved, misunderstood small caps out there, and that’s why we really do think that small caps deserve a prominent place in any portfolio.

Jason: Well, thank you, Lucas. We’ll leave it at that. It’s always a pleasure to have you back on the podcast. We certainly appreciate your time. Good luck over the next couple of days with the end of reporting season. And as always, thank you to our listeners for joining in. If you enjoyed the episode, please tune in again to hear more from our global collective of experts.

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