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Small caps to remain attractive for investors


Following the March equity market correction due to the COVID-19 pandemic, global equity markets rebounded sharply in April, with the small cap sector outperforming.
Although the short-term outlook remains uncertain, the market recovery was spurred on by several factors. Many companies were deeply oversold, with valuations having fallen significantly. Governments and central banks have responded with unprecedented levels of fiscal and monetary stimulus, limiting the downside. The market is also beginning to consider the trajectory of a potential recovery as signs of improving COVID-19 trends emerge and governments’ plans to re-open economies.
Looking back on the recent correction, a defining feature was the indiscriminate nature of the sell-off, with high-quality companies seeing significant share price falls.  The dislocations between share prices and valuations based on long-term cash flows provided an exceptional opportunity for long-term investors.
The DNR Capital Australian Emerging Companies Fund outperformance during April reflected the opportunities we took advantage of during the sell-off, when we increased the Fund’s exposure to a range of quality companies at significantly lower valuations. Rather than attempting to time the market bottom, our confidence in the companies and valuations enabled us to buy as share prices were falling sharply. This action positioned the Fund well during the April recovery.
The Fund increased 21.11% (net of fees) in April, outperforming the S&P/ASX Small Ordinaries Accumulation Index by 6.84%, which increased 14.27%. This came after the Fund also outperformed the Index during the March sell-off by 3.10%, benefiting from its focus on resilient business models with strong balance sheets.
Investors should now prepare for the post COVID-19 world.
COVID-19 is having a far reaching and unprecedented impact on the global economy. Given the magnitude of the virus’s impact, we have been considering the long-term investment implications for the DNR Capital Australian Emerging Companies Fund, as it could well mark an interesting turning point in history.
As the world comes out of this crisis, some key structural trends are likely to emerge or accelerate. Certain companies are likely to be beneficiaries of these trends and the strong structural tailwinds over the medium to long-term, while many others are likely to be negatively impacted as business models are challenged.
Examples of some of the structural trends emerging from the COVID-19 pandemic, and the small cap companies impacted include:

  • an acceleration in the transition to a more digital based economy.
  • market leaders strengthening their competitive positions.
  • an increased investment in healthcare and infection prevention.

Accelerating the transition to a more digital based economy
The transition to a more digital world is only likely to be accelerated by COVID-19. The digital world has been largely immune from the virus outbreak compared to the severe disruption seen in the physical world. The transition to a work-from-home environment and the use of collaboration tools, has highlighted the benefits of modern cloud-based software applications that can be accessed anywhere regardless of your physical location. This means that corporates are likely to continue prioritising high levels of IT spending to modernise IT infrastructure and facilitate remote working. Projects are likely to focus on increasing automation of manual processes, replacing old legacy systems, the shift to cloud-based computing and the adoption of new emerging technologies such as 5G and artificial intelligence. We believe the Emerging Companies Fund is well placed for these trends, with a 30% weighting to the technology sector. Some of the key beneficiaries are likely to include Bravura Solutions and Megaport.
Strong get stronger as industry leaders strengthen their competitive position:
During economic downturns we often see the competitive makeup of industries change as industry leaders strengthen their competitive positions. Competitors suffering from stretched balance sheets are being forced to cut costs compared to better funded companies that can invest more through the downturn. This may impact long-term market shares and the future margin and cash flow potential, with the industry leaders strengthening their competitive positions. In the Australian small-cap market there will be examples of this happening across multiple industries, with lower quality companies impacted most.  For example, we expect Credit Corp and IDP Education to emerge from this crisis in a much stronger position than many of their competitors.
Increased investment in healthcare and medical device companies
Healthcare investment will clearly be a focus in the coming years, with governments and the healthcare industry looking to improve their level of preparation for the next virus outbreak. An obvious beneficiary is Nanosonics given its focus on developing medical devices for infection prevention. Its core Trophon device is used to clean probes of harmful bacteria and viruses. The company is also developing new devices to build a more diversified medical device business focused on infection prevention. We believe the opportunities for Nanosonics will only improve as a result of COVID-19.
While the COVID-19 pandemic is causing a significant disruption in the near term, we believe investors should not lose sight of the longer-term opportunities. Certain companies will be big winners from the structural trends emerging from the crisis, and we have been positioning the DNR Capital Australian Emerging Companies Fund to take advantage of this.

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