Australia's current economic challenges may not have investors rushing to the smaller end of the market, but UBS small cap fund managers Stephen Wood and Victor Gomes say there are good opportunities on offer if you know where to look
A housing market boom that pushed prices to sky high levels in Sydney and Melbourne and consumers deeply into debt, coupled with power price bill shocks, are likely to all combine to keep interest rates on hold for some time, the managers of the UBS Australian Small Companies Fund said.
Given that backdrop, the Australian dollar may continue to gradually weaken and "we think the best way to play that is resources".
The lower the Australian dollar, the more money the miners make, they said, with costs in Australian dollars and cost inflation still under control. "The currency weakens and that supercharges the margins," they noted.
The fund managers have combined their view on an expected currency benefit to the mining sector with the technological change occurring elsewhere to put money to work in lithium, copper and nickel small cap resource companies.
In particular, they like lithium players Galaxy and Pilbara Mining, along with copper producer MetalsX.
These companies are a way of getting exposure to the renewable energy space, which has been sharply in focus ever since a widespread power blackout in South Australia turned up the heat on electricity supply and led to an offer from Elon Musk's Tesla to build a giant battery to help provide power for South Australia.
"That was a fabulous advertisement for renewables," the pair said.
Another way to invest in the small cap mining space is to buy the companies that are supporting these miners and that have seen their propositions improve, Mr Woods and Mr Gomes said.
Contractors that are helping to build new solar facilities that are only going to get bigger in Australia, where there's no shortage of land, are interesting, they said. Their stock picks along this theme include RCR and NRW, along with equipment firm Emeco.
One of the key characteristics of the small cap space is that it's a very active investment environment, the fund managers noted.
"A year ago we would have been driven by different themes," they said. For example, the mining sector has been through an evolution in recent years from being on its knees, to working its way out of the gloom, and finally benefiting from rising commodity prices.
Watching coal producer Whitehaven and iron ore producer Fortescue Metals take their costs down and cut their debt was quite amazing, the managers noted. "When commodity prices turned, the leverage was just enormous."
As Mr Woods put it: "Sometimes it's not about timing the market, it's about time in the market."
"You need to identify different market phases, you need continuous active management. Circumstances change and you need to be continuously monitoring."
The team, which has been together for seven years, and includes Mr Woods, Mr Gomes, David Haddad and Joel Fleming, invest with a six-year timeframe and are firmly committed to this.
"It needs something dramatic to move the dial on our six-year view. That's why our portfolio has a low turnover."
The market has already been through the industrialisation of China, the GFC, the early phases of fiscal stimulus, monetary stimulus, the winding back of unconventional policy and now aggressive fiscal stimulus, they said.
Going forward, they're looking at digitisation, the cloud and artificial intelligence, which they said "will damage or help companies depending on how they are positioned".
Companies they like for these themes include data storage group NDC and TechOne.
"A lot of investors see small caps as a casino. We take conviction views and we have a diversified portfolio with a good spread to ride out the speed bumps," they said. "And there will be speed bumps."
Overall the last year has been one where the median small cap manager has struggled to beat the index, they said, with UBS expecting 2.5 per cent to 3.5 per cent for the year, which they said will place it among the top performers.
That situation is the result of a more balanced year for sector performance, they said. "Some companies within a sector have done badly, some have done well."