Are small caps set to come back punching?

For small cap ASX-listed companies, the past year has been nothing short of brutal.

Sure, there have been exceptions – there always are – but for most, the cost of cash has become almost prohibitive. The discounts many companies have been forced into offering to entice punters to take up their capital raises have been remarkable.

Consider the average discount at which most small cap companies have managed to raise funds. That discount, which was hovering at about 10 to 15 per cent a year ago, has risen to more like 20 per cent – and in some cases even eclipsed 30 per cent and beyond.

While it would have been a red-faced MD who raised funds at a 30 per cent discount just a year ago, it is not treated with quite the same derision now. Albeit, it can still raise the odd eyebrow or two.

Big discounts to the last traded price in cap raises are almost a necessary evil in this market and a key part of managing pre-revenue listed businesses.

Lithium (and to a lesser degree rare earths) aside, some standout drill results are being met with a “ho hum” market response. Copper is a particularly puzzling one that Dollar Bill can’t quite get his head around. Share price spikes have been increasingly short-lived and those quick-draw, profit-taking rats and mice have held court. That said, history demonstrates every market funk has been transitory. There are always inflection points when value become irresistible. When the metrics, the fundamentals, the economics and every other quasi-indicator screams “buy”. So it’s now worth considering, have we arrived at that point?

At times like this, some of Warren Buffett’s famous quotes spring to mind – particularly the suggestions to be “fearful when others are greedy” and “greedy when others are fearful.” The point of the above and below is to consider how we pick a bottom (for the adults amongst us, let’s just move on….).

Consider some facts. Firstly, the worrisome.

It was just over a month ago when major ratings agency Fitch slapped US debt markets with a rare downgrade. The previous time was in 2011 when the equity markets slumped by some 20 per cent. Global equity market bellwether Apple also reported an almost unheard of dip in sales – its significance wedded with the fact that the US$3 trillion (AU$4.7 trillion) mega-company represents an incredible 7 per cent weighting of the entire US S&P 500 index. Declining sales numbers amongst the giants, especially when posted by the biggest company in the world, have understandably sent a ripple effect throughout the broader market.

In fact, the result of declining sales across a string of sectors has sparked, what in the industry is known as, a “flight to safety”. Major investment houses and retail punters alike have all deserted the small cap market with the most speculative end being the hardest hit.

During the past year, heaven forbid, even Dollar Bill has wound back a few excesses.

Indeed, many ASX-listed small caps have seen their market capitalisations plummet by nearly half in the past year, despite recording solid progress in development and some stellar drill results, in particular. Most notably, at the very pointy end, resource exploration and med-tech stocks have felt the burn the keenest.

However, before all those grizzlies get too carried away, consider a raft of other fundamentals. The top 500 US stocks as represented by the S&P 500 are collectively up more than 16 per cent for the year. Perhaps more importantly, US Nasdaq exchange traded funds are up more than 30 per cent year-to-date and these Nasdaq ETF’s have proven over time to be a reliable indicator of the future fortunes of small caps.

The often-quoted CNN “Fear & Greed Index” – cited regularly as a contrarian indicator that attempts to measure the emotions driving stock market investors – has most recently indicated “greed” as being a prime driver.

Another forward-pointing indicator is global interest rates. With the Reserve Bank of Australia’s cash rate having soared from less than 1 per cent at the beginning of last year to more than 4 per cent recently, many commentators consider it highly likely we are near the end of this period of continuous interest rate hikes.

And that thought seems to be supported by the fact that the past few months have seen the RBA put interest rate hikes on hold and an increasing number of commentators are now predicating the next move in interest rates could well be south.

A sharp rise in bond yields during the past year have presented investors with a supposedly safer alternative. The benchmark of global bond investments – the US 10-year Treasury note – hit a 16-year high last month, printing at 4.633 per cent. Typically yields rise in line with inflation and the US Federal Reserve’s sharp winding back of a zero-interest position has been at the heart of rising bond yields.

As a general rule of thumb, higher bond yields drag investment away from equities – money flows towards the greatest and safest returns. US Treasuries are the base form and in addition, corporate yields are always significantly greater.

Higher yields also represent a higher cost of capital. Borrowers are required to pay more to invest in other markets, including equity markets and most especially small caps. In the case of small caps, this part of the market is the first to feel the crunch of the capital exodus.

Stampeding interest rate rises in the past year have taken hold around the world and have been driven by inflation, which has also cooked household spending and other sectors of the global economy.

All these points offer something of an explanation as to why the fear and gloom has held sway. But at some point, there also comes a reckoning.

It’s a reckoning that arrives when value becomes too compelling. When markets inevitably bounce. And, if we’re not already there, we may be soon.

For more than 120 years since 1900, the average annual equity market return sits at about 13 per cent. In that time, the world has experienced two World Wars, multiple other global conflicts, any number of pandemic-related slumps, stock market crashes and the oil price shocks of the 1970s, just to name a few. But despite all this, the average annual return over time has held firm at about 13 per cent return on equity.

I’ll put my peanut to your pound there’s not a bank in town that will even come close to that record.

History is on the side of recovery.

To be sure, equity markets have been beaten down badly, with the small cap sector copping a particularly bloody nose courtesy of the combination of both geo-politics and economics. But that said, there is a scent in the air that is wafting along with the interest cycle, relative value and the rhyme of history that all suggests the small cap equity market could soon rise to its feet.

The major macro drivers of equity market pricing are GDP, inflation and employment, with each indicator heralding a recovery in equity market prices. Inflation – which is essentially the cost of money – has spiralled in the past year, but most indicators are that inflation is now in retreat.

Global GDP is expected to print at about US$105 trillion (AU$162.9 trillion) in 2023, up US$5 trillion (AU$7.8 trillion) from last year, reversing a 2 per cent decline from the year before. The point being, while all the historical indicators paint doom and gloom, the more important forward-pointing indicators tell a very different story.

To quote Buffett, “Price is what you pay, value is what you get”.

While most historical indicators look problematic and paint a grey picture, more forward-looking indicators suggest something else entirely. However, despite the most considered research and study, there is one immutable fact that should also ring loudly and that is that no-one knows what is going to happen tomorrow.

Or, as former heavyweight boxing champ Mike Tyson once said, “Everyone has a plan, until they get punched in the face”.

Dollar Bill (sometimes known as Bill McConnell) is an associate director at Bulls N’ Bears and a former derivatives trader. He is also a former financial journalist and a raconteur of note. This column is for informational and entertainment purposes only and nothing contained within it constitutes financial advice – in fact Dollar Bill specifically recommends that you seek advice from someone other than him!