Investors were cautious going into the company earnings reporting season in February, but generally company results were reassuring. Most financial metrics of companies within Mirrabooka’s diversified portfolio of small and mid-sized firms were quite solid and resilient. However, there was more caution in the outlook comments on earnings. Portfolio manager Kieran Kennedy shares his takeaways.
The impact of past interest rate rises has a delayed impact on inflation, so we are yet to see the full effect of higher rates on consumer demand and the consequent impact on company earnings.
As companies emerged from the initial impact of the COVID pandemic, they struggled to find sufficient inventory to meet pent-up demand. In the current climate of higher interest rates, demand may be starting to soften and consequently we believe the economic environment is likely to be more difficult for companies to navigate over the next three to six months. This is likely to have implications for company earnings.
Small and mid-sized companies can sometimes feel greater pressure on their earnings than larger companies because their businesses are often more narrow and singularly focused. Therefore, we are cautious about the short-term outlook.
It is important though to distinguish between caution over three to six months versus confidence over the longer term.
Our investments can navigate challenging periods
Companies that are more consumer-facing will likely feel more earnings pressure as higher interest rates and a transition from fixed-rate mortgages to a variable rate hit consumers.
In Mirrabooka, we have invested in companies that we believe can navigate more challenging periods well. Quite often these companies represent good buying opportunities for the longer term should valuations prove attractive as share prices fall in response to short term caution.
For example, companies like auto parts supplier ARB, kitchen appliance supplier Breville, plumbing supplier Reece, and online retailer Temple & Webster are all companies we currently hold where we feel there may be good buying opportunities in the future.
Reece’s financial results in the recent reporting season were strong, with over 20 per cent sales growth and profit growth. This growth was primarily driven by price increases, rather than volume growth demonstrating Reece’s leadership position in the market and its ability to lift prices and pass on cost increases when necessary.
We’re conscious though that when consumer demand softens, a company can only lift prices to a certain point. So although Reece’s result was excellent, the short-term outlook is cautious.
ARB and Breville also held up well but, similarly to Reece, are likely to see some softening in demand over the next three to six months. They are still good investments and we’re comfortable in accepting volatility in the short term because we see the long-term opportunities for growth in these companies.
Our approach is to invest over the long term in companies that are better positioned to manage more difficult circumstances. Those companies need resilience, a strong balance sheet, and good management who can see through challenging times.
Small companies have advantages
The long-term returns of smaller companies are superior for two reasons.
Firstly, earlier-stage companies have more years of higher growth ahead of them, where they can win more market share and be innovative. Secondly, they are less understood by the market, so there is a “discovery premium”.
As these companies grow and become better known, they will attract more buyers. That’s why Mirrabooka’s long-term returns are superior compared to both its benchmark index and the ASX 200 index.
The appetite for investing in small companies is very cyclical. In buoyant tomes, investors often chase small companies because there are better returns on offer but the tide can go out quickly when you get significant challenges and greater volatility.
At present the appetite and trading volumes for small companies are low and some investors have moved away from this end of the market, believing it to be safer in bigger companies where there’s less volatility in an uncertain time.
Whilst this is understandable, we believe it’s a good environment for Mirrabooka as it enables us to find better opportunities to invest in the small company sector.
We don’t know when interest rates will level out, but we may be getting closer, and markets will again resume a focus on company earnings. We’re also very observant of the sentiment towards smaller companies but Mirrabooka has a track record of superior long-term performance, so we believe that once companies get through a period of challenged earnings, it will be a very good environment for us to buy well for the next five to 10 years.