The Crash Playbook for Small-Caps

The RBA lifted the cash rate to 4.6% yesterday.

That’s the fourth rate rise this year, and a 15-year high.

According to figures reported by the ABC, that adds about $110 a month to repayments on an average $731,000 mortgage.

That one stings.

Yet the market barely blinked.

The ASX 200 closed ~0.3% higher, and my own small-cap watchlist looks pretty decent, all things considered.

The reason is simple enough.

Before the announcement, the ASX’s own rate tracker put the odds of a hike at 92%.

If it’s in the news, it’s in the price

That’s the old chestnut of the stock market.

Expectations get priced into shares quickly, usually well before the front-page headline lands.

Our job at Fat Tail Daily is to keep you ahead of the news, so you can potentially get better prices in the market.

Some of our calls miss the mark, of course.

But we relish presenting ideas still bubbling away beneath the surface of the mainstream media.

That’s your edge as a reader.

A crash WILL happen

So here’s an idea you’ll rarely hear on the nightly news.

At some point, a crash will come.

(They tend to only tell you once it’s happening)

And in the meantime, they try to keep you as scared as possible.

Right now, the feeling in the broader market is palpable.

Bond yields, AI capex debt, government debt, recession, high rates, and on and on and on!

Crashes always happen — I’ve lived through three. Perhaps more for you.

As always, the exact timing is anyone’s guess.

As I wrote yesterday, the RBA looks prepared to accept a slowdown and higher unemployment to tame inflation.

More rate rises are already pencilled in.

But before someone yells “Fire!” in the theatre this time, consider the following…

Anyone living near the bush knows to clear the gutters in spring, long before smoke appears on the horizon.

Investing works the same way.

The best time to prepare is while conditions still look calm.

Where the stuff comes from

Take a look at this sector breakdown of the S&P/ASX Small Ordinaries, an index tracking the smaller end of the ASX:

Source: State Street

[Click to open in a new window]

The materials sector, mostly miners and resource companies, makes up 28.83% of the index.

Industrials, the businesses that build and move physical things, add another 16.92%.

Together, that’s nearly half the index.

The smaller end of the ASX is packed with companies that dig things up or build things.

Now for context here…

The gap shows up in the price tags, too.

On State Street’s numbers, the Small Ordinaries [XSO] trades at around 14.4 times next year’s forecast earnings, while the ASX 200 [XJO] trades at around 17.5 times.

That’s a discount of roughly 18% for the smaller end of the market.

It also puts the small end below the Australian market’s long-run average of around 15 times earnings, while the big end trades at a premium to it.

Part of that premium comes from the heavyweights at the top, with Commonwealth Bank alone trading on around 23 times its earnings.

To be fair, some of the small-cap discount is deserved, because the average small company earns lower returns on its capital than the blue chips do.

However, that’s exactly why picking the right companies matters so much down here, and why I think the discount between the big boys and the smaller fish creates a real opportunity for patient investors.

Positioning for the next 18 months

In my paid advisory service, Australian Small-Cap Investigator, I’ve positioned readers for a continuation of the commodities supercycle.

A supercycle is a long stretch, often a decade or more, when demand for raw materials outpaces supply and prices trend higher.

Now I’m increasingly looking towards small, well-run industrial companies on the ASX.

(Especially logistics — stuff always has to move.)

I see them as a potential buffer against the economic headwinds Australia faces over the next 18 months.

In a crash scenario, they could suffer less than commodity stocks, which tend to swing hard with global sentiment.

And in the aftermath, they may bounce back harder than much of the market.

Provided their balance sheet is in good shape, they should attract defensive/fear-motivated capital quicker than the more speculative/greed motivated capital that struggles for targets in a crash.

So here’s the play…

We need more stuff!

Inflation is simply too many dollars chasing too few goods.

Canberra keeps adding dollars, so the RBA keeps lifting rates to cool demand.

The longer-term fix is simply more supply.

Australia needs more homes and more energy, and both require raw materials and serious industrial muscle.

Commodity producers dig up the raw ingredients, and industrial companies turn them into the housing and infrastructure we use every day.

Between the two, I expect they provide the solution to the problems keeping rates high right now.

Next week, I’ll share what I look for in a well-run small industrial company.