Two cafes in my neighbourhood closed this week. One was terrible. The other had a great product and hard-working owners, but not enough customers.
Yes, forming a view on the economy based on anecdotes is dangerous. But everywhere I look, there seem to be empty shopfronts and store closures, and growing signs of small-business distress.
Insolvencies have hit a record high, according to data from debt-monitoring firm, Creditor Watch. Businesses in the hands of external creditors are up 22% on this time last year. More firms will fail as Australia’s economy slows.
My previous column outlined the case to increase portfolio cash allocations and take a more defensive stance in the next six months, in what is a seasonably weak period for Australian shares.
I’m still not convinced the next rate move in Australia is up, but the odds of further rate hikes this year are shortening due to persistent services inflation.
Another one or two rate hikes in the next 12 months would surely send more consumers – and small businesses that rely on them – to the wall.
I see more signs of consumers cutting back. Our suburb used to be full of Uber and Menulog drivers whizzing takeaways to time-poor households. Now, there are far fewer deliveries or people having expensive café breakfasts.
There’s more economic pain ahead. Australian consumers built large savings buffers due to excessive government stimulus during COVID-19 that brought forward years of economic growth. When those savings buffers are exhausted, more households will aggressively curtail their spending.
Normally, I see share market pullbacks as an opportunity to add equity exposure at lower prices. Not this time. Although I remain bullish on equities on a medium-term basis (1-3 years) due to rate cuts then, the next six months are a risk.
The equities market has not sufficiently adjusted to the likelihood that inflation will remain higher for longer due to large increases in services that are hard to avoid. Think education, healthcare and rental costs. Nor has the market adjusted to the prospect of rate rises and what that would do to economic growth.
This is a good time to take profits and trim positions in successful stocks. That doesn’t mean rash action or exiting the market. Rather, taking some money off the table so that there is more cash to redeploy into better-value stocks over the next six months.
Takeover activity
The great thing about the market is there are always different ways to play trends. A slowing economy will pressure households and some small firms, but it also could create opportunity for active investors through corporate activity.
A sluggish economy will encourage larger firms to grow through mergers and acquisitions rather than only organic growth. Falling valuations for many small-cap firms will attract the attention of corporate predators.
I’ve long thought there are too many small-cap companies on ASX and that many would be better off in private hands. If a recession is ultimately required to break the back of inflation in Australia – which is not my central base – conditions will be ripe for cashed-up corporates or private equity firms to pounce.
Small-cap companies are coming off years of underperformance compared to large-caps. Moreover, small-caps tend to be relatively more exposed to Australia’s economy because they have fewer international operations.
If ever there is a time to mop up quality small-cap companies that the market has underestimated or forgotten about, it will be over the next six months.
As I have written previously, investors should never buy small-cap stocks based on takeover alone. Stocks should be a good buy regardless of takeover.
Think of a takeover bid as confirming your thesis that the small-cap is badly undervalued and overlooked by the market. Don’t buy solely on takeover speculation because M&A is exceptionally hard to predict and time.
Caveats aside, here are two stocks that warrant further investigation for experienced investors who understand the features, benefits and risks of investing in small-caps that are badly out of favour. I’ll cover more small-cap takeover targets in coming columns.
- Bapcor Group (ASX: BAP)
I covered the automotive parts retailer and distributor in this column at $6.38 a share. I wrote: “… further price weakness this year [for Bapcor] is a risk as the market digests management changes and the full effects of a slowing economy.
“For all the challenges, Bapcor is an excellent business in a market with solid medium-term growth prospects as more vehicles need more repairs and parts. It just needs to get through a tougher 12-18 months ahead.”
The warning on short-term performance was timely, although Bapcor fell further than I expected after a trading update this month disappointed investors. The weak economy is affecting sales in Bapcor’s retail automotive division. Bapcor shed more than a quarter of its value after the news and now trades at $4.46.
Bapcor has much work ahead to rebuild market confidence. Poor consumer sentiment will continue to weigh on retail parts demand and possibly on wholesale parts demand if more people delay or cancel costly car services.
Every stock, however, has its price. Beneath the short-term price volatility is a quality business with a large footprint in its market. Macquarie Equities, in a research note this month, tipped Bapcor as a potential takeover target and Morgans, a broking firm, highlighted the potential for corporate activity.
With a lot of private equity ‘dry powder’ on the sidelines looking to be invested, Bapcor surely has more suitors running their ruler over the business given its depressed valuation, management change and difficult trading conditions.
Chart 1: Bapcor Group
Source: Google Finance
- KMD Brands (ASX: KMD)
The owner of Kathmandu, Rip Curl and Oboz brands has been belted, its shares slumping from almost $2.50 in early 2020 to 44 cents.
KMD reported a 14.5% decline in sales growth for 1HFY24 partly due to unseasonably warm, dry weather and poor consumer sentiment that affected sales products. Underlying earnings tumbled by 66% over the same half last year.
KMD hasn’t attracted media speculation as a takeover target, possibly because few brokers cover it these days and the market is more focused on other potential retail takeover targets.
I wrote in mid-February: “KMD will take time to fix and needs the weather gods on its side, at least in the short term. But at 62 cents, the market is pricing in a lot of bad news to continue.” Even worse news is reflected at 44 cents a share.
I added: “If KMD can’t stem the falling sales growth, a larger retail predator could pounce on the stock through a takeover. Alternatively, a private equity firm could acquire KMD, privatise and fix it, away from the glare of an exchange listing.”
KMD has traded inconsistently over the past five years due to unseasonal weather conditions, a changing outdoor retail-apparel landscape, a decline in outbound tourism (buying a warm Kathmandu jacket was popular with travellers) and now the softening consumer environment.
It’s getting to the point where KMD would be better off in the hands of a private equity firm that can fix the business and capitalise on what remains a strong portfolio of brands with a large customer base. How much more pain can existing shareholders bear?
It’s hard to see KMD recovering anytime soon amid forecasts of a mild winter this year and the likelihood of further deterioration in consumer spending. Its best chance of a higher valuation in the short term could come from a predator paying a premium to acquire a business that has latent value that can be unlocked.
Chart 2: KMD Brands
Source Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 8 May 2024.
