The S&P/ASX Small Ordinaries Index has experienced a brutal correction, falling more than 30 per cent since the start of the calendar year. The sell-off has been painful across a range of sectors, in particular impacting the more cyclical areas of the equity market. Retailers, consumer products, travel and tourism, commodities and financials exposed businesses have all fallen heavily.

There’s only been a select number of gold, consumer staples, healthcare and software companies, which have demonstrated any defensive qualities. As liquidity has been pulled from the small-cap market, even many of the more defensive or higher-quality businesses have seen material share-price falls. The sell-off has certainly been very indiscriminate in nature. 

The duration and severity of the business disruption are unclear 

Given the lack of visibility, many companies have already downgraded or stepped away completely from providing future earnings guidance. The challenge is that there’s still considerable uncertainty in assessing the duration and severity of the COVID-19 outbreak. This uncertainty adds to the sense of fear and panic in the market, with investors having to consider various types of worst-case scenarios.

For example, whether the containment measures and disruption to business last for three, six or 12 months. Many companies with high levels of operational gearing (high fixed costs which are difficult to reduce) or significant financial gearing (high levels of debt) could see a material impact on their profitability and/or solvency position.

This means that the impact of the disruption will vary widely across the small-cap index, with many lower-quality companies with stretched balance sheets placed in a more precarious position. Having a resilient business model and strong balance sheet will certainly be a key advantage in the coming months as the extent of the downturn becomes clearer.   

Significant uncertainty increases the likelihood of share-price overreactions 

With the probability of downside scenarios for earnings and balance sheets still unclear, this only adds to the significant share-price volatility seen on a daily basis. The fear and panic now rampant in the market increase the likelihood of short-term share-price overreactions. Just as the market has overreacted to positive news in recent years, the short-term focus of many investors suggests the reverse will also be true. During periods of market stress such as this, we believe opportunities for long-term investors will be at their greatest. 

Staying committed to the investment process 

As long-term investors, our focus is to ensure we take advantage of the significant dislocations arising between share prices and fair values. Poor investment decisions are likely to be made when investors neglect their process, especially in times of elevated market stress (i.e. don’t panic). This means focusing on factors we can control, rather than the uncontrollable such as the extent and duration of the virus outbreak. Central to our investment process is to identify the highest-quality smaller companies, especially those that are significantly undervalued by the market.  

What have we been up to? 

Over the past few weeks, we have focused on reviewing the investment cases for all our holdings in the DNR Capital Australian Emerging Companies Fund. This includes revisiting our valuation models and detailed stress testing of all assumptions. We have also been speaking directly with company management to understand how they are dealing with the current crisis, reviewing balance sheets and the likely impact on long-term cash flows. While management and the market can attempt to estimate the short-term impact of the COVID-19 disruption, we believe there is more value in understanding the potential longer-term impact. 

What should drive the valuation? Long-term cash flows! 

Ultimately, the main driver of value is the sustainability of long-term cash flows, as opposed to the cash flows over the next six to 12 months. This often gets forgotten when share prices are falling sharply and panic selling is in full force. It is never comfortable seeing shares of high-quality businesses collapsing even further than we imagined. However, for long-term investors with the ability to look through the volatility, this is the kind of market where outstanding opportunities will arise. It’s essential to keep revisiting valuations, as this provides conviction to buy companies when share prices are falling sharply.

Sam Twidale, portfolio manager, DNR Capital