Small caps: Emerging opportunities amid Middle East turbulence

As the US-Iran stand-off continues, gold isn’t delivering the usual safe-haven comfort. Pendal investment analyst RACHEL FOLDER explains how to stay positioned for volatility

• Gold crowded
• Geopolitical volatility is creating opportunities
• Find out about the Pendal Smaller Companies Fund

WITH gold positioning already stretched, the evolving geopolitical backdrop is creating fresh opportunities beyond the crowded trade.

Gold has increased from roughly 5 per cent of the S&P/ASX Small Ordinaries Index (benchmark) four years ago to 18 per cent, at the time of writing.

Over the course of January alone, the gold price rallied nearly 30 per cent to over US$5,500 an ounce. However, it has since given back many of those gains.

While Folder describes the precious metal as having had an “incredible run” in recent times, the Pendal Smaller Companies Fund has actually been underweight in gold small caps.

Why?

“When commodities rally, we tend to see the lowest quality assets run the hardest.  While we have participated in the gold rally, our investment process has a strong bias to quality, which has resulted in us being underweight the really pointy end of the sector. This is a deliberate risk management strategy,” says Folder.

Gold positioning has been extreme, and the sector hasn’t escaped the fallout from the current geopolitical uncertainty.

The flow-on effects of the Iran conflict include higher diesel costs.

Folder’s team recently spent time in Perth visiting numerous gold companies to understand the sensitivity of fuel price moves to production costs.

“These companies are significant consumers of diesel, and broker research suggests the increasing diesel price in the last month equates to around A$200 per ounce of gold produced – for some operators this represents a significant impact to cash margins,” she says.

“We are picking stocks rather than trying to time the market or solve for one macro outcome. So, in positioning the fund in a balanced way we are always aiming to ensure we have positions that will perform across a range of scenarios.”

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AI sell-off

Another key thematic that has been driving markets is AI disruption.

In these types of situations, Folder says the market’s instinct is to “shoot first and ask questions later”.

“We see this as an opportunity, and we think some names have been unfairly hit,” argues Folder.

“We have seen a selloff in some key high-quality names such as AUB Group, for example.”

This has been indiscriminately impacted by the fear that AI will disrupt the insurance broking sector – for example, Tuio, a small Spanish insurance company, launched a vibe-coded app that quotes and binds simple insurance policies.

AUB has de-rated on this uncertainty alongside many global insurance broking names.

“We see AUB as being disproportionately impacted here, because the AI disruption narrative misses some key points around the complex commercial risks that rely on deep domain expertise, market access and underwriter relationships,” explains Folder.  

“Ultimately we see AI making these businesses more productive with broader moats.”

Opportunities emerging from Middle East conflict

Gold has retraced as the weight of money flows into oil/energy exposures and inflation fears persist.

Defence stocks are performing well on a relative basis, with Codan – an Adelaide-headquartered company providing advanced communications solutions to defence and security forces across various international jurisdictions – one example of this.

Another key beneficiary of the Middle East conflict, according to Folder, is Channel Infrastructure – a New Zealand-based operator of the country’s only fuel import terminal.

“The company has significant latent capacity at its storage facility, supporting a strong upside valuation case as it enters further long-term contracts,” says Folder.

“Following recent developments in the Middle East we think the likelihood of Channel selling its remaining capacity at very attractive rates has just improved considerably.”

But Folder notes that these beneficiaries are companies that are already well understood by the Pendal team.

“Both Codan and Channel Infrastructure have been held in the fund for a while. While prospects for both companies have recently improved, this is in addition a strong investment thesis that already existed without the crisis.”

The length of the war will determine how far reaching the impacts are into the broader economy, but Folder says the Pendal small cap team is carefully monitoring the situation.

“We aren’t radically changing the portfolio at this stage given the uncertainty, we continue to take a balanced approach,” she says.