3 ways to win in Australian small caps

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Ahead of the upcoming Pinnacle 2020 Virtual Summit, we asked three Australian Small Cap equities managers to share a chart from their presentation and explain its importance. 

Firetrail’s Matthew Fist urges Small Cap investors to look beyond industrials to the opportunities in resources and technology. For Longwave Capital’s David Wanis quality remains the key variable no matter where one stands on the growth versus value debate. Finally, Spheria’s Marcus Burns warns that loose monetary conditions and Government stimulus programs can’t prop up failing companies forever. Our experts will highlight the risks many equity investors are taking today and explain why now, more than ever, you should be focussing on business fundamentals.

Why looking beyond industrials is key to small cap success

Matthew Fist, Portfolio Manager, Firetrail

Australian small companies can be a material investment opportunity. In 2019, the top five performing companies in the S&P/ASX Small Ordinaries Index delivered an average total return of +192%. Outperforming the top five performing large caps by almost 2x times!

However, the risks are also heightened. The bottom five performing Aussie small caps delivered an average return of -75% over the same period. This was almost 3x times the bottom five performing large caps (which fell -25% on average). When investing in small companies, you need to be selective, and you need to be active. But not all active Aussie small cap managers are created equal.

The slide we have shared highlights one of the big advantages Firetrail has in small companies. Most small company managers focus on the industrials sector to add-value for investors. In fact, many small company peers exclude resources all together.

Click on the image to enlarge

However, industrials are only 60% of the small cap market. There are also material opportunities across the rest of the market including resources, technology, and biotech sectors. But you need specialist expertise to take uncover them.

During my presentation I will explain why specialist expertise across the entire small cap market provides a big advantage in small companies. I’ll also reveal two of the team’s best ideas in small companies today, across the biotech and resources sectors.

Quality first remains the golden rule

David Wanis, CIO and Portfolio Manager, Longwave Capital, 

Value or Growth? Growth or Value? The debate rages on distracting from the golden rule of small cap investing: Quality. Investors often don’t like quality for the very reason it continues to work – the definition lacks consensus. Value or growth stocks end up being defined by a very small number of variables (such as p/e ratio) which has made them ripe for algorithmic replication.

Quality is in the eye of the beholder and for fundamental investors this is a feature, not a bug.

There are many ways to observe quality (we note eleven in the chart below). There are many grades of quality. And each change with time. What matters, to what extent and over what period comes down to investor judgement and insight into the business.

Click on the image to enlarge

Small caps are different from large caps in some ways that are obvious and many not readily apparent. 

  • Early company life cycle 
  • Exposure to emerging growth industries 
  • Founders and management with significant equity and influence 
  • Businesses less diversified by business lines, geography, funding source and shareholder base 
  • An opportunity set changing over time 

These characteristics all add up to significantly different investment outcomes to large caps.

Quality matters in small caps because unlike value or growth, quality focuses on the business, not the market. Quality matters in small caps because of the much greater exposure to low quality or junk businesses than found in large caps. Junk includes value traps which can go bust or speculative growth names that never live up to their valuations.

Value and growth remain critical as a consideration into an investment, but during our presentation I’ll explain why, in small caps, quality first remains the golden rule.

Governments can kick-start economies … but something needs to fail

Marcus Burns, Portfolio Manager, Spheria 

It’s the law of unintended consequences that in the process of optimising for one variable, you invariably impact numerous other variables at the same time. We live in a highly interconnected world with economies and markets interlaced in real time and each adapting to the other. As Governments and Central Banks have worked in unison to kick-start economies; first out of the GFC and more recently out of the COVID-19 pandemic, they have provided a backdrop of ultra-loose monetary conditions and added a multitude of Government stimulus programs to the mix.

Click on the image to enlarge

Source: Bloomberg data, ASX stock with market cap >$50m and EV/Trailing Sales multiple over 10x.

The primary idea behind these has been sound – to provide employment and stable business conditions. The secondary impacts, however, have supported and even encouraged risk taking in equity markets. With such loose monetary conditions, it has been difficult for companies to go bankrupt and it has been very easy for new businesses – many that are so called “disruptive” business models – to get abundant capital to compete with incumbent businesses. In the short term this provides full employment. However, over time, something needs to fail.

The chart above shows how many stocks listed on the ASX with market caps over $50m have an EV/ Sales ratio of 10x. This would normally be considered an extremely high valuation benchmark and reserved for highly profitable and very well-established growth businesses. As the chart demonstrates, however, investors have been emboldened by near zero interest rates to bet on many businesses being able to reach these rarefied levels. History has shown this cannot be the case and loose monetary conditions alone can’t spawn such incredible new wealth generation. 

At the Pinnacle 2020 Virtual Summit, I’ll further highlight the risks that many investors in equities are taking today and explain why now, more than ever, you should be focussing on business fundamentals.

Register for the Pinnacle 2020 Virtual Summit

In the Australian Small Cap equities session, there will be two presentations on compelling smaller companies, sectors and investment ideas that may help you participate in the potential growth of these investments. There’ll also be a Q&A session with the panel of presenters hosted by Mercer’s Rebecca Jacques.

You can register for the session here, or view the entire event calendar here

Important Information: Please be advised that the Pinnacle 2020 Virtual Summit is designed for sophisticated investors only

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