5 ways to filter small-caps

When filtering the more than 2,200 stocks on the ASX in the hunt for that under-appreciated gem, it is essential to have an efficient and effective system to sort the wheat from the chaff. So, following on from our recent report on how professional investors generate new investment ideas, we asked our five contributors: ‘once identified, how do you filter these ideas down to determine the best opportunities?’ The responses reveal to Livewire readers the processes honed by decades of experience of some of the best performing small-cap and midcap managers in the Australian market. Insights provided by OC Funds Management, K2 Asset Management, Katana Asset Management, Bennelong and Totus Capital.
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10 criteria to screen stocks

Romano Sala Tenna, Katana Asset Management: (VIEW LINK)

 

The vast majority of investment ideas are quickly filtered by some relatively apparent impediment, such as an inherently dangerous balance sheet, poor valuation metrics or a terminal business model. This high level but rapid assessment is critical in eliminating ideas early in the process, to enable the majority of time to be spent on the better prospects. The handful of ideas that survive, then move into the Investment Process proper.  Every investment idea at Katana is mandatorily assessed and rated on 10 criteria:

  • Management  & Organisational Culture (also ‘Corporate Culture’)
  • Business model  (short-medium term advantage) & Competitive Advantage (medium-long term advantage)
  • Valuation metrics including Price Earnings Growth (PEG) ratio, Price to Earnings Ratio (PER) and dividend yield
  • Macro and sector outlook
  • Appropriate price action; we seek to move ‘in harmony’ with the greater market and in this respect technical analysis provides insights into investor sentiment
  • Strong balance sheet, indicating safety, prudent management and flexibility
  • Quality of Earnings (6 key assessments)
  • High Operating Cash Flow (OCF)  & High Free Cash Flow (FCF)
  • Return on Equity (ROE), Return on Price Equity (ROPE) & Return on Assets (ROA)
  • ~ to assess effect of gearing on ROE
  • Liquidity and Size.

 

Identify a catalyst that will release the value

Nick Leitl, K2 Asset Management: (VIEW LINK)

Companies that are ‘cheap’ can be easily identified using quantitative screens. However understanding why they are cheap and, more importantly, identifying a catalyst which may unlock this value is the critical part of the investment process. Drawing on K2’s eighteen years of investment experience, we determine the best opportunities by using a combination of top-down industry research along with bottom up fundamental analysis. Meeting company management also plays a key role in the investment process as does establishing expectations from the investment community. Identifying a catalyst can come in many forms and over various time frames. However the focus will always be on specific event/s that will drive the market to re-rate the stock. Companies can remain undervalued for long periods, and therefore timing will also play a key part of our investment approach. 

 

Six considerations in assessing key risks

Robert Calnon, OC Funds Management: (VIEW LINK)

Once we have identified a pool of potential portfolio holdings, we undertake a comprehensive “operational risk assessment” of each company. OC considers risk to be investing in companies we don’t understand. So we go to great lengths to analyse what we think are the key risk characteristics of a company. We do this examining in depth the following:

  • Management – track record, key man risk, skin in the game, remuneration structure
  • Business model – understandable, barriers to entry
  • Operating history – proven, audited track record
  • Industry structure – mature, profitable, subject to regulation
  • Corporate structure – major shareholders, vanilla equity
  • Financial analysis – including valuation

 

Look for what others have missed

Julian Beaumont, Bennelong Australian Equity Partners:  (VIEW LINK)

Firstly, we are looking for certain attributes that give us confidence to invest. Generally, we are looking for quality companies that are growing nicely. Ultimately however, we are looking for a company whose prospects are better than what is perceived by others and therefore implied in the share price. The idea is to tilt the odds of investment success in our favour.  If it is a new idea, or even an old one, we will undertake very extensive research to understand the company, its competitive position, risks and opportunities. Most importantly, this involves meeting with management and other industry players and experts. We’re looking to identify something important that has been overlooked or isn’t fully appreciated, typically relating to business quality, growth options or general prospects. Investing then comes down to our levels of conviction around the downside risks and upside potential of any particular stock, and to this end, new ideas will have to compete with existing holdings.

 

Two filters to select the best contenders

Sam Granger, Totus Capital: (VIEW LINK)

Once we have an idea we then apply financial filters to assess the quality of the business. We first filter for the historic return on invested capital, which is usually a good indication of the competitive dynamics within an industry. We are looking for businesses in concentrated market structures with high barriers to entry. Secondly we look at the historic free cash generation in order to understand the capital intensity of the business and how much cash it generates relative to accounting profit. These two filters enable us to quite quickly focus on the highest quality businesses amongst the ideas that we generate.

Watch out for the next report, where the Managers talk stock picks

This report is the second in a series of three. You can see our first instalment here, (VIEW LINK)  which looks at effective ways to generate stock ideas. Watch out for the third and final report next week, where the fund managers discuss stocks that have recently passed their filters. 


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