Big shifts redefining small caps

The prospect of outsized returns in small caps is a calling card for investors. Returns above of 150% for the top quintile of small-cap stocks dwarfs the ~50% returns for the equivalent large-cap cohort, according to Refinitiv. The catch, however, is that the worst-performing small-cap stocks have more downside than their large-cap counterparts. 

In this thematic discussion, small-cap specialists Tobias Yao from Wilson Asset Management and Arden Jennings from Ausbil Investment Management discuss the significant shifts they're observing in small caps and the opportunities catching their attention. Increased volatility, a burgeoning tech sector and the value of strong balance sheets are three notable trends. 

Please tune in for more detail and some of the stocks they're following closely this August. 

Access the podcast 

edited transcript

Vishal Teckchandani:

Welcome to Buy Hold Sell, brought to you by Livewire Markets. My name is Vishal Teckchandani, and today we're going to talk about how you can identify those epic, small cap growth stocks before they become legendary names. How do we find the next Afterpays and the A2 Milks before they become big things? Joining me on the show to share their secrets is Tobias Yao from Wilson Asset Management and Arden Jennings from Ausbil. Arden, I might start off with you. Before we talk about future opportunities, why don't we reflect on the past for a moment? What's been some of the really big shifts in the world of small caps, two to three themes which have really stuck out to you that are kind of redefining this market?

Arden Jennings:

Yeah, sure, Vishal. So one of the things would be volatility. We've seen the fastest bear market in history followed by a stunning recovery in markets. But what we have seen is passive and retail flows really pick up, which has increased the volatility that we've seen. And a good example of that is we've seen Afterpay and Zip, just in July month to date, be among the top 10 traded buy value stocks in the market, which, when they're ahead of the likes of blue chips like Woolworths and the like, that says there's potentially a lot of retail money in the market. Probably one of the other things that we've seen is a significant rerate in some sectors, and particularly the technology sector. We've seen plenty of smaller micro cap companies be put on astronomical market caps when they have very little revenue. So there is a lot of speculative activity out there as well at the moment.

Vishal Teckchandani:

Okay. Gee, who would have thought CBA, BHP being displaced by technology companies. Are those among the tectonic shifts that you're seeing in the world of small caps, Tobias?

Tobias Yao:

Yes, absolutely. So one of the first themes we are seeing is that the strong companies continue to get stronger. Some of these technology companies, particularly in the digital and eCommerce space, have done exceptionally well over the last few months, which is a testament to the resilience of their business models, the stickiness of their customers and the overall flexibility of the operational model as they continue to gain market share and disrupt the industries they're in. The other theme we are seeing is that companies with healthy balance sheets continue to outperform, and we think that's going to stay true over the coming months as a result of their ability to weather more prolonged COVID uncertainty, and then also the optionality to be able to acquire companies that at attractive valuations.

Vishal Teckchandani:

Okay. So the focus of today, we want to really talk about technology and finding growth stocks. So I might come back to you, Arden. You've done a really deep piece of work at Ausbil breaking down the technology universe into five core segments, is that right? Can you talk me through what those are and maybe which ones excite you the most?

Arden Jennings:

Yeah, sure. I might touch on two of those. So the first one would definitely be the physical and software networks. And since the onset of COVID, we've seen an acceleration in the adoption of cloud technologies, not just domestically here, but globally. We've seen the Microsoft CEO come out and say that they've seen two years' worth of digital transformation occur in two months. More domestically focused, we've seen Craig Scroggie from NextDC say that what we've seen occur has brought forward probably five years' worth of demand, probably in the next one to two years. So ways to get exposure to that would be good examples are probably NextDC and Megaport in that physical and software networks part of the market. One of the others possibly is probably the communication space. So with the working from home dynamic at the moment, with most of us still working from home, and that uncertainty still here, the consumption of data has gone through the roof. And we've seen that data come through from the NBN, where usage rates are up 20 to 30% for various customers at various different times. So we continue to see the demand for data, particularly from working from home, as another key tailwind for some of the communication players, those like Uni Wireless and Opticom.

Vishal Teckchandani:

Okay. So Arden, would you say that, and these are really hot growing areas. Would you say that kind of in the world of small caps, if you want growth, this is some of the parts that you need to be looking to?

Arden Jennings:

Absolutely. Yeah. I would definitely say that this is one of the highest growth segments of the market. And like I mentioned earlier, we have seen a rerate in these sectors, but the growth that they are seeing is not just the structural trend that we had pre COVID, but that's actually been accelerated further going forward. And we believe that that will continue.

Vishal Teckchandani:

Okay. Now, Tobias, you were recently profiled in the Australian Financial Review. And what I got out of that was that you're particularly excited about eCommerce. Is that right? What's your conviction there?

Tobias Yao:

Yeah, so I have very strong conviction in the eCommerce names. We believe right now we are seeing a permanent shift in terms of the growth trajectory for a lot of these companies. This is a result of people working from home and changing their spending habits. So the growth will come from first-time online shoppers, as well as existing customers shopping more regularly due to the value proposition, the convenience and the overall customer experience. For eCommerce companies, their incremental unit economics is very attractive due to the lower cost of doing business. They have superior digital expertise, so they're winning online and they have a relentless focus on growing their customer base and reinvesting their profit back into driving their customers and customers satisfaction.

Vishal Teckchandani:

Any other sectors that stand out to you within growth areas for small caps and technology?

Arden Jennings:

Yeah. So similarly to what Arden was saying, a lot of the telco names and the NextDC, MP1 are companies we like as well.

Vishal Teckchandani:

Okay. So before we talk about how you picked these companies, let's touch for a moment on valuations. These stocks in the thematics you've both talked about are running very, very hot. How do you discern the valuation argument here?

Tobias Yao:

Yeah. So we break it down to the fundamentals. So for eCommerce companies, there's a few things we look at. I guess the first thing is how well do they understand their customers? What's their real-time decision making capabilities in terms of the data that they have? Ultimately for us, it's to gauge how they can scale efficiently and effectively, and whether that incremental unit economics continues to hold or improve. We also monitor qualitative metrics, such as customer satisfaction ratings, which is a precursor to how the first-time customers can come back as repeat customers in the future. And we check that against externally sourced data to try to gauge how all the businesses are going.

Vishal Teckchandani:

Okay. Valuations, Arden? Too hot or still room to grow and rerate?

Arden Jennings:

Right? Yeah. I think with record low interest rates, that has a lot to do with the technology sector in particular, particularly for those companies at high growth. They've got long dated cash flows, and with record low interest rates, that risk-free rate comes down. So that terminal value for a lot of these tech stocks is now worth a lot more in a low interest rate environment, so that it definitely is driving the valuations.

Vishal Teckchandani:

Okay. Let's open up your secret sauce bottles now and talk about how you find some of these companies. So even within very high growth pockets of opportunity, you've got leaders and laggards. In buy now pay later, it's Afterpay that's taking market share, someone like Zip and Splitit, they're relative under performers. So throughout your investment process, how do you find out the winner and how do you stay away from the laggards?

Arden Jennings:

Yeah, I think one of the key things that we look for in the winners is their focus on the customer. And Afterpay is a good example. They have a relentless focus on the customer. They're playing a long game, and their customers will reward them for that. And so they're, you know, the customers enjoy using the product, they're using it more and they're willing to pay for it. So that's a really good indication of these technology companies that are disrupting an existing market, and for the buy now pay later space, that's the credit card market. And there are many other sectors that are being disrupted by technology.

Arden Jennings:

But one of the things I definitely would point you towards is those customer cohort charts. So for Afterpay, for example, they provide the purchasing frequency over time. So you have customers that have just joined that might only use the product a handful of times, but as they mature over time, you'll see that they actually use the product more and more, and that's a really healthy sign of adoption. And another one would be Megaport. They provide a cohort chart every year at their full-year results, and they show that the number of ports that are being adopted, sorry, the number of services rather, and the revenue per port that's being adopted by each of the customers is increasing over time. So the longer maturity that they're customers with Megaport, they're spending more.

Vishal Teckchandani:

Good points. Tobias, turning to you. You were actually an investor in the IPO for Afterpay. So using that as an example, or another example as well, what is it that you look in growth businesses, and how do you separate out the leaders from the laggards?

Arden Jennings:

Yes. So for us, it's all about the management. We want that entrepreneurial flare. We want the never-say-die attitude and the relentless focus on customer satisfaction. We tend to stay away from copycat customers, where we can identify a point of differentiation and a competitive advantage.

Vishal Teckchandani:

Okay. So let's change gears and talk about reporting season strategy. Now I can feel it in my bones. It's going to be a very volatile month, and for small cap investors and managers, I guess it's especially hard, because when companies don't meet consensus expectations, they can get smashed. And of course, the other way, if they blow past expectations. So what are your top tips to keep sane during reporting season, Tobias?

Tobias Yao:

Yep. So for us, it's about cutting through the noise and focusing on the fundamentals. Given the overall uncertainty, I suspect that companies will be more measured in the way they report and the way they provide outlook statements, which the wording could surprise some investors. So when that happens, you just have to take a step back and revisit your investment thesis and do a lot of on-the-ground due diligence, speaking to customers, suppliers, as well as competitors, to try to understand the real picture. One of the other things we want to do is to separate what's permanent and what is temporary, and try to figure out what the run rate is coming out of this pandemic to ascertain whether this business is still a good investment opportunity.

Vishal Teckchandani:

Okay. Same question to you, Arden. In particular, what do you do if a company blows up or underperforms on reporting day?

Arden Jennings:

Yeah. So coming into reporting season, you've got to do your homework. You've got to be prepared so that you can avoid the blow ups. And one of the quotes that I took from a well-known fund manager is, "If in doubt, ship it out." And I think going into reporting season, if you do have doubt on any of those companies, you need to move on. Smaller micro-cap investing is all about avoiding the blowups. If you can do that, you set the rest of the portfolio up to perform well relative to the rest of the market. And maybe one of the other things is to be really disciplined in cutting your losers. You must be objective and unemotional. And that's really one of the keys that instead of doubling down on a position, if the investment thesis is broken, cut your losers and move on.

Vishal Teckchandani:

Okay. If in doubt, ship it out. Why don't we tie this in with some stock stories that you're looking for during reporting season? Are there companies that you're eyeing in particular, Tobias?

Tobias Yao:

Yeah. So for us, there are two companies which are beneficiaries of the working from home thematic and where people are dining in. The first one is Breville. Breville is one of the most innovative companies in their space in kitchenware and small appliances led by an incredibly capable management team. And they are gaining market share globally. We believe as consumers stay at home and having to cook for themselves, they're more likely to want to upgrade and replace their existing small appliances, which is exactly what's going to support the demand profile for Breville for years to come. In addition, they're going into other geographies, which could further boost their organic growth rate. They can also acquire companies that they can bolt back into the business. Similarly, for another company is Marley Spoon. Marley Spoon is a global online meal kit delivery business.

The key thing we're monitoring there is how sticky are the customers, where they feel if you're working from home and dining in, and if you can reorder Marley Spoon products over time, then that's really profitable. That's really profitable for Marley Spoon. So these are the two companies.

Vishal Teckchandani:

Okay. Two companies for you, Arden, where you're going to stay there on the ASX screen in the morning, hit refresh until it hits, until the earnings announcement is published?

Arden Jennings:

Yeah, well naturally it's probably going to be the two biggest positions in our portfolio. But other than that, I think two that are really interesting coming up, one would be City Chic. It's just announced the acquisition, proposed acquisition rather of Catherines last week, so I think that's going to be really topical. The result, we'll get the full details of how that went, but I really think the market probably does underestimate the significance of that transaction. So it'd be great to get some more detail on that.

And probably the second one would be Macquarie Telecom. They recently held an investor day in June, and they mentioned that they're going to look at splitting out some of their segments so that you can see more transparency around the data centres. There's always been a huge rerating in some of these data centre players. NextDC has had some success with some recent contract wins. So I think if the market can see that segment split out, it may rerate the share price further.

Vishal Teckchandani:

Now, remember investing in small caps can be extremely volatile, but it can be really rewarding as well. So before you get into this part of the market, you may need to arden up and go in with a plan.

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