With reporting season in full swing, we took some time out to catch up with Lennox Capital Partner’s James Dougherty and Liam Donohue to get their views on navigating the small caps landscape, why being active is key to picking winners, and how short-term market interpretations are creating some standout opportunities.

Q: How have you fared in the recent small caps environment, and what techniques are you implementing to try and dodge the potholes?

We focus on preserving capital. Half of the battle in small caps is avoiding the downgrades and disasters. There are 200 companies in the small cap index, but with semi-annual changes, there’ve effectively been 600 companies come in and out of the index over the past 10 years.

Almost 50% of them have doubled or more over that period, around 40% have fallen by more than 70%, and the index has returned 0%.

The opportunities are there, but if you're not active, you will end up eroding your winners with your losers and go nowhere. Early on, it became very apparent to us that you need to worry about capital preservation as much as capital growth.

The primary way we do that, is to look for companies that we believe are investment grade. That way we can do our job and forecast earnings in a confident manner. We look at the management and sustainability to determine if a company is investment grade. Sustainability tells us if a company has the potential for any negative surprises. When assessing sustainability, we look at the complexity of the business structure, how opaque the business is, we’ll also consider governance and the social and environmental consequences of their business. If a business model has significant negative social consequences, at some point in the future, the government will say, "we need to change regulation to stop that happening", and at that point in time, earnings will fall significantly. The problem is, we have no way of determining if and when that will happen, so we choose to avoid companies like that. If a company can get through that screening, then we'll go and do the fun stuff, the real deep dive analysis, forecasting earnings over the next three years, go kick the tires a bit more.

It’s quite hard to get a company through all these factors, and then still make sure it's cheap enough to give us enough upside, but when we do, we're usually pretty confident of a getting a positive outcome.

Q: Why do you think the market's nervous going into reporting season, and what are some of the things that stand out to you?

You have seen over the past few months that the consumer is weak, and there are a fair amount of consumer facing businesses within the small cap market so that’s a concern. A lot of those companies have downgraded coming into reporting season, and that's created a lot of nervousness out there. Also, valuations have risen but nothing's really changed so as an investor that can make you a bit edgy.

Q: What are some of the ideas around the common characteristics or traits of companies that have been successful in your portfolio?

The core thesis behind the way we invest is that change is mispriced, whether that be structural change within an industry, cyclical change or company specific change. There is always going to be a catalyst, something that means that a company's mispriced. We ask ourselves

what is the change, why is the share price going to move and has the market got it wrong?

We believe the market interprets change incorrectly in the short term and we look to capitalise on that.

Q: Can you give me a specific example?

RCR had two real change drivers that attracted us to the business. The first was within the business itself, in that the business operations changed. They were previously a mining services contracting business based over in Perth, but in 2013 they acquired an east coast civil infrastructure business, which has become the main driver of their growth, and will account for roughly 80% of the group's revenue over coming years.

Secondly, and probably a more widespread tailwind for the company is the volume of infrastructure spend that is planned to come down the pipeline, particularly in New South Wales and Victoria. Perhaps that has been underappreciated by the market in terms of how that was going to benefit contractors that were in the right place with the right skill set. That was a great opportunity that we got into a little while ago now.

Q: 16% of your portfolio is currently invested in technology stocks. People don't see Australia as a haven for strong IT businesses. Why is that?

I’m not sure, there are some great technology companies in Australia. Technology companies fit our process well as they often create or benefit from change. We own companies like WiseTech, which is a market leader for logistics globally, as well as data centre operator NEXTDC.

Wisetech has used technology to make the processes required to ship goods globally more efficient and cost effective, and Next DC benefits from the exponential growth in data storage required because software as a services companies, like Wisetech, are growing so strongly.

Q: What's your sense on what's happening in the IPO market at the moment?

We've always considered IPOs as opportunities, but we are very selective about what we go into. They go through the exact same process that any of our other investments do: so unless we can get comfortable with management, the sustainability of earnings, and all the same rules that we apply to our standard investments, an IPO doesn't excite us that much. I think the biggest problem is the quality has really dropped away, but if a good IPO came to market, it would probably be swamped.

Q: Given your time in small caps, do the stats on recent downgrades seem abnormally high?

We'd say it's abnormally high. We wouldn't say it's the worst it's ever been or that there haven't been periods like that before, but it does seem like the worst in recent years. There are pockets of the economy that are okay, but consumers are starting to be more sensible, perhaps under the realisation that house prices aren't going to go up forever. Businesses that were built around the assumption that they could get continual growth in like-for-like sales and push that through their highly leveraged business models, are also unwinding a little bit.

Q: Tell me a story where you learnt a valuable lesson the hard way

Probably the best example is Slater & Gordon. It was an absolute glamour stock in the index, and at its height many managers including ourselves participated in the final capital raising at $7.50.

Where our story would be different to most though was following the announcement by the company that their accounting in the UK was incorrect. Despite their strong protestations that there was no material change and the net impact was zero, that was an absolute red flag to us. If we couldn't trust one part of their accounting, we couldn't trust any of their accounting, so we sold it at four bucks, which was painful. When we look at how the Slater & Gordon story played out, it was the right decision to cut our losses and run.

It was an experience we gained from and ended up being a huge positive for us, as it built conviction in our investment process

For further insights from Lennox Capital Partners please visit their website