The broader opportunities for small caps have clearly been identified and explained in the thematic piece of our series, but I wanted to provide some local context, looking at the inefficiencies of small caps and why they are more prevalent in this part of the market. The first factor driving this is (lack of) coverage.
If we consider the current largest small cap stock, Altium, there are five analysts covering and providing research on this company. This compares to 34 for BHP Billiton. An active manager, explicitly one that undertakes their own deep and robust research, has a much better chance of developing insights into a company that is not well understood, or is underappreciated, by the broader market. A clear opportunity for alpha generation.
The second factor is our local market structure. As we know, there is a high concentration in very large stocks, with the top 20 representing 57% of the Index. In contrast the top 20 Small cap companies only represent 12% of the Small Ordinaries Index. Sector concentration is also apparent. For large caps, 50% are represented by the banks and miners. By removing the top 100 companies, stock concentration is reduced and sector exposures change dramatically, providing a more balanced, not to mention richer and more diversified, opportunity set.
The third factor is the fluid nature of small caps, specifically the constant change of companies at the top end. If I consider the top 10 companies in the Small Ordinaries Index today, we have a heavy skew to the Technology sector. Three years ago, they were completely different. Likewise for five and 10 years earlier when the top 10 names were all Mining and Energy companies. In comparison to the ASX200, of the top 10 names, nine have held that position over the last three, five and 10 years. Clearly there is a greater need for bottom up portfolio construction, with little reference to the Index required for successful long term quality investing.
The main challenge with domestic small caps is that returns are heavily skewed to the downside.
History has shown that Australian companies in the small cap space are highly volatile and can be prone to some serious disappointment. Looking at the data, if you take the Small Ordinaries Index, over the last five years, 52% of all small caps have generated negative returns; 31% of them halved in value and only 12% have doubled in value. And this is over a very constructive period with cheap debt, strong underlying macro drivers and momentum driven markets.
For context, over the same period, only 20% of the ASX100 companies have delivered negative return, and only 2% have lost half their value.
When taken in aggregate, the performance of Australian small caps over the last 10 and 20 years has underperformed their large cap counterparts. On an annualised basis, the Small Ordinaries has returned 7.4% and 5.6% over 10 and 20 years respectively. This compares to 10.0% and 8.1% over 10 and 20 years for the ASX 200. So this downside bias is something an investor needs to be very mindful of and avoiding some of those failures is just as important as picking the consistent performers.
The other challenge within small caps is the creation of “mini bubbles” within this part of the market. I’ll give you some examples: Back in 4Q17, we saw an eye-watering run in our listed lithium companies. This was driven by the broader global thematic of Electric Vehicles and the potential demand this brought for lithium batteries. In the fourth quarter alone some of these names like Pilbara Minerals were up a lofty 200% and Orocobre up 120%. Shortly after that, share prices collapsed. In 2015/early 2016 we had a similar boom in the aged care providers - Estia Health, Regis Healthcare, Aveo Group, Japara Healthcare - which coincided with a number of IPOs. Some years prior it was early childhood providers. The fate of these industries hasn’t been a positive one. Currently we are experiencing another surge in share prices and this time it’s within a number of technology names. We even have an acronym for it: the so called WAAAX stocks. Whether this is a bubble, or there are in fact fundamental and sustainable growth drivers behind this sector is a topic for another paper. What is clear is investors should avoid getting caught up in the hysteria of these mini bubbles.
The comment I universally get is that small caps are not only higher risk but also lower quality – either the business model hasn’t been tested through cycles, they are reliant on one product/commodity, capital is more expensive, they don’t pay dividends. And many times this is the case. But what you will find is that these generalisations can mean missed opportunities. The reality is small companies can have strong balance sheets, high margins, market leading positions and excellent management teams. Below are a couple of local small caps that meet this description, together with a strong runway for future growth, and both being global companies.
Vista Group is a business providing software solutions to the global cinema industry. The software is mission critical, embedded in a customer’s cinema operations. They have grown organically and through acquisition to hold a 40% global market share, 48% ex China. There are multiple drivers of growth including market share growth, structural shift to multiplex chains, new geographies and the increasing complexity of cinema operations requiring advanced software solutions. There is a high level of recurring revenue (~60% of group revenue) and scale advantage generating operating leverage. They have a position in developing markets such as China, where box office revenues are expected to grow at double digit rates over the next three years driven by screen penetration and attendance. The main part of this company we believe is being underappreciated by the broader market is their subsidiary, Movio.
Movio aggregates anonymous moviegoer interactions into a central database, leveraging their relationships as the market leading position Vista Cinema. The larger opportunity within Movio is Movio Media which allows film studios to access the database and conduct pre-production research and improve advertising effectiveness. Movio has signed deals with the top film studios and is in the early stages of monetising this opportunity as digital advertising spend grows. There are estimates that the digital advertising market could be worth a few billion dollars, where Movio will earn a slice of the pie. Timing is the uncertainty as to when we will see that shift. In the meantime, the company is generating 30%+ margins, mid teen ROEs (and expected to improve), holding net cash on the balance sheet. They have a very experienced management team, pay a small dividend (unlike most other technology companies) and the valuation represents greater value than the WAAAX names, trading on an EV/Sales of 4.5x and PE20 of 34x. Vista Group has been a core holding in the Aberdeen Standard Australian Small Companies Fund for over three years.
The other high quality company we have identified as being underappreciated by the market, given very limited stock coverage, is a New Zealand based wine manufacturer and exporter, Delegat Group. Delegat have built a sustainable business model, with strong brands (Oyster Bay, Barossa Valley Estate and Delegat) and a high quality product that has proven resilient through cycles. The company has been able to generate an EBITDA margin in excess of 30%, averaging 35%, and a very consistent ROE between 15-20%, over the last seven years. This was over a time of heavy investment, and a cyclically over-supplied global wine industry. The medium term growth (next three years) is well mapped out given capex they invested into vineyards and wineries. Post this, China represents a meaningful opportunity given the size of that market, and one that remains virtually untapped at this point. They are now entering a de-leveraging cycle as capex unwinds and will be spinning off large amounts of free cash flow. Valuation is reasonable, relative to other comparable wine companies given the consistent delivery and focus on returns. The company pays a dividend, and the founders still own 67% of the business, remaining highly engaged and aligned.
Clearly small caps can be a challenging asset class in Australia. However, given the higher potential for alpha generation in this part of the market, the opportunity is hard to ignore. We believe, and have demonstrated, that there are opportunities for consistent outperformance if you have a disciplined approach and undertake robust, fundamental research with a clear focus on Quality investments and downside risks.
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