The UBS Australian Small Companies Fund has been successfully investing in great businesses for more than 12 years. Over that period of time the fund's investment process has consistently focused on "quality characteristics" when choosing what companies to invest in. This process has served our investors very well. Fundamental message: Don't buy index in Australian small companies. Consequently, we thought a review of the key lessons learned from the fund's journey of investing in good businesses over that period was in order. We have found that there are eight key factors that time and again consistently distinguish a truly successful business from the also-rans. Today we will start with the first two factors.
(1) Management are owners/founders or otherwise act as if they are
The fund has owned ARB (a global leader in 4WD accessories) for more than five years. The company was founded in 1975 by Roger Brown, his brother Andrew and his best mate John Forsyth. It was listed on the ASX in 1987. Today the company is still run by the same three men, and they remain large shareholders. While the company may occasionally transgress the current-day politically correct corporate governance standards of a small board and an executive chairman (Roger), shareholders are not complaining having seen earnings grow by 13% pa over the past ten years. As owners, it's not surprising that the senior management pay themselves very modestly by industry standards ($250k-$380k each).
Another and more recent example is our fund's investment in Wisetech Global (WTC), an IPO from earlier this year. Not only did we like the high growth and recurring revenue basis of their cloud-based logistics software business, but we also really liked the fact that the founder and CEO, Richard White, sold very few shares into the IPO (about 2.5m of his 151m shares). Today he still owns more than 51% of the company.
(2) High returns on capital will often dispense with the need for high debt
High returns on invested capital (ROIC) are an investor's best measure as to the quality of a company's business franchise. TechnologyOne (TNE), a now cloud-based enterprise software business based in Brisbane is another long term holding of our fund. Its ROIC is a not-too-shabby +200% pa. Partly because as a software business it does not require much capital, nevertheless, by giving Adrian di Marco, its CEO and founder, your $1 of new capital (should he need it), he can then earn more than $2 annually from that original $1. Unfortunately, the (quality) problem for us as investors is that because of his very high ROIC Adrian's business is more than self-funding and doesn't require any new equity capital from us. Consequently, TNE is not only debt free (as are ARB and WTC from #1 above), it periodically pays out a special dividend in addition to its normal dividends to return cash and franking credits to its shareholders.
Sirtex Medical is another long term holder for the fund (>5 years). Sirtex has a ROIC of >80%, has no debt (net cash) and pays a fully franked dividend. Although in a higher risk industry of medical technology, its net cash position and stable yet fast growing existing business (treating liver cancer using an internal radiation therapy in “salvage” patients) mitigates some of the inherent industry risk that high debt levels would simply magnify further.
We know of many examples of poor businesses masquerading as quality franchises through the use of high debt. One in particular (who shall remain nameless to protect the guilty – you know who you are!) is a recently re-floated “old” business. After departing the listed scene for a period whilst its private equity buyers worked their special magic to polish up an average business with the usual tricks of doing a “Pro-forma” on the historical numbers, stripping out hard assets and then adding high debt to paying themselves a large pre-IPO dividend, it is now back listed on the ASX and pretending to be a better and reformed business. Fortunately for us, having been around the block a few times, just like with Dick Smith, we still remember what it looked like in its “pre-polished” days. The underlying business franchise remains average at best as reflected in its return on assets (ROA) of less than 6% pa. However, with the magic of a lot of debt, this sub-par franchise indicator transforms into a surprisingly strong return on equity (ROE) of almost 15%. Debt is (currently) cheap and tax deductible so it can mathematically enhance poor returns easily. This is no more than a case of good ol’ fashioned financial engineering and is not a sign of a good business. Caveat emptor!
Stay tuned for the next episode featuring #3 and 4 key factors of successful businesses:
- Re-invest profits – don't perpetually raise new equity.
- Stable management who often promote from within.
Written by Victor Gomes, Portfolio Manager of the UBS Australian Small Companies Fund. Contributed by UBS Australia: (VIEW LINK)