The Eiger Capital small caps team has collectively accumulated more than 60 years of investment industry experience. Over this time, we’ve observed what we think are the key factors that distinguish the truly successful businesses from those less successful. Here’s our list.
1. Management are owners or otherwise act as if they are
Over the years we have consistently invested in ARB (a global leader in 4WD accessories). The company was listed on the ASX in 1987 and is still run by the same three men who remain large shareholders. While the company may occasionally transgress the current-day politically correct corporate governance standards (it has a small, mostly male board and an executive chairman), shareholders have seen earnings grow by almost 10% p.a. over the past 15 years (300% better than the small companies index). As owners, it's not surprising that senior management also pay themselves very modestly by industry standards.
A more recent example is our investment in Wisetech Global (WTC). We like the high growth and recurring revenue of their cloud-based logistics software. We also like that the founder and CEO has sold few shares either into the 2016 IPO or since then. He still owns more than 40% of the company, despite a share price that has risen more than 700% since 2016.
2. A business with high returns on capital is often self-funding
Sustainable high returns on invested capital (ROIC) are an investor’s best measure of quality of a company’s business franchise. TechnologyOne (TNE) is a software as a service (SaaS)-based enterprise software business with a head office in Brisbane. Its ROIC is well over 50% p.a. The business is completely self-funding. It can fully fund its strong SaaS product and market growth opportunities, all from free cashflow. It needs no new capital (either debt or equity). TNE has no debt and a rising net cash pile that allows it to frequently augment its dividends paid with large special dividends.
3. Re-invest profits and don't dilute returns with new equity
Companies that can internally self-fund from profits don’t dilute shareholder returns through new equity issues. In its entire listed life TNE has not issued any material new equity capital (apart from minor share issues to employees). In 2000, it had 303 million shares on issue. Almost 20 years later it barely has 5% more (317 million).
The power of compounding earnings for a business with high returns on invested capital and low capital needs means a stable share count and very high shareholder returns. For TNE shareholders it has delivered more than 800% over 20 years. With no debt and no need for new equity, it is a unique business franchise.
Sirtex was another example of the power of compounding shareholder returns on a stable shareholder equity base. It listed in 2000 with a share count of about 54 million. When taken over in 2018 it had 56 million shares on issue. This lack of dilution helped deliver total shareholder returns of about 1,000% or around 11 times its share price in 2000.
On the other side of the coin, there are many companies that don’t sufficiently re-invest profits. Alternatively, they have such low returns on capital that they are unable to internally fund growth without resorting to more debt or equity. The global aviation sector has a poor industry structure where returns on capital are low and profits are volatile. Contrast then the share count increase for businesses like Qantas and Virgin Australia. They have experienced numerous large equity issues so it’s no surprise both have higher debt levels and poor long-term shareholder returns.
4. Stable and competent management that often promotes from within
Management quality (namely their honesty, integrity and competence) is one of the most critical success factors investors should look for when investing in smaller companies. The challenge is often how to make this assessment.
To recap, there are many sound reasons for investing in small companies, including:
- access to earlier stage and higher growth businesses – potentially bigger returns
- a broader sector universe allowing for more options within sectors - better targeted investment bets
- small companies are better placed to exploit disruption, innovation and structural change when compared to slower moving large companies – easier to back future trends.
- less researched and owned when compared to large companies – opportunity to exploit information inefficiencies.
However, all these positives can come to nought without good management to capitalise on them. We’ve found that one’s ability to judge management quality improves with experience (on seeing lots of examples of both the good and bad over many years).
A great management team will also grow their own successors, helping preserve corporate memory and build on a successful organisational culture.
Contrast this to poorly performing companies who are constantly changing management and tend to appoint from external candidates. These outcomes occur because of thin resourcing or otherwise as a way of bringing in an external change agent to fix existing difficulties with culture, structure or competence.
Domino's Pizza (DMP) and Flexigroup (FXL) are examples of the good and not-so-good management outcomes. Domino’s senior management team are all long serving and internally grown. The Group CEO started in 1987 as a pizza delivery driver. The CEO Europe started in 1994 as a Darwin store franchisee, and the CEO Australia also started as a single store franchise owner. Even the CFO has been with the company for 20 years.
Flexigroup on the other hand has had five CEOs in six years, all external appointments.
5. Do not needlessly diversify a good core business
Diluting a good business by adding a lesser business is not a risk diversifier. Discipline and focus trumps poor diversification every day of the week. Consider then the divergent strategies adopted by two mostly similar businesses, A.P. Eagers (APE) and Automotive Holdings Group (AHG).
APE has remained focused on maximising opportunities within the auto retailing sector. AHG on the other hand has diversified into an inferior industry, the transport and logistics sector.
Although both sectors are very cyclical, the auto retaining sector has a fragmented industry structure, higher capital barriers to entry and is characterised by inefficient, smaller and often family owned operators. AHG and APE are by far the largest participants in this sector.
On the other hand, transport logistics is a hyper competitive sector with low barriers to entry and often diseconomies of scale (the larger players have the higher cost structures as they have to follow all the rules). The industry also has very high customer concentration, with the large supermarket operators calling the shots. Accordingly AHG shareholders have suffered very poor returns from their company’s expansion into the logistics industry. AHG up until recently had underperformed APE by almost 200% over 5 years. This has provided APE with the opportunity to bid for AHG. It comes as no surprise that APE management plan to quickly exit logistics and refocus on the opportunities provided to a much larger scale auto retailer.
6. Earnings are all-inclusive, not ‘underlying’
Some companies have financial statements that are a breeze to analyse. Their numbers are clean and simple to understand. This is a strong quality signal. Their reported earnings are their earnings. Their invested capital is their capital – no adjustments are needed. Examples that come to mind include ARB and Reece.
Then there are those companies that engage in the (usually repetitive) practice of offering a range of adjustments to their reported earnings. They call this their ‘real’ or ‘underlying’ earnings. These adjustments will almost always improve on - rather than take away from - reported earnings.
Many businesses have been enthusiastic promoters of the concept of ‘underlying’ earnings in recent years. Some examples include Super Retail (SUL), Fletcher Building (FBU) and the aforementioned AHG.
SUL started with an outstanding core business in the Super Cheap Auto parts retailing chain. It then diversified with acquisitions of lesser-quality businesses (Rebel Sport, Greencross Bicycles, Workout World, Ray’s Outdoors, and MacPac). Some have worked better than others (Rebel, MacPac) but all are inferior to the original business.
Their need to explain underlying earnings by excluding restructuring costs, exit losses, one-off costs etc. is a sign of management's poor capital allocation decisions. We can compare the divergent strategies of SUL with that of Bapcor (BAP). BAP have also acquired to grow over the past five years but unlike SUL, they have not diversified outside of their focus sector of auto parts. Accordingly, BAP has outperformed SUL by almost 200% over five years.
FBU is another example of a company with a mixed recent track record of acquisitions and poor operating outcomes. This has led to a number of ‘non-cash’ asset impairments and other one-off costs over recent years, all added back to boost reported earnings.
7. Do not rely on a ‘gifted moat’, it may fade
Some companies have no obvious ‘moat’ around their businesses to protect them from competition, yet they succeed nonetheless (think ARB, Reece and TechnologyOne).
Yet other companies are gifted a strong moat and then see it fade away. Before its takeover in 2017, SAI had been a business that took for granted its monopoly position in its standards and assurance business. It was also guilty of diversifying into lesser businesses, only to see the moat eventually weakened and threatened. Sky Network Television in New Zealand and Foxtel in Australia have had their monopolies on broadcasting certain popular sports eroded by cheaper and less capital-intensive streaming technology.
Our many years of investing experience have taught us to look for businesses that are successful without, or perhaps despite, a strong moat. As Andy Groves, former CEO of Intel, once said, “Success breeds complacency and complacency breeds failure. Only the paranoid survive.”
8. Remuneration should be aligned with shareholder interests
Management that are aligned as owners are always more interested in benefiting from a higher dividend and rising share price than from the stipend they can draw as CEO. A remuneration policy that closely aligns the amount that management are paid with long term shareholder returns will greatly enhance the management agency outcome.
On the other hand, misaligned remuneration will not tie a CEO’s rewards to shareholder returns. In these cases, the temptation is to make short-term decisions that are not in the longer-term interests of shareholders.
The IPO of Dick Smith was a textbook case of management incentive misalignment. Management were incentivised to reach ambitious profit targets (EBITDA) in the first year post-IPO to qualify for generous short-term cash bonus incentives.
Unfortunately, management achieved their financial targets partly by favouring certain suppliers who paid them the highest short-term rebates. The rebates were booked to profits (even before the stock was actually sold). This boosted the reported result for first year post IPO and delivered management a very large cash bonus. Unfortunately, the supplier-preferred inventory was a poor seller and impacted negatively on the results of the years following. Ultimately it led to the demise of the company and a total destruction of all shareholder value.
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A great article. Easy to read and understand as well as being educational. Thank you.