How to find global small-cap winners
There are few absolutes for investors. A company can possess bucketloads of customer goodwill, dominate in a high-entry barrier industry, have top-notch management and balance sheet and yet still be a dog of a stock.
This was emphasised recently by Ellerston Capital's Bill Pridham, who heads up the asset manager’s global small and micro-cap portfolios. With a “sweet spot” of companies typically between US$2 billion and US$8 billion, Pridham recently told us how his team spots firms with the potential to double or triple their earnings over time.
Throwing around numbers like this, it’s easy to forget we’re talking about small and mid-caps here. As Pridham highlights, companies that are small by US or European standards are far larger in an Australian context.
“Small caps have been one of the strongest performers over a very long period, but many Australian investors have very little exposure to this asset class,” he says
The crux of Ellerston’s small and mid-cap investing process lies in what is known in the industry as “price discovery”. Whether explicit or not, this refers to the process where buyers and sellers set – or reset – an agreed price for an asset. This is often set in motion by corporate activity that has a fundamental (or sentimental) effect on a listed company’s value.
“The market is incredibly smart, but it can also be incredibly lazy when companies are going through periods of change. That could be a corporate restructure, a spinoff or a new IPO, and these types of events underpin what we look for,” Pridham says.
In this interview, he explains how his team scours the world for companies that tick all his boxes – but as importantly – that are attractively priced because of this price discovery process. Pridham also digs out an example from his portfolio, a global logistics player whose recent demerger has created an enticing entry point.
Why should investors own global small and mid-cap stocks?
If you look at the MSCI world midcap index, which we're measured against the biggest stock has a market cap of US$55 billion. So that translates into around AUD$74 billion. So just to put that in a bit of context, that would make it the eighth largest stock in ASX, just behind ANZ bank. So these aren't really that small of companies that we're talking about here. For our fund, how we define it, we're targeting a universe around $15 billion and below in terms of market cap. And we've always said, and continue to say the real sweet spot for us is that $2 to $8 billion range. We find in that area that gives you real good opportunities for companies that have the opportunity to double or triple over time. And it gives a great opportunity to find stocks that aren't really well covered as well in terms of the overseas markets.
So I think there's a real misperception around size and risk when you say mid small caps. And I think this is especially true in the global context. So when we look at our portfolio, the average market cap is around US$9.4 billion, which is about AUD$12.7 billion. If you put that together in one stock, it would be in the top 50 on the ASX. So again, just underpinning that these are large cap companies and not small/micro-cap companies. And one of my goals over the past several years is to highlight that these mid smalls are firstly not those small companies you might think of first off, rather businesses with multi-billion dollar market caps. A lot of times they're multinationals, many times they are operating in very strong secular growing markets as well.
Many of them touch our lives every day, even here in Australia, they do many of the stocks in my fund touch our lives every day here in Australia. It's an asset class has been one of the strongest performers over a very long time period.
And the disappointing thing, but also the opportunity, is that many Australian investors have hardly any exposure to this asset class. So from my mind, it creates a great opportunity for people who are looking for diversification to really look at global small caps.
What do you look for in small and mid-cap stocks?
The first non-negotiable is I do have an ESG overlay. So you think of fossil fuels. You think of alcohol, tobacco, those are the easy ones in terms of screening out, but you know, there's a lot more emphasis on human rights, animal cruelty as well. So if you're to say what's a must not to have, it's companies that do harm. At the end of the day, I've always talked about this portfolio as a list of companies that are doing good in one way or the other, but the biggest must not have, is anything that does harm from that perspective. So that's the first one James from a screening point of view.
We look at companies that are going through a period of price discovery. The crux of what this fund is, is very simple. At the end of the day, it's all about conducting to tomorrow's returns today. And what underpins that is that the market is incredibly smart, but it can also be incredibly lazy when companies are going through a period of change and that change could be a corporate restructure, it could be a spinoff, it could be a new IPO or a management change. There's a number of different criteria that we look at and that underpins what we look for in terms of that price discovery mechanism.
At the end of the day, when we look for a company, what we love to see is one with a high market share or high recurring revenues, high customer retention rates, operates in a secular growing market with global context, great balance sheet, great cash flow. That's a great business. But a lot of times that may not be a great stock because a lot of times that will be valued in the stock itself.
So when you look at those price discovery mechanism, it gives you those chances to enter a business like that at a discounted price when they're going through that price discovery time.
What's one business going through "price discovery" now?
Yeah. I can give you a couple, I'll give you one that literally just happened about a month ago, James. So it was a company called XPO logistics. So they owned one of the largest, less than truckload businesses in north America. One of the larger ones in Europe as well, a large truck brokerage business, but also they owned the second largest contract logistics business in the world effectively. So they were going through a separation of the two. And it's amazing how it's a $9 billion market cap company, amazing how the market inefficiencies can come through in a company that size.
So on 2nd August, when the spin happened, the stock was $138 when you look at them together. Then they spun off from the two separate businesses, so to pure plays, one of the larger transport businesses in the world, and one of the largest contract logistics businesses in the world, and now the combined group is trading 25% above that in about a month and a half. So that's a great example of a business that, you know, it's gone through this change, gone through a corporate restructure. The market takes time to value each piece of the parts separately. And you know, what that type of return for that size of company is pretty interesting. And it's amazing to see that happen in real time. It just shows that it does work from that perspective.
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Bill manage a concentrated global equity portfolio with a mid/small cap bias based off the highest conviction ideas from a filtered universe of securities that he feels are in a period of ‘Price Discovery’. For further information on the Fund, please visit the Fund Profile below.
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