Hyperion's top small-cap picks for high-quality earnings in a slowing economy

Most investors dream of owning companies offering double-digit growth over time. This desire is strongest in tough economic times. Hyperion Asset Management argues the answer to identifying such growth stocks comes down to high quality and the use of two market inefficiencies – time arbitrage and the Quality anomaly. 

This approach paid off for its investors in the 2022-23 financial year, with three of Hyperion's equities funds ending up in Livewire’s top 10 rankings for Australian equity fund and global equity fund performance. In fact, the Hyperion Small Growth Companies Fund topped the Australian small-cap list, with one-year returns of 32.07%.

Unsurprisingly, technology companies were star contributors to small-cap strategy for the last financial year – and they still feature as a top pick for the coming financial year. This year though, a healthcare stock also stands out as a top choice. 

I spoke to Mark Arnold, lead portfolio manager, CIO and managing director for Hyperion, about how targeting inefficiencies helps the team identify high-quality growth stocks; which companies offered the greatest strength in the last year; and their top picks for the coming year.

What are two standout elements of your investment process and how do they contribute to the fund’s investment returns?

Hyperion looks to exploit two inefficiencies called Time Arbitrage and the Quality Anomaly.

Time arbitrage relates to the inefficiency caused by the mechanical mean reversion in longer-term consensus forecasts. It results from most market participants not spending as much time focusing on five-year and 10-year numbers as they do on one-year numbers.

For example, if we forecast a business to produce 15% sales and earnings per share growth per annum over the next 10 years, the broader market might factor in 15% growth for one or two years but then tends to revert to the mean and may forecast 12% for year three, down to 6% growth in outer years. 

We aim to exploit this inefficiency by avoiding average and below-average-quality businesses that tend to suffer from this mean reversion in their growth rates. 

Instead, we only invest in a collection of what we consider to be high-quality businesses that are less likely to suffer from this common mean reversion. 

Hyperion puts just as much thought into our 10-year forecasts as we do one year.

The Quality Anomaly tends to be rarer and is a sub-component of the broader Time Arbitrage inefficiency. However, this anomaly can supercharge returns over time.

If there is a business doing something highly unusual, innovative, and disruptive, the market may not understand the power of its long-term earnings profile, and in effect, it may be hidden. The business could be reinvesting heavily, spending on R&D, and yet to achieve high levels of scale as they are early in their life cycle. These are exceptional opportunities involving transformative companies that can accrue significant excess returns if identified early and held in the long term. 

Hyperion has seen this historically, whether through WiseTech (ASX: WTC), REA Group (ASX: REA) or Xero (ASX: XRO) in our domestic strategies, or Alphabet (NASDAQ: GOOGL), Amazon (NASDAQ: AMZN) or Tesla (NASDAQ: TSLA) in our global strategy.

Which investments have had the most meaningful contribution to your performance over the past year – and do you still own them?

Top two contributors (rolling 12 months)

Source: Hyperion Small Companies Growth Fund update June 2023

WiseTech (ASX: WTC)

In their most recent results released to the market (1H23), they experienced a 32% increase in revenue supported by continuing organic growth from existing customers and new large global freight forwarding contract rollouts. The company also experienced profit margin improvement driven by operating leverage, price increases and cost discipline.

Xero (ASX: XRO)

The appointment of a new CEO to Xero has proven to be beneficial as the company is now focusing on balancing growth and profit, as well as the structural growth opportunity in all markets. The 2023 financial year result was also strong with 28% revenue growth, and improved profitability and free cash flow which is likely to be sustained.

What are some of the largest investments in the fund and why do they still deserve a spot in your portfolio?

WiseTech - 11.7%

Generally, the logistics industry presents huge barriers to entry for leading software providers due to the high level of specialisation and integration required from the software. WiseTech has a strong and resilient competitive advantage due to over 5.3 million labour hours having been spent building the platform organically from a single source of code over the past 20 years. Furthermore, over the last five years, WiseTech has invested more than $695 million in product development and innovation, building research and development capability in their global teams across 35 development centres.

WiseTech's technical leadership should continue to grow as it expands its offering globally and its level of functionality across the supply chain.

Fisher & Paykel - 10.9%

Fisher & Paykel has built multiple sustainable competitive advantages in the high-flow therapy market with its Optiflow product. These include:

1. Higher humidified flow rates than competitors. This allows gas in a patient's lungs to be removed and replaced with oxygen faster, therefore accelerating recovery. The tubing technology also provides better condensation management.
2. The generation of substantial clinical evidence using Optiflow.
3. An established, reputable brand, particularly in hospital ICUs.
4. High barriers to entry in the industry. It takes years to replicate the technology, and Fisher & Paykel continue to invest significantly in R&D which comprises a high single-digit proportion of their revenue. There is also incumbency with already installed devices.

Can you discuss an investment that worked against you in FY22/23 and what have you done with it?

Dominos (ASX: DMP)

Over the 12 months ending 30 June 2023, Dominos saw a -31.7% price change. Its average weight in the portfolio was 6.9% and it's contribution to returns was -1.6%.

Domino’s Pizza’s half-year results in February were disappointing and were followed with a weak trading update in June this year, where despite positive trends in Q4, same-store-sales growth for FY23 will come in below their medium-term outlook of 3-6% growth per year. New store openings will miss their medium-term store growth target of 8-10% per year, though their long-term target of 7,100 stores by 2033 remains unchanged. The company also announced a series of cost-saving initiatives expected to deliver annualised savings of $53-59m, which includes the closing of its Denmark business.

Inflation post-COVID has created operational difficulties for the company and to protect franchisee profitability from the rising cost of inputs, Domino’s implemented a series of price increases. 

We believe Domino’s made pricing mistakes when attempting to offset rising input costs, which has resulted in a reduction in customer numbers and a loss in market share.

The weight of Domino’s in the portfolio had been reduced factoring in these challenges. 

While we continue to see the short term as challenged, including a weaker macro, tighter consumer budgets, and not meeting their short-term store targets, we remain constructive over the longer term. Recent initiatives such as the removal of the delivery surcharge fee, removing the loss-making Danish operation, and streamlining operations are long-term positives. 

Domino’s continue to have a significant runway for store openings which, even meeting the lower end of their medium and long-term guidance still results in double-digit growth annually. Based on our continued work, we remain confident in the value proposition and the store rollout opportunity.

What kind of market conditions do you expect over the coming 12 months?

As we continue to progress into 2023, we are seeing more evidence that inflation is returning to lower levels, and 10-year bond yields are stabilising. There is still a possibility of an economic slowdown in the back half of this year and early next year. However, it is currently difficult to know if this will result in a recession. In a relative sense, Hyperion is well placed to navigate these conditions with a portfolio of stocks that have the ability to grow organically through pricing power and market share gains.

In the long term, we still believe that declining population growth rates, high debt levels, and disruptive new technologies including AI, machine learning, and robotics will be highly disinflationary. 

These factors will see inflation levels continue to decline over the long term. In this environment, we believe a portfolio of structural growth stocks will become very rare and valuable.

How will you be positioning your investments if your base case plays out?

We believe the long-term return outlook for our portfolios continues to look attractive. Our portfolios have robust fundamentals with high and sustainable returns on capital, low financial gearing, and the ability to produce positive free cash flows. In addition, many of our companies are founder-led. 

The companies in our portfolio have robust franchises and grow by taking market share. They are less reliant on the general level of economic growth for their growth. They tend to have strong value propositions that allow them to take market share from competitors. This ability to take market share tends to increase during economic downturns when weaker competitors are suffering. This ability to grow by taking market share enables our stocks to handle cyclical earnings downturns relatively better than most listed companies.

We believe the negative duration impact from higher bond yields continues to provide an opportunity for long-term investors to increase exposure to some of the best listed businesses in the world at attractive prices. Hyperion’s global and domestic strategies continue to offer above average forecast 10-year returns at current prices.

What is the one thing the market will get wrong in the year ahead?

Potentially underestimating the value in high-quality businesses with persistent earnings and sales growth in a slowing economic environment.

Throughout the year to date, several positive emerging themes arose that we believe will continue throughout the year and beyond. 

The first of which is a shift in corporations focusing more on efficiencies within their businesses, particularly at the bottom line (earnings). 

We believe the ability for corporations to run their businesses harder by being more astute with their spending and sizing their workforce appropriately can help them achieve earnings leverage, which may produce considerable upside to margins over the medium term.

The second positive has been around artificial intelligence (AI) and machine learning (ML), where we are starting to see an inflection point. 

A key structural theme that Hyperion identified approximately 10 years ago was AI and ML, however, the potential upgrades to revenue/earnings streams, efficiencies in productivity and increases in market leadership are only now starting to be recognised by market participants. 

Your investment opportunities

Hyperion offers a choice of three funds to align with a range of investment goals. Each portfolio has one common objective – to deliver economically sustainable, long-term outperformance for our investors.

Managed Fund

Hyperion Small Growth Companies Fund

Australian Shares

View

Managed Fund

Hyperion Australian Growth Companies Fund

Australian Shares

View

Managed Fund

Hyperion Global Growth Companies Fund (Managed Fund)

Global Shares

View