What does life cycle investing mean?
The small-cap universe (outside the ASX100) is vast and varied, comprising around 2,000 companies operating across a broad array of industries and ranging in size from just a few million dollars in market value to multiple billions. How do we profit from companies as they grow?
Companies at the smaller end of the market cap spectrum are often at an earlier stage of development, while the larger small-caps are more established with proven business models. We look to invest right across the life cycle, and if you get it right and identify a good investment early enough, you can profit at each stage as a company effectively grows up, progressing through its development curve.
How do you discover these companies early?
A key feature of the market is that smaller companies tend to be under-researched relative to large companies, meaning there are many more companies with far fewer eyes watching them. This generally results in a less efficient market which regularly misprices stocks, creating compelling investment opportunities for those willing to roll up their sleeves and do the work.
Discovering the best ideas in small-caps involves covering lots of ground. In our relentless search for tomorrow’s leaders, we meet with literally hundreds of management teams each year to discuss their business strategies, industry trends and outlook.
We try and take in as many meetings as possible, leaving no stone unturned, and we will often meet with a company many times before deciding to make an investment.
Management face time is important because we view strong leadership and execution as critical factors for companies achieving their potential. We ultimately look for management teams with a clearly articulated vision and message which resonates with the market, and which consistently delivers.
Screening down to find the best potential
Our investment process is efficient through our proprietary screening tool which refines and narrows the small-cap universe into stocks of interest, requiring further detailed analysis. We cohort the market into segments so we can focus our attention on structural growth stories, companies benefiting from cyclical upswings, businesses in transition, as well as stable compounders which balance the portfolio.
Rather than just collecting a bunch of good ideas, we aim to build a diversified portfolio of 30 to 50 stocks which will outperform the broader small-cap market over a medium-term horizon, with a strong emphasis placed on superior risk-adjusted returns.
Managing risk within the portfolio is paramount to our process. Risk is carefully considered at both the company level (earnings, liquidity, valuation, capital structure), and across the portfolio (correlated risks).
Building a diversified portfolio
Our ‘Life cycle’ approach to portfolio construction adds a further layer of discipline to our uncompromising risk management process. By grouping the stocks we own into ‘four buckets’ based on their stage of development (early stage, emerging growth, developed and core) and applying lower portfolio weights to earlier stage companies, and higher weights to more developed businesses, we try to capture the upside potential whilst simultaneously managing the risks.
Early stage companies, led by entrepreneurial managers, armed with a disruptive idea can be really exciting and rapid growth stories. However, less established corporate governance structures and the likely need for further capital to fund growth ambitions warrant a relatively low weight under our ‘Life cycle’ approach to reflect the inherent risks (typically less than1 per cent of the fund for each early stage position). We look at many early stage companies although only invest in a few.
Emerging companies are those which have matured from early stage development, into businesses with commercialised products which are demonstrating their potential to the market. By this stage, they will generally have introduced a solid governance framework into the business and should be scaling towards profitability, if not already there. We still consider these investments as higher risk propositions so we weight them accordingly (each position usually 1-3 per cent of the fund).
We define developed companies as businesses with established product offerings, proven growth strategies and strong corporate governance. Consistent profit streams enable these boards to assess horizon two growth opportunities or capital management initiatives like paying dividends. The lower risk profile of this ‘bucket’ means we are generally more comfortable assigning higher portfolio weights to developed companies (2-5 per cent weights each).
Our final ‘Life cycle’ segment classifies the most developed companies as core. They are selected as core holdings in the portfolio based on their leading business models, exhibiting a sustainable competitive advantage, and excellent governance.
Small-caps that make it into this elite category often find themselves promoted into the ASX100 index (think REA, Carsales, Flight Centre, Altium and Afterpay). High profitability levels coupled with strong and reliable cash flows further support our case for greater portfolio weightings towards these leaders (3-7.5 per cent weights each).
Small-cap investing can be a rewarding journey, particularly when you pick an early stage company and watch it mature through its life cycle and become an ASX100 leader. All of our drive and determination is to find those companies with that potential.
Dominic is Portfolio Manager of the Montgomery Small Companies Fund – a small-cap Australian equity fund investing in 30 to 50 high quality, undervalued small and emerging companies with strong growth potential. The fund invests outside the ASX100.