TOL - 11th Mar, 2023
Outperforming against all odds: How Chris Stott's 1851 Capital topped the league table
Despite launching just a few days before the COVID crash, 1851 Capital has topped the Mercer survey for its stellar three-year returns.
Cast your mind back to January 2020. Back then, the market was reaching highs not seen before, investors were throwing their cash at stocks in droves, and a novel coronavirus in Wuhan, China was just starting to hit the airwaves but was of little global concern.
On February 1, Chris Stott and his team at 1851 Capital launched their highly-anticipated small and micro-cap fund. Just 20 days later, the market plummeted, having woken up to the idea of a widespread global pandemic. Within a month, the S&P/ASX 200 would fall more than 32% - the Small Ordinaries, nearly 35%.
Despite the rough start to the Fund's existence, the 1851 Emerging Companies Fund has just topped Mercer's performance survey for its stellar three-year performance.
Since its inception on February 1, 2020, the Fund has delivered a return of 13.3% per annum. That's compared to the S&P/ASX Small Ordinaries Accumulation Index's return of just 1.1%. In fact, the Fund has swelled 46.6% since its very first day in the market.
That's an outperformance of 43.2% in total.
So how did the team at 1851 Capital do it? According to Stott, it all comes down to sticking to your knitting and not getting drawn into fads. And despite the macro headwinds that continue to loom and the rebound in small caps in recent months, he believes there's still plenty of upside in the small end of the market over the coming months.
In this interview, Stott shares some of the best and worst-performing stocks in the Fund's three-year history, where he is seeing pockets of value right now, as well as some of the stocks that he believes have been unfairly sold off this reporting season.
Note: This interview was recorded on March 1 2023. You can watch the video or read an edited transcript below.
The best and worst-performing positions over 1851's three-year history
While Stott admits that the secret to success in small caps comes down to the people on your team, he notes that one stock has stood out during the Fund's three-year tenure.
"Uniti Group (ASX: UWL) has been our best-performing stock in our first three years," he says.
"We bought that at the inception of the fund. And lucky for us, we rode that wave up from a $1.50 to the $5 takeover price just last year."
That said, the last few years haven't been easy. As Stott explains, "it feels harder now than ever."
"The market is a great humbler. And day-by-day, we are consistently learning new things from our mistakes," he says.
The first mistake, according to Stott, was the timing of the Fund's launch.
"We launched the Fund in February 2020, as the worst pandemic of our lifetimes was just commencing. So I'm pleased to say that we've gotten through that period, albeit it was looking pretty shaky there in the early days," he says.
During this time, the team has learnt the importance of liquidity.
"One thing that has worked for us in the last three years is sticking to our knitting and not getting drawn into fads, like investing in unlisted companies or investing in the hot technology space with a lack of valuation support," Stott explains.
At the portfolio level, he points to Praemium Group (ASX: PPS) as his main regret - a position that the Fund invested in at inception.
"It had a great run up from around 30 cents to $1.50 after it had a takeover approach from Netwealth (ASX: NWL). But we held on too long," Stott says.
"The game changed when Netwealth made the approach. Essentially, the share price was no longer trading on fundamentals. It was a binary outcome, whether the takeover was going to go ahead or not. We held on too long and ended up selling it well below a dollar."
That was a great reminder of an important investing lesson, he says.
"You invest in a company for its fundamentals. And when it receives a takeover approach or something like that, the fundamentals are almost out the door," Stott says.
"And so that was a good lesson for us - to take more notice of those types of situations if they do arise again."
The outlook for Aussie small caps
Stott is "mildly positive" on the outlook for the Australian equity market over the coming year, particularly given the underperformance of small caps, particularly small-cap industrials, over the past 12 months.
"In over 15 years of investing, I've never seen such a high level of focus on the macro in the smaller end of the market. And I think that will continue again this year," he says.
Stott predicts the Reserve Bank of Australia (RBA) will likely announce further rate hikes over the coming months. With this in mind, he believes the prospect of a rate cut has now been pushed out well into 2024 or even 2025.
"We actually can't see any rate reductions coming perhaps into 2025 now, which is against consensus," he says.
"Likely, we get three or four more rate hikes in the next few months. And then hopefully the RBA pauses as we start to see a lot of the data go the right way. Whether it be the inflation data start to retreat, unemployment likely continue to rise, albeit very, very slowly, and GDP will likely slow down as well."
So how much of that has been priced in? According to Stott, all of it.
"There's a lot of negativity out there. I don't remember sentiment being this bad in the smaller end of the market in over 15 years. I'd compare it to the Global Financial Crisis at times," he says.
"There's just a complete lack of interest, particularly in the micro-cap end of the market."
But that's exactly what gets Stott and his team excited.
"The general consensus is the economy's going to fall away in the next 12 to 18 months, and it will get tougher, no question. It's already started. But the share market moves six to nine months ahead of the economy and we think it's pricing in some fairly negative scenarios already," he says.
Since hitting its low in early October, the S&P/ASX Small Ordinaries Index has rebounded around 11%, despite all the negative news we see disseminated in local media outlets. And as the recent reporting season demonstrated, things aren't as dire as many would have us think.
"We think that the smaller end of the market can continue to outperform relative to the larger peers," Stott says.
"A lot of that will be driven from the companies that have really got that pricing power to navigate through a higher inflationary environment and preserve margins that way."
These small caps need to boast pricing power and less debt on their balance sheets so they don't suffer from rising interest costs in a higher rate environment, he adds.
"We're seeing huge pockets of value out there at the moment in terms of stocks that we are looking to invest in and currently doing so now," Stott says.
So where are these pockets of value?
Glad you asked. Stott points to travel and international tourism as a key sector that looks compelling right now, naming Helloworld Travel (ASX: HLO) and Experience Co (ASX: EXP) as his two top picks.
"They're two that are really tapped into the recovery of travel, and they both reported really strong results - probably their best results in three or four years - just a few weeks ago," he says.
"We continue to see upside for those particular two names that we own in the portfolio."
These bets rest on the pent-up demand for "revenge travel" after three years of being confined to our country and state borders (and our homes). This is particularly true for retirees, Stott says, who saved a lot of money during the COVID period, and are now getting an attractive return on their term deposits once again.
"The baby boomer generation is ready to travel again," Stott says.
But there's another way to play this theme.
"There's a raft of international students coming back into the country," Stott explains.
"Nexted (ASX: NXD) is one that we own in the portfolio. It's the old iCollege Group. We've owned it for well over 12-18 months now, and it's been a good performer for us," he says.
"They're really well positioned to take advantage of international students coming back into the country to study... And there's been a huge structural change in that industry, which we think is highly beneficial to Nexted over the medium to longer term."
Costs, wages growth on the rise (and the demand for EVs Down Under)
There were three key themes that emerged during the recent February reporting season. The first, unsurprisingly, was that rising costs are finally starting to moderate.
"The last 12-18 months, in particular, we've seen a large level of cost inflation, whether it's higher input costs for building materials, steel, timber. If you've tried to do a renovation recently, the cost of is exorbitant," Stott says.
"So we started to see some of those cost pressures abate. And a lot of the companies that we met with have suggested that is the case."
He points to retailers such as The Reject Shop (ASX: TRS), Adairs (ASX: ADH), and Super Retail Group (ASX: SUL) as examples, which are now seeing logistics costs such as shipping rates fall back to levels seen before the COVID pandemic.
During the month, Stott and his team met with over 100 companies. And wages growth was a key area of concern.
"Wages growth this year is likely to be the highest level of wages growth we've seen for many decades, and that's probably no great surprise. But companies are really thinking about forward planning for that right now, particularly over in the west," he says.
"Companies like Perenti (ASX: PRN), Emeco Holdings (ASX: EHL), and SRG Global (ASX: SRG) to a lesser extent, all in that mining services bucket, all called out that there are higher labour costs that they're having to absorb. That's really a function of the shortage of labour.
"People are calling for a recession. We can't see that with full employment. The unemployment rate still sits shy of 4%, and I just can't see a recession in that scenario."
The final theme that emerged during reporting season was the demand for both used and new electric vehicles, Stott adds.
"Talking to companies like Eagers Automotive (ASX: APE), Autosports Group (ASX: ASG), and Peter Warren Automotive (ASX: PWR) - they're the three listed owners of car dealerships in Australia. They're all seeing huge levels of demand for EVs or electric cars," he explains.
"So APE is one that we own in the portfolio, it reported quite well. They've got a joint venture with a Chinese manufacturer, BYD, which is the largest seller of electric cars in the world, ahead of Tesla. They've just entered the market with an SUV electric car for $48,000 with an eight-year warranty. We think that's a pretty compelling offer."
There's huge demand for electric vehicles, Stott says, but the key question over the next decade is whether or not we have the infrastructure to support it.
"I jumped on YouTube the other day and someone filmed themself driving their BYD car from Sydney to Melbourne. It's a nine and a half hour drive. It took him 12 and a half hours. So he spent three hours across various stops along the way, charging his car," he adds.
"It took a little bit longer than it probably would in a petrol car, but the cost of it was cheaper. It cost him $70 to get from Sydney to Melbourne charging his car, versus say $150 to $200 for a petrol or a diesel car.
"So we certainly think that the EV space and any companies that are tapped into that over the next five or 10 years will do quite well."
A company that was unfairly sold off (and a result the market missed)
While there were significant share price movements off the back of earnings results during the month, many stocks have ended up back at their pre-result share price (or even below that) once the dust had settled.
"One company that stands out for us, and full disclosure, it's the biggest stock in our portfolio, is a little radiology business called Capitol Health (ASX: CAJ)," Stott says.
"They reported a result which was weaker than expectations. So the share price has been sold off around 15-20% in the last two or three months."
Stott believes Capitol Health has been unfairly sold off, noting that the "fundamentals remain in place."
"The reason why they struggled with their result was we had another spike in COVID, if you remember, back in November/December last year, and so the visitation rates and GP referrals were down," he says.
"But they've got a highly strategic level of assets across the portfolio, and a strong balance sheet in a market that's fairly uncertain. I think that's a fairly good sector to be in."
Another stock that was unfairly sold off this reporting season was Frontier Digital Ventures (ASX: FDV), Stott says. Frontier Digital runs a collection of online real estate and car marketplace portals in emerging markets around the world.
"It's been a core position for our Fund since its inception three years ago. They recently reported their results, which we thought were ahead of our expectations, albeit the share price has been sold off," he says.
"The reason for that is just a short-term weakness in the technology market, particularly the NASDAQ over recent weeks. So we see that as an opportunity. We've added to our position in that particular company more recently."
This is a very well-managed business run by Shaun Di Gregorio, Stott adds, and the sum of its parts is worth far more than the stock's $255 million market cap.
"The key to our investment thesis with Frontier Digital is their real estate portal in Pakistan called Zameen, which they own 30% of it. We value that particular stake at around $400-$500 million compared to their market cap of $255 million," he says.
"They've got another 15 or 20 different assets in addition to Zameen, which we think clearly adds some great value to them over time and are performing very, very well."
How to succeed in the small end of the market
While Stott notes that the key to funds management success really comes down to the people - pointing to his small team of three (Martin Hickson, Matt Nicholas and Mary-Ann Baldock) as the backbone of the business, a love for investment is also crucial if investors have any hope of success in small caps.
"You've just got to enjoy what you do. It's the old adage, but if you're not excited and energetic about going to work, then you're probably not in the right industry," he says.
"The beautiful and lucky thing for us is that we are privileged enough to manage over $400 million on behalf of 1,000 different investors in Australia. And we spend our days speaking to CEOs and CFOs of some of the most prospective small-cap companies in Australia. That's a really humbling thing for us."
So is there any hope that the Fund will reopen to new investors? As I learnt the hard way (having implored after the interview), unfortunately not.
"We get a lot of interest about that, and we've had a lot of approaches, again, which is quite humbling, for new products. There are no current plans to launch any new products at the moment, but certainly, that is an opportunity for us to do that sometime down the track," Stott says.
"We're only three years into our journey. We see it as a 20-year journey."
The four staff members of 1851 Capital are currently the largest investors in the Fund. It soft closed in August 2021 when it hit its $400 million target. As of the Fund's latest update, it has a net asset value of $414 million. The fund remains open to existing investors only.
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Ally Selby is the deputy managing editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your Money, Sky Business and Sky News.
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Ally Selby is the deputy managing editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian...
Expertise
Ally Selby is the deputy managing editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian...
Expertise
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