Australian Small Caps: value vs. cheap
“For strong free cash flow and returns to be sustainable, a business needs to demonstrate it has sustainable competitive advantages.”
Summary below by Anthony O'Brien
A small companies fund is very different from the Small Companies Index.
A good small companies fund should invest in a concentrated group of stocks, which collectively have a better return profile than the index. It will also have a stronger balance sheet, significantly better management, more free cash flow and a higher ROE than the index average.
The ideal small companies portfolio will also offer significant value relative to the index. We use the term ‘value’ rather than ‘cheap’ because the average PE of the portfolio might, for example, be higher than the index.
Therefore when assessing an investment opportunity, we spend a lot of time analysing the company’s value proposition, customer concentration risk, product/service distribution, intellectual property and the quality of the asset base.
To provide some clarity on how we assess ‘value’, we highlight our insights on two small company stocks; BC Iron and TPG Telecom.
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Frequently Asked Questions about this Article…
A small companies fund is distinct from the Small Companies Index because it invests in a concentrated group of stocks that collectively have a better return profile. These funds typically have stronger balance sheets, better management, more free cash flow, and a higher return on equity (ROE) than the index average.
The term 'value' is preferred over 'cheap' because a portfolio's average price-to-earnings (PE) ratio might be higher than the index. Value focuses on the overall potential and quality of the investment rather than just the price.
When evaluating the value of a small cap company, it's important to analyze the company's value proposition, customer concentration risk, product or service distribution, intellectual property, and the quality of its asset base.
A small companies portfolio can offer significant value relative to the index by having a better return profile, stronger balance sheets, superior management, more free cash flow, and a higher ROE than the index average.
The article highlights insights on two small company stocks: BC Iron and TPG Telecom, as examples of small cap investments being assessed for value.
Sustainable competitive advantages are crucial for a business because they ensure that strong free cash flow and returns are sustainable over the long term, providing stability and growth potential.
Management plays a critical role in the success of a small companies fund by ensuring strong leadership, strategic decision-making, and effective operations, which contribute to better financial performance and higher returns.
Customer concentration risk affects small cap investments by potentially increasing volatility and risk if a company relies heavily on a few customers. Diversifying the customer base can mitigate this risk and contribute to a more stable investment.
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