Hunting for small caps gold

The best clues for finding small cap nuggets are buried in the market’s bigger success stories.

PORTFOLIO POINT: Small cap companies with global selling power, good IP and technology, strong profit margins and that engage well with their customers generally outshine in performance.

The reason I invest in small or emerging companies is for superior growth potential.

The best and the most financially rewarding type of growth for shareholders comes from companies growing organically. I see most acquisitions failing to add shareholder value, but that said some acquisitions, particularly those with an emphasis around intellectual property and information technology, can be rewarding for investors.

Working backwards I have identified four now large-cap Australian investment success stories. They have graduated from being emerging Australian companies into global companies with the process of commercialisation being very rewarding for shareholders.

  • Sleep disorder breathing company Resmed commands over 40% market share in the medical device market of continuous positive airway pressure “CPAP” devices.
  • Cochlear is the global leader, with circa 65% market share, in hearing implants.
  • Blood products company CSL commands 30% US market share and a strong European presence.
  • Computershare is a global leader in the share registry space and has a strong information technology heritage.

I have tried to break down the common characteristics of these four Australian companies, to get a template to help finding the next good thing.

These successful companies sell products and or services into a global market. They are selling products which have a heavy emphasis on intellectual property, technology or both. They all generate strong gross profit margins and pre-tax profit margins of 20% or greater.

These four, acquisitions aside, don’t have a big ongoing appetite for capital, so cash generation is strong. They all generate high return on equity, with Resmed the lowest as it retains a lot of cash on its balance sheet. Cochlear pays decent dividends while Resmed and CSL have been focused on share buy-backs in recent years. Computershare, historically, has funnelled a lot of its free cash flow into further acquisitions.

The more successful companies engage directly with their final customer and have little in the way of revenue concentration issues. They sell products or services of good relative quality or efficacy when compared with their competitors, which is something I always look for.

Perhaps the most important similarity between these successful Australian companies is they exist in growing spaces with real thematic growth drivers. The relationship between poor sleep and disease for example has propelled Resmed’s sales revenue 21% per annum for the last 10 years.

Computershare has grown its revenues 9% per annum over the last 10 years through acquiring share registry and other businesses. Computershare has been a beneficiary of outsourcing and high share trading volumes (until recently). CSL has grown revenues 13% per annum over the last 10 year after successfully acquiring quality businesses in a strongly growing blood products market.  

I see one of the tasks in managing our flagship fund, the Smaller Companies Trust, is finding the next emerging company that may kick on to become a global business.

I go about alpha hunting for these companies using a variety of screening tools. For instance, data is pulled from Bloomberg or Factset, sliced and diced for whatever financial metric one wants to target, such as return on equity or free-cash generation.

Motivated investors can quickly assess relative value and highlight companies that warrant further investigation. This database type screening is however commoditised and all professional investors worth their salt should be actively screening the market on an ongoing basis.

The more meaningful screening occurs in the face-to-face company meetings over a number of years. I have a specialist investment mandate and a smaller investment universe compared with other small-cap managers. This has allowed me to dedicate more time and effort to developing domain knowledge and expertise in the medical and technology spaces, which allows me to follow these companies at a more granular level.

I firmly believe in keeping our door and ears open to new companies and new ideas as this space, in particular, is fast changing.

I clearly like to see a positive industry dynamics and drivers in the companies I invest in. Companies have a hugely enhanced ability to generate earnings growth and deal with many bumps in the road when their top-line revenue is growing.

For example, we have investments in the enterprise hosting company Macquarie Telecom and data centre business NextDC and see both benefiting from growth of the online space and the trend to outsource more IT functions.

It’s also nice to participate in sectors which have high barriers to entry, whether they be intellectual property, expertise or capital requirements. The medical device and biotech companies all potentially have strong global intellectual property positions underpinned by legal patents. The likes of Pharmaxis in the respiratory space and Universal Biosensors in point of care blood diagnostics both have strong IP, with the potential to become global businesses.

I highly rate businesses that engage on a regular basis with their final customers. The internet service providers like iiNet or IT services company UXC hold the majority of their key customer relationships. Companies that engage with the final customer are less vulnerable than distributors from being shut out of business relationships.

The likes of plumbing supplier Reece has its own channel to market, with 453 Reece outlet stores selling bathroom and plumbing products to the trade. This compares with other housing recovery investments that are more reliant on national hardware chains to distribute product.

I also favour companies where a big chunk of revenue comes from recurring revenue sources. The software companies I hold include broking and wealth management software supplier GBST and enterprise resource planning software provider TechnologyOne.

These software companies charge an annual recurring maintenance fee and also can consistently count on a portion of revenues from professional services work. The software industry is morphing towards applications being delivered in the cloud, which should attract a higher element of subscription type revenue in the future and less reliance on initial licence fees.

I do like companies with high gross profit margins as this enables investment into bigger sales-force engines. It also allows investment into product development, which should retain and hopefully extend product competitiveness. The likes of Queensland headquartered TechnologyOne reinvests over 20% of its sales back into software development, while GBST invests over 10%.

The strength of the intellectual property makes a big difference. Australia has a good pedigree, particularly in the medical device space with Resmed and Cochlear. We, as a country, do good science, with many ASX-listed biotechs today having emerged originally from university or CSIRO research.  

Investment at the right time in these companies’ commercialisation has been extremely rewarding. The first item on my medical device and pharmaceutical company tick list is product quality and efficacy compared to the existing standard of care. Health budgets around the world are under pressure, so new products have to add innovation and improvement.

I like CEOs and company managers whom I can relate to and who are personally motivated to succeed. I like to see the commitment from managers, with steady share ownership in the company. I dislike managers selling stock, although I understand the pressures of divorce, tax and estate planning do come into play. I am wary of big salaries, bonuses and option packages, but unfortunately this is often how talent is attracted and retained.

I also see ad-hoc opportunities presented in the market from time to time. The market struggles to value a company which has a loss-making division and generally excessively discounts its valuation. This loss-marking division is then either turned around or closed down, and patient shareholders get a big uplift.

The issue of time horizons and investment confidence creates opportunities for patient investors, as the market is short-term focused.

I am wary of small-cap stocks with a “market darling” status, particularly those on high earnings multiples. Conversely, at the other end of the spectrum, there are many value-traps trading on lowly earnings multiples and big dividend yields. These companies have commonly earned their stripes for a reason and more often than not the market is right.

The stockmarket presents many opportunities and threats. I firmly believe it’s worth the time to understand and invest into small cap emerging companies as they will provide superior growth potential over the medium term. Understanding the characteristics of larger successful companies can provide vital clues.

Andy Gracey is portfolio manager at Australian Ethical Investment.

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