Small Fry, Big Returns

Sean Cunningham was one of the first of the market's institutional investors to pick this year’s rebound in consumer stocks, such as David Jones , Rebel Sport and JB Hi-Fi. Now he's worried about mining service companies.

As you can see in the accompanying video, Cunningham is happy about the lack of research done on smaller companies. For the purposes of this fund, “smaller” means those outside the ASX top 50, reaching down to firms with a market capitalisation as low as $50 million.

With the horde of market analysts poring over the top 50, there’s little chance of discovering a mispriced gem. That does occur, however, among the small fry. The downside is that investor have to do their own hard work on the stocks, but at least Cunningham tells Eureka Report how to go about it.

Smaller companies might be expected to mean more risk, and certainly there are plenty of penny dreadfuls that justify that tag. Cunningham says Perpetual’s system of filters means its small cap portfolio is no riskier than the big stocks.

Reducing risk does mean missing out on the froth in the occasional bubble because companies actually have to make a profit to be included in Perpetual’s investment universe. That meant poor performance during the dot-com bubble, but outstanding performance afterwards.

One of the usual stockmarket sub-cycles is played out between the big blue-chips and the small cap stocks: first one will break ahead of the other, then the other will catch up and pass, and so on.

In this particular bull market, though, there hasn’t been much of a gap. The ASX200 made the 5000 point mark before the All Ordinaries index, which has another few hundred minnows in it, but there wasn’t much difference. That comes as no surprise to Cunningham, who counts among his responsibilities looking after half of Perpetual’s Smaller Companies Fund, which has averaged a very handy 17.09% performance over the past 10 years.

Michael Pascoe: Which is more fun '” fishing in the big pond or among all the little fish?

Sean Cunningham: Much more fun from my point of view in the X50 area [stocks outside the top 50] '¦ a lot less people covering them. I’ve been here 10 years now and I’ve invested in a lot of stocks that are covered by no brokers and you get the best mispricing opportunities there and then when these companies start delivering and one, two, five or 10 brokers start covering them then everyone else jumps on board.

Smaller companies that are under-researched are harder to invest in, though, because there’s not the research. It means you’ve got to do your own. What do you look for?

You’ve heard a lot of noise about boutique fund managers and they might only have two or three investment professionals. Here we’ve got 10 people looking at stocks so we’ve got certain criteria that, first, we filter stocks to come into our investable universe and one of them, for example, is debt so a lot of these infrastructure companies for example just don’t meet that filter. We will not invest in them. Recurring earnings is another one, so companies that are speculative or loss-making or a concept won’t meet our criteria and we won’t look at that.

So the filters narrow down the universe that you can invest in. But after the negatives are taken out, what do you look for? Or do the filters take out most?

I think in our investable universe '” I can’t give you the exact figure but it’s between probably 220–250 stocks are left in our investable universe '” and then it all comes down to valuation. Obviously, there’s a multitude of valuation techniques, depending on the stock you’re looking at, but my favourite valuation technique is EV to EBITA. So it’s really a price/earnings [P/E] multiple that adjusts for the strength of the balance sheet.

Can you explain that?

Yeah, sure, EV, enterprise value, is the market cap of the company plus the debt or minus the net cash, and then you’ve just got the EBITA, which is earnings before interest tax and amortisation. So companies with net cash on their balance sheet, their enterprise value is much lower. In other words, the company is cheaper than it looks on a P/E basis. So if someone were to make a takeover bid for the company, for any company, they look at the number of shares and the stock price for the market cap, then they’ve either got to take that debt on board that the company has, or if the company’s got cash obviously they’re paying less for the business. So if you look at a straight P/E it doesn’t tell you how cheap the company is really.

The over-researching or just all the researching that’s done with major companies '” does it add value?

It’s a good question. I think it’s much harder to add value in the bigger stocks. In the smaller ones, you can focus on the financials and get an edge that way, where in the bigger stocks you’ve got 10 analysts spending a lot of time doing all the financials and I think it’s more important in the bigger stocks to get the strategic side of it right. For example, in Telstra, which is a big stock that everyone’s covered, we’ve been underweight for a long time because we could see that all these little competitors are coming in and nibbling away at all their revenues and there’s a lot of price competition so you didn’t really have to '¦ there’s 10 guys out there telling you what they think the numbers are, but if you have the overall big picture right you’re much better off.

Another one that we’ve done well on the other side being overweight is Rinker. Sure, there’s a lot of people doing out numbers out there but what people missed was that gravel in Florida, for example, is a rare commodity so the demand supply situation there has seen their gravel prices go through the roof. It’s quite a hard product to import and export because of the weight of it '” it’s not cost efficient to do it. So yeah, I mean if you got the big picture right in those two stocks that’s all you needed to do. As I say, in the small companies where there’s not a lot of analysts covering them, you’ve got really got to do your own numbers.

Are there any particular sectors that you like at the moment?

I have to say a couple of months ago I think I was quoted in the press as saying that the professional market had deserted the consumer discretionary area and we’ve seen some big rallies, fortunately, in the past few months in that area. David Jones, Rebel, JB Hi-Fi '” all of these companies reported respectable results and with the professional market abandoning that area they’ve all had to get back in there and we’ve seen some pretty big rallies.

And here we don’t really do things on a sector basis, but that just happened to be when we do bottom-up stock picking that we were holding more stocks in that area. An area of the market that I think is a little bit dangerous in terms of valuation at the moment is the mining-related services area, and these are basically contracting companies which historically would trade on 8–12 times earnings are now trading 19–20 times earnings. That’s only part of the danger.

The other danger is that we’re operating in a high cycle environment at the moment, so I’m not saying this environment will change tomorrow; it’s very hard to time. I think sometime within the next five years there’s going to be one hell of a train smash there because you’ve got high P/Es in high cycle in low-quality companies. It’s a recipe for disaster because what happens is that the earnings come off and then they halve eventually and then the P/Es halve so you can see stock prices down to a quarter of the levels they are now. It’s the same with any cyclical company. Why I said consumer discretionary is an interesting area is because you had low-cycle earnings and low P/Es so you get the opposite effect, obviously. They’re cyclical businesses but when the earnings turn around you get the re-rating just from the earnings going up and you get a re-rating because people think they’re better businesses now because they’re growing profits faster.