The inside word

PORTFOLIO POINT: They’re off the radar of the big broking firms, but small caps can be very lucrative investments. Matthew Kidman’s new book tells how.

There are about 1500 ASX listings capitalised at less than $500 million. The combined market cap of all 1563 companies outside the S&P/ASX 300 is $120 billion, excluding ETFs and secondary-listings – only two-thirds of BHP Billiton’s market capitalisation of $180 billion.

Over the past three years, the S&P/ASX Emerging Companies Index has doubled in value, whereas the S&P/ASX Small Ordinaries index has gained 37% and the big-end of town, the S&P/ASX 100 index, has crept forward only 8.7%. Despite this, comparatively few fund managers focus on the emerging companies sector. As a result, research on these companies by stockbroking firms who are typically reliant on fund managers for their income is minimal.

But it is outside of the S&P 300 that we are going to make our money most often. These smaller companies are the source of much of our country’s innovation, our productivity gains and our employment. Of course, they are also the source of the greatest risk.

In his excellent book, Bulls, Bears & a Croupier, former fund manager Matthew Kidman talks about how he went about helping Wilson Asset Management generate an annual return of more than 20% over 13 years, backing such success stories as salary packaging company McMillan Shakespeare and software group Reckon. He notes the stunning successes of many small mining stocks over the past five years. Common sense would suggest that if the small miners as a sector have risen by 250% then that sector has the ability to mirror that performance on the downside.

Kidman is also cautious when it comes to biotechs, saying he has been burnt too often waiting for a stock to win approval from North American regulators.

Kidman calls himself a stock picker who concentrated on fundamentals and the identification of a catalyst that would re-rate a stock in the market’s eyes. On his morning commute he would scour newspaper listings of stocks trading at 12-month highs and lows. Something we can all do.

His firm’s valuation template concentrated on forecasting the next two years’ earnings of a company, working hard to get a grip on the rate at which earnings per share could grow. They would then divide this EPS growth by the P/E in the relevant years to get a valuation filter, ensuring that they were not paying too much for that growth. Finally, they would rate management and the industry in which they operated following a series of face-to-face meetings with management. This template would spit out a score. Ideally the firm would find a company that could grow its EPS at twice the rate of its prevailing P/E ratio.

If a company produced a high enough score then the firm would take three further steps:

• They would calculate the return on equity to ensure the company was growing profitably and not in need of major capital injections.
• This was followed by a cash flow calculation to ensure the company could grow without having to raise further equity.
• Finally they looked for a catalyst that would change the value of the company in the market’s eyes.

If the company ticked all these boxes they would start to buy. Wilson’s emphasis on a rolling two-year forecast of cash flows and profits is worth highlighting. They found that any predictions beyond this point usually undershot or overshot the mark by up to 50%. Second, a slight variation in the discount rate (the interest rate used in discounted cash flows valuations – the rate of return that could be earned on an investment in the financial markets with similar risk) would radically alter the valuation of the company. They wanted to deal with the realities of today rather than the possibilities of the future.

Kidman puts emphasis on finding companies that have great internal cultures, nominating Reckon and Ramsay Health Care.

He cautions against backing sectors or stocks that are the “flavour of the month”. One such sector prior to the GFC was listed property trusts, which traded at a premium to the value of their underlying assets at the time. Today property trusts generally trade at a discount to the underlying assets, providing an opportunity for investors to make a significant return over the years to come, according to Kidman.

• Bulls, Bears and a Croupier by Matthew Kidman is published by John Wiley & Sons

Stewart Oldfield is a research analyst at InvestorFirst Securities.