InvestSMART Australian small companies - March 2018

The March quarter was one we'd like to forget. After a relatively error-free first year, with excellent performance to the end of January 2018, we've had some disappointments over the last couple of months – such as Amaysim and CSG Limited (discussed last month). As a result, the fund lost 10% in the first three months of the year, compared to a loss of only 3% for the S&P/ASX Small Ordinaries Index, although it has still returned an annualised 14% since it began life just over a year ago.

Mistakes are an unavoidable part of the investing process. Even the very best – like Warren Buffett and Charlie Munger – only get six or seven right out of ten. It is a game where even ‘good bets' – like receiving four to one odds on a coin flip – will lead to losses some of the time. Small company investing, in particular, involves making considered bets, and sometimes they just go against you.

In a perfect world, mistakes would be evenly distributed over the year. Better yet, they'd fall alongside offsetting winners. But that's not the world we live in, and our recent experience illustrates the point. It will be especially frustrating for investors who have joined us recently, but it also highlights why a long-term focus is paramount, as it's only over the fullness of time that these forces can balance out.

More stalwarts as animal spirits flow

It became apparent late last year that animal spirits were beginning to flow, with the riskiest investments – such as cryptocurrencies and questionable technology start-ups – among the best performing. When other investors are being less prudent with their investments, it's often a good time to be more prudent with your own.

We're countering by investing more of the portfolio into some high-quality stalwarts like TradeMe and ALE Property.

We've sensed an opportunity in TradeMe as the market has sensed a four-hundred-pound Gorilla. That gorilla is Facebook, which continues to push into TradeMe's space with its general items Marketplace.

The market's concerns are not unfounded. With 2.2 billion users, Facebook's ability to leverage product development is almost unmatched. But despite stiff competition from Facebook and others, the impact is confined to a decreasing portion of TradeMe's business.

Meanwhile, TradeMe's best businesses – its motors, jobs and property classifieds – continue to stride ahead with revenue growth accelerating to 14% in the first half of 2018. TradeMe's problems are shrinking while its winners are compounding. The long-term outlook for TradeMe's classifieds is promising, as Carsales.com, Seek and REA Group have demonstrated in Australia, and at current prices, we think we're getting the stock cheaply.

ALE Property is another recent addition. We like the rock-solid cash flow it receives from owning 86 pubs, which are leased to a high-quality tenant (ALH, which is 75% owned by Woolworths) under triple net leases. We're also at an interesting juncture in the trust's life with a rent review around the corner. ALE Property may not set the world on fire, but we think it should prove a worthy addition to the portfolio, offering decent value and balancing out some of the riskier situations.

Audinate added

One of those riskier situations is Audinate Group, the owner of Dante, a digital protocol for installed audio-visual systems. Our thesis for the stock is simple: one protocol is likely to dominate the audiovisual (AV) industry as it becomes digital, and Audinate's is the most likely to do it.

Installed AV systems, found in concert halls, stadiums and public transportation, are ‘digitising'. Installation costs of digital systems are cheaper, as they do away with expensive copper cables, and sound quality and usability also improve.

Original equipment manufacturers (OEMs), such as Yamaha, Bosch and Bose, are playing their part by embedding digital protocol chips into their microphones, amplifiers and mixers. The protocol defines how the device shares digital audio signals with other devices.

We suspect one winner will emerge for two reasons: it's cheapest for OEMs to adopt one digital protocol and that forces them to pick a winner. Users also avoid interoperability issues by sticking with a single protocol. Over time, these forces are likely to drive the industry to the point where the leader enjoys most of the profits.

As Audinate already has its nose in front, with five times as many adopted devices as its nearest competitor, the industry leader has emerged. Herein, OEMs have the greatest incentivisation to adopt Dante because it's the most widely used, which means Audinate can earn more revenue, spend more on research and development (or reduce unit prices to ward off competitors) which should perpetuate its dominance.

This process is still in its early stages and the investment is far from risk-free. But as long as Audinate remains the industry's most adopted protocol, we expect to continue holding as long as pricing remains rational.

With a large pile of cash we're in a great position to take advantage of further opportunities, and we're sifting through several a week. We're in no rush, though. It's far better to be patient for the right opportunities to appear. As our founder John Addis noted recently, one way or another, they always do.