Hi, I’m Adrian Ezquerro, senior analyst with the team at Clime, and manager of the Clime Small Cap Sub-Portfolio.  Today I’d like to share a few thoughts about why we believe it is important to allocate at least some of your capital to high quality small-cap companies.
Recently we have introduced a more purposeful approach to building portfolios that are capable of achieving strong risk-adjusted total returns. At the heart of this message is the need to sensibly build exposure to those companies that can grow at sound rates. At present we believe that most of these types of companies exist in the small and mid-cap areas of the Australian market.
As we have previously highlighted, although simplistic in nature, one of the most powerful concepts of equity investing is that ultimately share prices follow earnings growth. For those companies that can reinvest and compound at high rates of return, the prize of substantial investment returns awaits. That is, of course, provided you pay an appropriate price for this growth profile.
While there is a wealth of evidence to support our contention that small caps tend to outperform over the long term, today we highlight a study demonstrating the consistent premium earned by small caps over the long term. Its findings are best summarized in this chart that compares the performance of the largest 30% of US listed stocks versus the smallest 30% of US listed stocks over the past 90 years. Interestingly, the smallest 30% cohort has outperformed by about 2.1% per annum over this time frame. Given the effects of compounding, the difference in the end result for each of these cohorts is substantial.
This of course begs the question: why is this so?
In our view, the broader investment industry continues to operate to effectively ensure that small-caps are structurally inefficient. Relatively low commission potential and limited trading volumes generally keeps stock brokers away from the small cap market segment. Concurrently, lower levels of liquidity prevent large institutions from meaningful participation. These factors swing the probability of success significantly in favour of the insightful small cap investor.
We use the word structural as we believe these forces are unlikely to change. Traditional brokerage business models require more than just a good idea to ensure profitability. To be commercialised the good idea also needs sufficiently available trading volume to generate commissions. The traditional institutional asset management approach would need to swing more towards preserving high returns for clients than maximising profitability via increasing funds under management. In our opinion, we don’t see these established approaches changing any time soon.
Having said this, we believe that having a diligent investment framework is still critically important. And this is not about simply throwing money at small-caps being pitched as the next big thing. Consistent with our investment approach, we focus on key factors such as competitive positioning, future prospects for the business, balance sheet strength, cash flow characteristics, profit and profitability profiles, quality of management and of course, valuation.
To briefly present this process in action, I’m pleased to introduce three small caps that we believe are worthy of further research. In our view, all are high quality, financially strong and offer sound prospects for future growth.
The first company is Citadel Group, a leading provider of managed services to both government and corporate clients. Citadel has a strong net cash balance sheet, is growing at healthy double digit rates and trades at a discount to our 2017 valuation of about $5.90.
The next company is Collins Foods, a leading restaurant operator, manager and administrator. Collins’ core business is the operation of 191 franchised KFC restaurants across Australia. We believe that the company can self-fund the growth of this store network through both organic and acquisitive means over the next 3 to 5 years towards a range of 250 to 300 stores. Provided Collins can successfully execute this strategy over the medium term, we believe the business will be worth far more than its current market value.
Lastly, we also believe HFA Holdings looks interesting at current prices. HFA is the parent of Lighthouse Investment Partners, a US long-short multi-strategy hedge fund manager. Lighthouse has US$8.5bn Assets Under Management across 20 portfolio managers. HFA is run by a sensible team of owner managers, has consistently generated a healthy amount of cash flow and is well positioned with a strong net cash balance sheet. The business concurrently trades at a discount to our valuation and offers an unfranked dividend yield of about 9.5%.
That’s all we have time for today, thank you for watching and should you require any further information, please contact us via our website.