1st August, 2019
What method(s) do you use for generating fresh microcap ideas? Why do you think it’s effective?
Uncovering the next A2 Milk or Afterpay early in the company’s journey is the product of good industry research, understanding the key stakeholders and trends, both quantitative & qualitative fundamental analysis as well as an inherent openness to new business models, technology and concepts that challenge your historic beliefs. Good fortune can also not be discounted as timing can be everything.
Idea generation can take many forms hence many methods can be useful. We have discovered emerging companies through our examination of the supply chains of larger listed players. Take A2 Milk as an example, its key infant formula manufacturer Synlait was once a microcap with the market taking time to ascribe the appropriate value to its Chinese registered manufacturing capacity, concurrently the importance of DHA as a differentiated ingredient led us to discover Clover Corp.
Global trends spawn entrepreneurs the world over and typically they require access to capital. Great management teams articulate how their business models are taking advantage of a global trend. By taking the time to understand universal movements such as cloud computing and the stakeholders involved, ideas such as Rhipe – a Microsoft Azure & 365 partner emerge or Megaport with its software defined networking approach to data centre connectivity, are discovered.
Source: Megaport Investor Presentation, March 2019
With an investable universe of over 400 stocks, many of these conceptual or pre-revenue and a substantial number without formal analyst coverage, we often start with a screen of our universe against several current/historical financial metrics. Some which include revenue/earnings trajectories, the ability to generate operating cashflow, Return on Equity benchmarks and multiple valuation metrics. From the results we conduct a detailed critique of each business model.
Often overlooked is a company’s Annual Report. While the length can be daunting, direct insights from directors and management on how the business makes money, key opportunities and risks, and an audited set of accounts is one of the most effective ways to come up to speed on any listed business.
What are some of your favourite questions to ask management when meeting for the first time?
One of my favourite questions to ask management is “Would your investment priorities, size and timing, change if you were not listed, you had capital at your disposal and you were not managing your business within the restriction of a semi-annual earnings cycle?”. While an unrealistic scenario, the responses usually give you a good indication on what management’s approach is to allocating capital and whether they are managing the business for short or long term.
Other questions we often ask are how much capital has been invested into the product, technology or business to date, particularly for businesses new in their listed life. This is a good sense check on the barriers to entry from a capital standpoint and whether the market is ascribing an appropriate valuation to the revenue or earnings of the business in its current form. In addition, we often ask management to describe the inherent IP within the business model partly because if it’s a relatively easy premise to understand and explain, investors will be able to assign an appropriate valuation, once the business is better understood.
Finally, one of the more obscure questions our team often asks management in a first meet is what keeps you busy outside of the business. Getting a sense for the person behind the leader can be incredibly insightful in understanding their motivations and commitment.
What are some of the risks that are unique to, or more prevalent in the world of microcaps? How do you manage these risks?
Liquidity is often the most under-priced risk in any microcap portfolio. As an institutional investor with larger pools of capital to deploy, the ability to back management with a significant financial commitment, likewise, taking a decision to reallocate capital as markets change, requires significant discipline around managing to liquidity filters.
By maintaining a focus on average daily turnover as part of any investment decision, it ensures we don’t put our investors capital at risk in a downturn, as retail investors can look to liquidate positions at deep discounts to realise cash.
Corporate Governance is also in its infancy in many microcaps with some boards under-resourced and many yet to transition from private to public life. Ensuring we understand the makeup of the board, the background of the Chairman and the board’s working relationship with the Managing Director/CEO, can be a very useful risk management tool. A greater understanding that strategic alignment runs from the top down, and determining who ultimately is in control of a business’s destiny, will assist in better investment outcomes
Expectation, whether it be too great or too little can also be the source of much joy and pain in microcap investing. With the absence of consensus in many microcaps, taking the time to evaluate how the market may be positioned for a particular outcome or result, can be a very effective tool in risk management. Adjusting position size to reflect risk outcomes, will ultimately reduce the downside should expectations not be met.
Could you share a unique microcap opportunity that looks attractive today? i.e. One that could not exist among larger stocks.
A 130yr old Melbourne based financial services company that is synonymous with corporate governance, entrusted with bestowing the wishes of many and often ‘wins’ customers as they leave this world is not your typical speculative microcap. But for us Equity Trustees (“EQT”) is a company that fits the mould of a micro-cap opportunity that looks attractive today, in a terrific industry structure with high recurring revenue streams and a clear path to global growth.
We acknowledge the business of testamentary and charitable trusts may lack the sizzle of investment platforms (i.e HUB & Netwealth) but having a differentiated core skill set in the structuring of trusts and ultimate trusteeship, to ensure estates are planned and the intention of trusts adhered to, is a very lucrative business.
Source: Equity Trustees 2018 Annual Report
The recent Royal Commission into Banking, Superannuation & Financial services has shone the light on the ineffectiveness of some inhouse trustees. Conflicts have emerged and ultimately the corporate affiliated with the fund is unwilling to the take the risk of non-compliance. EQT is very well equipped to take advantage of this opportunity with very few companies in a position to ensure a Super Fund is meeting the obligations set out in the trust structure.
Concurrently corporate trustee services are critical for the effective administration of unit trusts the world over. Having a key market share position in Australia providing Responsible Entity services to leading fund managers and an emerging opportunity to provide similar services for global fund managers is a key growth leg of this story. With ~$80 trillion USD in the global funds management market, launching a capital light office in Europe to take advantage
of the quest for prolific retail distribution will ensure EQT is well positioned.