Roy Keenan from Yarra Capital Management shares insights with James Dunn from The Inside Network on the role of active management. The Inside Adviser
After the Hayne Royal Commission many advisers decided to steer away from large dealer groups in favour of becoming self-licensed. In the last six months, however, that trend has taken an abrupt turn.
‘Analyst vacuum’ an enduring alpha opportunity in small caps
Australian portfolios are not appropriately positioned for the risk and reward on offer from the multitude of asset classes and sectors available, contended Nick Cregan of Fairlight Asset Management. Speaking at The Inside Network’s Equities and Growth Assets Symposium in Adelaide, he was challenged to explain why now is as good a time as ever to ‘flip the script’ on portfolios in the pursuit of returns.
The timing clearly couldn’t be better, with all the strategies that have worked so well for several decades now, be it fast growing technology stocks, long duration bonds, or high yield debt, having suffered a significant body blow to begin the year. In a thought-provoking presentation, Cregan sought to challenge the stigma and misconceptions around the sector by running a ‘blind audition’ similar to that used by the popular TV show The Voice.
And the evidence was abundantly clear, global smaller companies, which range anywhere from US$2 to US$15 billion in market capitalisation, sound significantly better than their more popular large cap alternatives. The story begins at the universe of investment opportunities, which is summarised down to 690 in larger, developed world companies, and more than 5,350 in smaller companies.
Investors in the sector are spoiled for choice, though Cregan notes as many as 30 per cent make no profit and hence aren’t worthy of consideration by most investors. The real opportunity, however, comes in the form of the “analyst vacuum” that has evolved in the sector. Whether due to changes in funding and charging of fees, or simply limited resources, there are fewer and fewer research analysts covering the growing list of quality global smaller companies.
Whereas close to 20 analyst might cover every movement or comment made by Amazon’s management, just five on average cover smaller companies and in many cases, none at all. Naturally, such information asymmetry, where fundamental research, cold calling and scuttlebutt can be rewarded, offers a unique opportunity for alpha in a market becoming more challenging by the day.
The concentration risk in US equities is by now well appreciated, but remains persistent in almost every major Australian portfolios, with larger companies outweighing smaller companies by at least four to one. This despite more than 100 years of data, according to Cregan, showing that outside of Finland and Australia, smaller companies have consistently outperformed their larger counterparts year after year after year. In fact, on average the outperformance is around 3 per cent per annum, which can add significantly to the compounding effect Cregan explained.
After a stellar run in 2020, it has been a difficult few years for smaller companies, which according to data provided by Fairlight, show that valuations are now below those that prevailed amid the worst of the COVID-19 selloff. That is, smaller companies are cheaper today than at the point where we were all worried about the future of the world as we knew it. At this point, where “smaller companies are well below their historical range, looks like an interesting starting point” according to Cregan.
One case in point is research house and data provider Morningstar, which every financial adviser would be well aware of. The US$10 billion company does not have a single analyst covering its stock of announcement. One key reason is that 55 per cent of equity is owned by the original founder, and the company does not rely on financial markets for capital, hence has limited need to engage with brokerage houses.
Morningstar reflects one of the ‘wonderfully resilient, durable companies’ that are pervasive across the smaller company’s sector explained Cregan. The resilient business model, of which 90 per cent is driven by subscription revenue and some 99 per cent of customers remain with the firm every year, stands out amid a period of upheaval.
Cregan explains what it is that Fairlight looks for in every business they own, but particularly in an inflationary environment. That is, they need strong pricing power and strong margins, with a lack of the former resulting in a significant fall in the latter when inflation hits, and they need to be capital-lite.
