2020 and much of 2021 have been fertile hunting grounds for smaller-company investors in Australia. So much so, that the last 12 months has seen an influx of new managers raising money to invest in pre-IPO, IPO, and other fast-growing small-cap sectors.
Firetrail’s Australian Smaller Companies Fund, while launched in February 2020, is no Johnny-come-lately. The strategy, despite being new, is run by Matthew Fist, Eleanor Swanson and Patrick Hodgens, all of whom were part of the fund’s previous iteration at Macquarie Group.
Even during a renaissance year for smaller companies, the fund’s 75% return over the 12 months to 31 May was a standout. Interestingly, it comes with a somewhat unique approach compared to most competitors in the sector. First, the portfolio manager has extensive experience and responsibility for both mining and mining services businesses, sectors typically excluded from most similar strategies due to their perceived “cyclicality.”
In a recent update to investors, Swanson highlighted a number of key contributors to recent performance, which are as diverse as you would expect. Gold Road Resources (ASX: GOR), recently listed drilling service provider DDH1 (ASX: DDH) and outdoor wear retailer Kathmandu (ASX: KMD) were among the leaders in May.
The smaller companies strategy is able to leverage-off the resources of the entire Firetrail boutique, relying on the same separation of portfolios into themes, being: Australia, Global, Yield and China. According to the interview, global remains the largest overweight, albeit through Australian companies with global exposure such as Serko (ASX: SKO), Aroa Biosurgery (ASX: ARX) and Megaport (ASX: MP1).
What stood out, though, was the decision to have “boots on the ground” in Perth; a concept foreign to most Melburnians. The management team recently visited Perth to be at the coalface of the iron ore and resource boom and highlighted three key trends, delivered by both real and anecdotal evidence.
The first was that “the labour market across Australia is tight and nowhere more so than in WA mining.” According to Firetrail, the data is still playing catch-up with what is happening on the ground, with sign-on bonuses and staff turnover common. Secondly, Firetrail flagged risks with mining services and engineering operators who entered fixed-price construction contracts, with more pain to come.
The issue, the manager suggests, is that fixed-price contracts do not allow for increases in labour and non-labour inputs, meaning profit margins disappear rapidly. On the other hand, experienced mining services operators, like DDH1, tend to have pass-through mechanisms that mean any cost inflation can be passed-on. Finally, the team was “impressed with the financial discipline being shown in tendering activity by service providers.”
One of the highlights of 2020 was the boom in fast-growing, smaller businesses with even the slightest hint of a ‘technology’ theme. In 2021, many of these companies which moved to significant valuations were severely tested ,as earnings growth failed to deliver.
Firetrail’s approach to the threat of inflation and an improving economic outlook is to remain overweight to the globally exposed growth companies outlined above, rather than domestically focused ones; as well as to cyclical businesses like Beacon Lighting Group (ASX: BLX) and Seven West Media (ASX: SWM). Finally, the firm is now underweight property and bond proxies, preferring defensive exposures in gold, infrastructure and communication service providers.