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How to spot the next big thing

Photo of Roger Montgomery By Roger Montgomery

min read

Some simple rules can help identify small-cap companies with big prospects.

It has been tough for companies at the top end of the market in the past 12 months. The 10 largest companies on ASX, measured by market capitalisation, have fallen more than 20 per cent in aggregate, with CSL Ltd the only one of those whose market value is higher than this time last year.

A valid alternative framework is to apply the same quality and value investing doctrine to small emerging leaders. Although many investors believe there is more risk because the companies are smaller and the shares more volatile, the risks of an individual failure can be mitigated by focusing on quality and value, and by diversifying across a number of stocks.

Because smaller companies have a lower base, there is simply more growth potential than larger companies. Also, large companies often have significant entrenched incumbent revenue streams they don’t want to disrupt. As a result, they prefer to allow disrupters (emerging companies) to build a small market share with lower price points rather than bring prices down for their much larger revenue streams.

An example is the emergence of foreign-exchange transaction providers such as OzForex. The big incumbent banks charge larger amounts for currency transfers compared to OzForex, whose keener pricing has allowed it to build a business that is showing very strong growth rates.

The banks are caught between a rock and a hard place. They would rather not concede business to a smaller upstart but cannot afford to lower their own prices because the business and revenue streams from it are so large.

Another advantage of investing in smaller companies is that they tend to be less well researched than their larger peers. This is because analysts typically work for brokers who generate more brokerage from trading the large-cap companies.

This dynamic has evolved because large companies are more liquid and fund managers must restrict their efforts to companies they can trade large positions – which have a meaningful impact on returns – in and out of easily.

Occasionally small companies have a few false starts and management changes. Once this happens, the professional investing community tends to throw the name on the junk pile in a case of once bitten, twice shy. The company, however, will often continue to be dismissed by the investing community even as a renaissance takes shape. This gives the private investor an excellent opportunity.

Beware the risks

Of course, investing in small companies is not all beer and skittles. One must always be mindful of liquidity (share turnover). Large profits can easily be eroded and losses magnified when small trading volumes prevent a quick exit.
 
Another risk is buried in the revenue line of the company. Smaller companies can often be reliant on one or two large customers, leaving a large hole if they walk. Such dependency produces asymmetric risks; in other words, it all looks good until it isn’t. It is incumbent on the investor to prosecute the case that revenues are not reliant on a very large single customer.

If you are after income, remember that smaller companies in the rapid growth stage may, quite rightly, retain their profits for reinvestment rather than distribute them.

At Montgomery we don’t see this as a problem if the funds are being profitably redeployed. Example: $100,000 invested in 2005 in relative high-yield Telstra Corporation shares had only grown to $117,000 a decade later and the $5970 of dividends in 2005 had only grown to $6508 by 2015.

Contrast this with the smaller telco M2 Group. An ability to retain profits and generate continuing high rates of return on the incremental equity meant it was able to compound investors’ wealth; $100,000 invested in M2 had grown to $3 million a decade later, and the $3910 of dividends being paid on the $100,000 investment in 2005 had grown to $99,800 of annual income by 2015.

Clearly, it makes sense to invest a portion of your funds, at the right price of course, in some faster-growing emerging leaders.

Choosing small-caps

Most investment opportunities can be analysed along three key principles – quality, prospects and price.

Put simply, begin your search with companies that have demonstrated sustainable earnings, show an ability to deploy capital at high rates of return, and are trading at a price that provides a sufficient margin of safety to protect against unexpected events.

A high-quality company is distinguished by a range of factors, including high profit margins, a strong balance sheet with little debt, and cash flows that support earnings. But the most important is the ability to generate a high rate of return on incremental equity (extra shares issued). Montgomery describes a company with this characteristic as having superior economics.

When one is found, an analysis of its prospects can be framed in two ways – what is the company’s addressable market and what is its ability to penetrate this market?

Frame your analysis around the company’s strategic vision, then determine if it has the necessary infrastructure, funding and management competency to support it.

Small or mid-size companies that will turn into large companies will be those with a product or service that offers compelling value to customers on a large scale. Provided these companies can continue to reinvest increasing amounts of capital at high rates of return, their intrinsic values should steadily rise over time.

The “next big thing” is not always easy to find. Here are three smaller companies on ASX that fit the criteria; and more importantly are trading at prices that suggest the market is yet to appreciate their emerging prospects.

(Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this story).


1. Challenger

Challenger distributes retirement income annuities, a product that offers a specified income payable in the future. Annuities are not well known within the Australian market, but this will change dramatically as the legion of baby boomers begin to consider how they will fund their retirement.

There is currently $66 billion transitioning out of the wealth accumulation phase and into the retirement phase in Australia every year. If industry forecasts are right, within 10 years this will grow to more than $200 billion, a compound annual growth rate of approximately 13 per cent. Of the current pool of funds flowing into the retirement phase, just 4 per cent is directed to annuities.

Challenger stands head and shoulders above its competitors. It has taken many years to develop its products, generate trust with advisers and build a recognisable brand in the Australian market. These qualities are difficult for competitors to replicate quickly, and with government growing increasingly supportive of the annuity market, Challenger is in a prime position to roll out its products on a very large scale through distribution platforms.

2. REA Group

REA Group operates www.realestate.com.au. Real estate agents have historically played a critical role in bringing together buyers and sellers, but have charged a considerable premium for doing so. REA charges a fraction of the agent’s commission to list a property, with prices ranging from a few hundred dollars to a couple of thousand, depending on the prominence of the ad.

REA Group has no debt, is generating returns on equity above 40 per cent and has grown earnings by more than 30 per cent each year since 2010. This growth has been achieved through rising volumes and price increases, which is a clear sign of increasing market power.

The website attracts the largest audience of interested homebuyers in the market and therefore provides considerable leads for the agents. Because of this, there is an incentive for agents to continue listing properties and advertising, which allows REA to reinvest earnings into growing brand awareness and further strengthening its advantage over competitors.

While realestate.com.au is the premier listing site in Australia, REA Group only comprises a small part of the estimated $6 billion real estate advertising pie, which is dominated by the agents. We consider REA provides a considerable value proposition for both buyers and sellers of property, and that its positive network effect will allow the company to meaningfully grow share over time.

3. Fisher & Paykel Healthcare

Fisher & Paykel Healthcare is the market leader in the humidification of gases for hospital patients requiring respiratory support. Humidification is critical for patients on invasive ventilation as the gases are pumped directly into the lungs, yet the delivery was difficult to standardise until Fisher & Paykel Healthcare released its range of superior devices.

Their business model is similar to the printing industry, where printers are sold on low margins to secure ongoing demand for high-margin ink cartridges. Around 30 patients use one humidifier per year, with each patient requiring a new tube, interface and water chamber sourced through the company. This highly recurring revenue stream has allowed Fisher & Paykel Healthcare to grow earnings by 10 per cent each year since 2010 and maintain a modest debt position.

Having entrenched itself in the hospital network, Fisher & Paykel Healthcare is positioned very well to expand its addressable market. Clinical evidence is demonstrating that humidified gases aid in the recovery of less-critical patients, which is appealing for hospitals that face rising demand for their facilities as the population ages.

Management estimates that for every patient that requires invasive ventilation, three to five less-critical patients could benefit from humidified gases. The company has invested heavily in manufacturing facilities to support this growth trajectory and is already planning for the next growth horizon.

About the author

Roger Montgomery @rjmontgomery, of The Montgomery Fund, can be contacted at www.montinvest.com or visit www.rogermontgomery.com
 

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