If a rising tide lifts all boats, then the Australian small and micro-cap market is experiencing what can only be described as the mother of all king tides.

There are several forces behind this monster tide, but monetary stimulus is the most significant.

While many market commentators have discussed the large amounts of additional liquidity provided by the US Federal Reserve, the Reserve Bank of Australia has actually been increasing the supply of M1 (the measure of cash or highly liquid assets in the economy) at faster rates.

Until the onset of COVID-19, Australian M1 supply had been growing at around 12% compound since 2000, compared to 8% in the US over the same time. 

Following the onset of the pandemic, M1 money supply in Australia has surged further. The RBA expanding M1 by around $320 billion or +29% year-on-year in its efforts to mitigate the economic impacts of the pandemic.

This liquidity surge has naturally resulted in a further cheapening of cash rates and falling bond yields.

The king tide is also being partly driven by the rise of the retail investor and passive investing.

Recently we've seen the incredible market impact retail investors on social networks such as Reddit have had in the US. This surge in retail investors trading on free or extremely cheap trading platforms is happening in Australia too. These are investors doing little or no fundamental analysis, but instead simply buying what's popular.

Likewise, ballooning passive funds simply select stocks in a given sector based on their size. There's no quality or valuation overlay.

The stock market beneficiaries

Expensive concept stocks are standout examples when considering the biggest beneficiaries of this market environment. Or put another way, they're examples of how to identify the so-called "investors" who are actually "swimming naked".

High-multiple businesses that are often labelled "disruptors" or "next-gen tech" are floating at all-time highs. Yet many make no money.

Below we have charted the number of ASX stocks with a market cap of between $50 million and $3 billion trading on an enteprise value-to-sales (EV/sales) multiple above 10-times. To provide context, we'd typically say an EV/sales multiple of more than 5-times is expensive. So, 10-times is truly significant.

You can see in the past year there's been a massive surge in the number of stocks on 10-times or higher.

If you break this down further and look at the recent growth of operating cash flow negative companies versus operating cash flow positive companies, you find further evidence of the types of businesses benefitting most from the metaphorical king tide.

Over the past 12 months, ASX small cap stocks with negative operating cash flow have materially outperformed those that actually have cash flow. This is illustrated below.

Why has this been occurring? 

The liquidity surge and low-rate environment have led to a zero cost of capital and markets today appear to be continuing to assume central banks will leave rates near zero for a long period of time, thus supporting the notion that cash tomorrow is worth more than cash today.

What could go wrong?

The answer is the re-emergence of the cost of capital.

A zero cost of capital is unsustainable and in our view, the re-emergence of the cost of capital is already underway.

While Central Banks are likely to continue to defend rates for as long as possible, they also appear to have been successful in generating inflation which is incompatible with ultra-low interest rates.

The re-emergence of the cost of capital will turn the tide. The investors swimming naked will be exposed. Those in their togs duly rewarded.

How to avoid being caught naked

When it comes to small and microcaps, cash today is king. Not aspirational future cash.

The proof is in the data.

When you look beyond the past year and back-test a portfolio of positive operating cash flow vs. negative operating cash flow companies, the result is stark.

Below we zoom out to provide you with a view across the past decade. The blue line (+872%) represents a bundle of all ASX small caps stock with positive operating cash flow. The orange line (+323%) represents the index and the grey line, a portfolio of stocks with negative operating cash flow.

We think long term investors in the small and microcap space should always assume an 8% cost of capital and apply a discounted cash flow valuation. As the tide subsides, discount rates are once again becoming relevant.

Small and micro cap companies with strong cash flow conversion rates offer a pillar of portfolio strength in reflationary environments and historically, have strongly outperformed.

As the crowd continues to ignore the warning signs, the opportunities are abundant for investors focused on finding great businesses with strong fundamentals.

Epicormic buds lie dormant, hiding underneath tree bark waiting for the right conditions to sprout. They serve a regenerative purpose in the overall forest system and flourish when conditions are at their most dire. Bushfires for example, trigger epicormic buds to sprout with extreme heat and the clearing of nearby vegetation. In other words, the emergence of new growth stems from the wreckage of the established.

Just as a botanist studies epicormic growth, I've been looking at buds and shoots in a different world. The questions remain the same. Which environments foster this latent growth? Where can I find the most regeneration?

I've spent a lot of time investigating these questions in the context of the current investment environment and I'll outline how I've positioned my fund.

Noise, distractions, smoke and epicormic buds

There's a lot of noise in financial markets. Think back only a few months ago during the Trump presidency. The headlines were volatile and anxiety inducing. We had it all, from a promise to clamp down on big pharma, to the US expulsion of Chinese companies accused of breaching data security, and the US withdrawal from the Paris climate accord. I've raised these headlines as examples because as much noise as they created at the time, they have all fizzled out like an old balloon. The world keeps revolving. But feel for Mr. Market, for at the time he was brought to his knees by the amount of anxiety this news had caused him. One can look back now and reassure him everything is ok, but at the time he was in no state.

Today the noise is all to do with interest rates and inflation. Endless predictions about the actions of central bankers and the interpretation of every word spoken at press conferences. The problem with short-termism and quick news is that everyone is focused on it. Everyone has an opinion. It's a crowded space. It is not where you can get a competitive edge as an investor. Instead, the edge comes from being able to strip away the noise and focus not on the smoke and fire, but seeking out the epicormic buds that are developing underneath. Don't be like Mr. Market.

The most common theme of today

Let me paraphrase today's rhetoric:

A huge wave of inflation is coming. Bond yields will rise in response, and so too will interest rates. This leads to a revaluation of assets as the time value of money increases the value of predictable cashflows as opposed to the uncertain.

This means companies with predictable cashflows come back into favour (value), as opposed to those with unpredictable future revenues (growth). It's a matter of perception - interest rates alter how analysts value companies, just like how the sea level changes the impression of a mountain's height.

The fact remains, a valuable company will remain valuable, just as a mountain remains a mountain. The effectiveness of either strategy, growth or value, is driven by the prevailing market conditions and whichever curries favour. Just like fashion trends, market conditions are becoming increasingly unpredictable.

Growth investors flourished last year as technology companies soared, but if your allocation had been solely to growth, you would be having a rough couple of months of late. The key to a resilient strategy is to remain adaptive. This means having a balanced portfolio that flexes with prevailing conditions without being overly extreme any which way.

And this is how I've positioned my portfolio.

Structuring a portfolio in today's environment

Given the inherent uncertainty and whimsical views of the market, there is opportunity to profit from both growth and value when markets flip from one school of thought to the other. With a dual structure, a portfolio remains balanced, there are no big bets and risk is tempered. What I'm seeking is a resilient portfolio that focuses on two types of buds.

Bud 1: Emerging companies selling new products and services

Bud 2: Existing companies experiencing temporary price dislocations but due for a resurgence

This structure captures the rise of both growth and value whichever the direction of sentiment. A 50/50 split at the start, which is then flexed when the opportunities prevail.

When I look for the Bud 1's, I'm looking for emerging companies that offer a compelling new product or service. They aren't startups, their product should be new, yet proven with growing demand. The customer base absorbs the new product like a fresh paper towel to a drop of water. It solves a problem the world has struggled with previously and craves for.

When analysing the Bud 2's, the lens is different - I'm looking for a resurgence or reinvention of an established business. Sentiment surrounding them may be negative and they may be facing a challenging macro environment. I'm looking for headlines that make Mr. Market nauseous. The bigger his overreaction, the better the opportunity.

Growth - the first mover advantage

Delving further into the first type of buds - emerging companies selling new products and services. This is all about capturing long-term possibilities and investing in growth opportunities.

Given today's market conditions, it's important to de-risk growth investing given the uncertainty with inflation and interest rates. I mentioned one of the strategies is to stick with proven new products that are already experiencing growing customer demand. Equally important is to find companies facing few competitors. If they're selling a new product or service, they should be one of the first movers solving a big problem for the world. Again it's all about de-risking the potential for a margin squeeze if inflation picks up. The safest companies in inflationary environments are those that command monopolistic pricing power.

Some readers may wonder: why not just avoid growth investing altogether? The weakness of this strategy is it assumes you'll be 100% right about the timing of when interest rates will rise. The all-terrain portfolio seeks to capture gains from any possible direction the market takes, including the next generation of world-changing companies. Sea levels fluctuate with the tide, but mountains will still be mountains.

Value - opportunities lie where there is greatest anxiety

Equally important is the search for the second type of buds - existing companies experiencing temporary price dislocations but due for a resurgence. These are the established businesses that haven't fully recovered from the pandemic - and there's plenty of them globally. In Australia we've recovered quickly but if you look across Europe, US and Asia, industries such as entertainment, hospitality, drinks, logistics and leisure will explode when their lockdowns abate.

Mr Market ruminates on uncertainty and often winds himself up in knots. Look for areas of greatest anxiety and that's where you'll find the greatest value. Value investing is about picking up immediate mispricings and targeting shorter term profits. But be prepared when stocks reach full value, you'll need to offload and recycle the strategy when growth plateaus to normalised rates.

Balancing the risk and reward

How the portfolio gels together is equally important as each individual investment. I spend the same amount of time thinking about the correlations between each investment to ensure the all-terrain portfolio spreads volatility. Look far away to Europe and Asia which are on a different recovery trajectory to the US and Australia. As specialists in founder-led companies, I also find European and Asian founders more prudently focused on generating profits rather than pumping revenue metrics, which again tempers the risk.

After any devastation, there will always be new growth. As the world recovers from this one-in-a-century event, pay attention to both the emerging new buds and the recovery of the existing trees. There are two types of gains to be made so make sure your all-terrain portfolio places you well for both.

Happy compounding.  

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that invests in the best founder-led companies in the world. We scour the world looking for unique, overlooked companies in markets and industries on the edge of greatness.

Disclaimer

The material in this article is general information only and does not consider your individual investment objectives. All stocks mentioned have been used for illustrative purposes only and do not represent any buy or sell recommendations.

Ownership of this publication belongs to Lumenary Investment Management. Use of this material is permitted on the condition we are acknowledged as the author.