Global small caps: From unrecognised growth to future global titans

Tobias Bucks and Simon Wood, Ausbil Investment Management

September 2021

Small companies offer the potential for growth that can exceed their larger peers over the long term, an assertion supported by the data. Small Companies offer investors early stage entry into names destined to become future global titans. Tobias Bucks and Simon Wood from Ausbil's global small-cap team answer some key questions on how to access such unrecognised opportunities.

Q: Can you give us the elevator pitch for what you do?

TB: We find global companies that are early in their stages of development, are not actively covered yet by the market, and have latent, unrecognised growth prospects with the potential for major rerates and sustainable unrecognised earnings growth. Finding uncovered 'gems', the names that offer what we call 'unrecognised growth' is where an active global investment manager like Ausbil can help investors take advantage of smallcap idiosyncrasies, while helping to reduce the typical level of risk that come with early-stage small-cap investing. We like global small caps because over the long-term, smaller companies consistently show outperformance against their larger peers, as evidenced in Chart 1

Chart 1: Small is beautiful: The compelling performance of smaller companies

From Chart 1, since the inception of the MSCI indices in 2000, small companies have compounded well in advance of mid and large-cap peers. Over this twenty-plus years, small caps have risen by a factor of almost 6-times, mid caps buy almost 4-times, and large caps by the best part of 2.5-times. The outperformance of small companies has been shown consistently in the empirical long-term evidence provided by esteemed researchers such as Siegel (2015). Banz (1981) and Fama and French (1992), and in the market data.

Q: Can you explain the term, 'unrecognised growth'?

SW: Unrecognised growth is where a company exhibits the signs and potential for future earnings growth that is conceptually ahead of peers or the market in general, but for which there is no consensus as the company is not yet covered by a bevvy of institutional analysts. The company is 'unrecognised' because, due to size, it is yet to become large enough to warrant broad institutional coverage. Chart 2 illustrates how analyst coverage changes as companies become bigger. Global small caps operate in a 'sweet spot' of opportunity that has yet to be noticed or acknowledged by the institutional equity research machine.

Chart 2: What 'unrecognised' looks like

Ausbil's global small-cap team seeks the opportunities in the 231 developed markets in which we invest before any reliable institutional consensus has been established. In the case of some companies, there might be a consensus based on the views of a handful of analysts, as illustrated in Chart 1, but there is typically a significant divergence in views on valuation, opportunity and risk. The essential idea is that we focus on companies where growth will surprise, in companies that are attractively valued, and which we believe demonstrate relatively less risk in proportion to the opportunity. Combined with a lack of analyst coverage, forward surprise potential at attractive valuations reveals companies with unrecognised growth, which ultimately drives share prices. 

Q: Why do these companies go 'unrecognised' for a period of time?

TB: Fast growing smaller companies are proving their business models, their sales and earnings can be volatile, and their businesses can be undiversified in terms of steady-state earnings. Institutions, like insurance companies which are not specialist small-cap investors, typically look for larger-cap equities with steady historical earnings, and more mature business models. However, large super and pension funds often carry significant allocations to small cap equities for the superior long-term returns they can offer in equity portfolios. Small companies, when the fundamentals are sound, the management is strong, and the business model is relatively unassailable, can offer upside potential for investors who are comfortable with riding-out shorter term bursts of volatility. From the sell-side perspective, small companies are often supported by specialist financiers, angel investors, cornerstone investors, large insider holdings and small broking houses in their early years, before they graduate into the bigger leagues and into larger capital raisings with larger investment banks. This creates significantly more opportunity for astute smallcap investors to participate in funding rounds for businesses that are on a trajectory for major growth, ownership transition events and other ongoing capital raisings and block trades that offer the potential to steadily build positions in companies with the potential to become the next global titans. Q: In your experience, what are the features of a good unrecognised opportunity? SW: Our fundamental and quantitative research seeks to unearth the unrecognised winners that have a high probability of earnings upgrades. Chart 3 illustrates how, to date, we have been able to consistently track ahead of the market on capturing earnings upgrades.

Chart 3: Beating the consensus on identifying quality and upgrades

There is no exact template for finding companies with significant unrecognised growth that are also in the process of exceeding market expectations on earnings growth, however there are some key elements that appear in the excellent examples we have found in the past.

A great, unrecognised growth company often starts as a niche leader, that has global ambitions and products that are capable of contesting position in the global market place. Unrecognised growth companies often invest capital into their own expansion, as opposed to paying higher dividends, as they are able to earn a greater return on capital for investors through reinvestment. Quality unrecognised growth companies seek expansion, but not at the expense of strong ESG characteristics, which ensure critical elements are in place for successful expansion: strong corporate governance; and low environmental and social risks. An attractive company that exhibits unrecognised growth offers the potential for earnings surprise in future years, which ultimately draws the attention of the institutional market and eventually catalyses significant re-ratings.

It may be an oft-repeated cliché, but what holds all together, from the development of great strategy to the execution of a successful local and global business strategy, is the quality of leadership. Great unrecognised growth companies invariably boast great management. People matter in successful companies, and as active investors, we are well positioned to meet with, review, question and assess management as part of our due-diligence process.

Q: What about risk? Aren't small caps riskier investments than larger companies?

SW: In theory, small caps should be riskier than larger companies when compared on crude measures of diversified income and size, however, when adjusted for risk, small caps can be surprisingly rewarding. As illustrated in Charts 1 and 4, using the Sharpe Ratio measure of risk adjusted returns, global small caps typically demonstrate a superior risk-adjusted returns (higher Sharpe ratios), than both mid and large-cap stocks. Moreover, an active investment approach can increase this Sharpe ratio through concentration in high-quality unrecognised growth companies, and the active avoidance of low quality small caps that do not match the criteria we apply.

Chart 4: The risk-return profile of small caps in perspective

In taking a wider range of risks into consideration with the application of additional ESG risk filters, it is possible to further improve the risk-return outcome for small caps. ESG considerations can help reduce many tangible and intangible, un-quantifiable risks that help select winners and deselect losers in the risk-return equation. 5 Contactus@ ausbil.com.au

Finally, liquidity management is key to success in global small-cap investing. Unlike mid and large-cap stocks that typically have deep order books in the marketplace, global small caps can display shallower order books, to the point of illiquidity. A company needs market trade flow in order for the execution of a clean investment thesis through the clean entry and exit of positions. In an illiquid stock, news can hamper the ability of investors to trade or exit. Ausbil manages exposure to liquidity risk very closely, and we will not enter positions that we cannot exit at any time, and within a reasonable timeframe. Relative to all small caps, this further improves the riskreward positioning of our approach, and can also materially improve our Sharpe ratio.

In today's volatile markets, large companies are not a guaranteed mitigation for risk. The market has rapidly sold down many large caps regardless of size, and institutional share registers can be brutal to large caps, as much as they can to smaller companies.

Q: So can you give us some examples of what a great, unrecognised growth story looks like?

TB: Australia is only 2% of the world market. There is a lot of potential on offer in the other 98% of markets, and a lot of companies and sectors that are just not available in Australia. Moreover, small caps in larger markets have a natural advantage in being 'small fish in very large ponds'. One such company is theTradeDesk (TTD). The Global SmallCap Fund invested in TTD in June 2018. At the time, TTD was marketing online banner ads and content that rivalled Google Ads, but protected the identity of advertisers. TTD was a small fish in a very large pond, but it offered a compelling challenger solution to the dominant player in one of the world's most profitable spaces.

TTD displayed many of the crucial characteristics we look for as a sign of quality, unrecognised growth. It was a niche leader in digital advertising, with global expansion ambitions for developed and emerging markets. It offered new and unique products, especially in universal IDs that was not being offered by Google. The management team were already proven, and reinvesting a growing earnings stream back into expansion of the business. With strong ESG credentials and a focus on improved data privacy, a competitive edge in the market, TTD was able to build and expand, and generate earnings surprises that were not recognised by the market. The result is that from the $87 entry price in June 2018, earnings surprises drove the stock price to $900 by January 2021, at which time the Fund exited, with TTD graduating 'with honours' as an emerging global titan, moving from the Fund's benchmark into the mid-cap benchmarks.

Another example from the Fund's portfolio is Generac, a world leader in generators, based in the United States. Generac (GNRC) is another company that demonstrates the features of an emerging global titan, similar to our experience with TTD. Generac started as a niche leader in generators and smart energy. Growth ambition has since seen it expand globally, into South America and Europe. GNRC has expanded its product offering into inverters and smart grid tech, further investing through accretive mergers and acquisitions that expand both its capabilities and its footprint. GNRC has strong ESG credentials, especially with its link to future sustainable energy demand, and like TTD, it has a highly regarded management team. The Fund has seen its investment to date rise to over $280, from an entry point of $50 in May 2018, with the stock a key holding for future earnings surprise.

Q: Can you summarise the benefits of adding global small caps to a portfolio?

SW: We think the proposition for investors is simple. Global small caps offers a superior riskadjusted return from a global opportunity set of companies, many of which are not represented in Australian equity sectors. The opportunity to invest early in the next theTradeDesk, Google or even Tesla are waiting to be discovered in these 23 developed markets. They are not common, but with the criteria we apply in selecting companies demonstrating superior unrecognised growth potential, we believe the odds are significantly shortened for investors capturing the growth of future global titans.

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References

Banz, R. W. (1981). The Relationship between Return and Market Value of Common Stocks. Journal of Financial Economics, 9(1), 3-18. Fama, E.F. & French. K.R. (1992). The Cross-Section of Expected Stock Returns. The Journal of Finance, 47(2), 427. Siegel, J. J. (2013). Stocks for the long run: The definitive guide to financial market returns and long-term investment strategies. New York: McGraw-Hill.

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A short notice on the COVID-19 public health event, and how it can impact investments

Given the currently evolving issues around the Coronavirus (or Covid-19) globally, which has officially been designated a pandemic by the World Health Organisation, we wish to notify that, as with many firms, business may be disrupted. A public health crisis, pandemic, epidemic or outbreak of a contagious disease, such as the recent outbreak of Coronavirus (or Covid-19) in Australia, Italy, China, South Korea, the United States and other countries, could have an adverse impact on global, national and local economies, which in turn could negatively impact investment returns in any of Ausbil Investment Management Limited's registered managed investment schemes (the Funds). Disruptions to commercial activity relating to the imposition of quarantines or travel restrictions (or more generally, an inability on behalf of authorities to contain this pandemic) may adversely impact any investment, including by delaying or causing supply chain disruptions or by causing staffing shortages. The outbreak of Coronavirus has contributed to, and may continue to contribute to, volatility in financial markets. The impact of a public health crisis such as the Coronavirus (or any future pandemic, epidemic or outbreak of a contagious disease) is difficult to predict, which presents material uncertainty and risk with respect to any investment or fund performance.

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Funds operated by this manager:

What is a Life Settlements investment? 

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Laureola Australian Feeder Fund

Is Evergrande Contagious?

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Crispin Murray: What's driving ASX stocks this week

Crispin Murray, Pendal

20 September 2021

Here are the main factors driving Australian equities this week according to our head of equities Crispin Murray. Reported by quantitative analyst Lee Ma

GLOBAL EQUITY markets remained soft last week. The S&P500 fell 0.5%, bringing month-to-date performance to -1.9%.

In Australia the S&P/ASX 300 was flat, though there was some meaningful sector divergence. Metals and Mining came off 4.4% while Energy was up 3.5%.

There were two key drivers of this performance:

1. Concerns about Chinese growth in the wake of a potential default of Chinese property giant Evergrande, which led to a slump in bulk commodities
2. Concerns that central bank policy tightening may come through sooner than expected due to building inflation pressures

Covid and vaccines

Domestic news has been generally positive.

NSW Covid cases peaked at a lower level than feared and vaccine penetration has continued to grow solidly.

Take-up rate for the first dose has risen to 82.2% — up 3.7% compared to last week. This rate has been holding up well. That's important since a higher rate will help relieve potential strain on hospital systems in future outbreaks and reduce the likelihood of future lockdowns.

The seven-day moving average for second-dose vaccinations is close to 61,000 this week — up from about 50,000 last week.

If this trend continues we might get to 80% full vaccinated — and further relief from lockdowns — before October 18.

Globally case numbers continue to improve, albeit marginally in the UK and the US. 

Return-to-school impact can be seen in the higher ratio of kids in case numbers. Though this is tending to sustain case numbers rather than increase them.

Hospitalisation numbers have been slowly improving in both counties. This is leading to some evidence of improved sentiment in the US.

Economics and policy

Tension has been building for weeks around Evergrande, China's (and the world's) most indebted property developer.

Evergrande's bond interest payments are due on September 23. The question is whether the market will see a bankruptcy or some form of debt restructure.

More importantly, people are contemplating whether this will have a cascading effect on China's other property developers and the economy more broadly.

Weakened sentiment contributed to the precipitous drop in iron ore over the week.

We see great uncertainties around how this will eventually play out. There is a good chance a default is possible with the Chinese government choosing to send a strong message on property speculation.

But we think the outcome will be something the government can manage, since Evergrande is not a state-owned enterprise and is not as systemically important.

That said, we will reach a crescendo of concern over the next couple of weeks.

Outside China, the focus has been on renewed concerns that inflation is set to be persist for longer, leading to faster tapering and potentially an earlier move in rates.

Inflation fears in the US have come mainly from a combination of labour shortages and unemployment insurance (UI) payments coming to an end. The next few weeks will be an important test of the durability of labour tightness.

Recent pricing power surveys clearly indicate that US companies are pushing through pricing increases in a number of sectors. This reflects input price pressures, constrained availability of product and higher labour costs.

Also, gas prices continue to remain far higher than we have seen for years in the US and Europe.

Inventories are low heading into winter. There is a 70% probability of a La Nina weather event, which may lead to a colder winter. There are concerns elevated gas prices will persist, which has already led to higher electricity prices in the US and UK.

All eyes are on the Fed's September meeting this week.

The market will closely watch how they signal the pacing of tapering and their quarterly update on the dot plots. The dots are expected to have shifted forward again towards the median rate rise around the turn of 2023. The other focus will be on the number of rate rises through to the end of 2024.

Similarly, there was media attention on unpublished forecasts by the ECB, which could see inflation rising 2% by 2025. This may lead to rates rising in 2023.

All this has added to the market's wariness on the inflation impact on central bank policies.

Markets

The market saw a continued drop in iron ore price. The seaborne benchmark fell 22% last week and is now down 37% for the calendar year-to-date. In contrast the oil price was up by 3% and 45% in the same periods.

The main reason for this disconnect was iron ore's reliance on Chinse demand, compared to oil's link to global demand.

The fall in iron ore has been driven by a number of factors.

It had an over-extended starting point, driven by surging steel production in China in 1H21.

The production surge was then met by a dramatic slowdown starting from 2H21: steel production was down 18% in July and a further 10% in August.

The Chinese government has an aggressive rhetoric around holding down steel production through 2H21 for environmental reasons and trying to keep production growth flat for the full year.

These restrictions are expected to continue limiting steel production through to the end of the winter Olympics in late February next year.

At the same time the Chinese government has introduced policies to maintain controls of the property sector, which is a key driver of steel demand.

Fears for the overall sector have been exacerbated by the Evergrande situation.

Also weighing on demand, the Chinese economy has been generally softer recently due to rolling COVID lockdowns. More stimulatory policies on local government bond issuance that funds infrastructure spend are unlikely to kick in until 2022.

Lastly, the deteriorating relationship between China and Australia may have led to other measures impacting on the commodity price.

Where to from here? The debate is not so much whether iron ore bounces much, but rather whether it can hold in the US$100s or if it continues to move towards a longer term price of US$70.

The Evergrande final resolution may mark a sentiment low in China and its property sector.

Consequently, some measures to support the economy may be introduced such as the RRR cut.

We should still expect relatively subdued demand from China, but the real-time indicators on the economy look to be near their lows.

Global demand for steel remains strong, as evident from the very high global steel spreads, suggesting there are still cyclical tail winds.

Supply disruption also continues to emerge, with Vale announcing this week its iron ore production next year will be lower than expected.

Overall, this week could be the crescendo in negative sentiment before investors start to rebuilding confidence slowly.

Against this backdrop, equity markets overall are re-testing support levels.

There could be support in early evidence that the US economy is experiencing a re-acceleration as Covid cases start to stabilise and fall. And liquidity from Central Banks remains abundant.

Lastly, we note the rotation of value to growth has been mirrored by fund flows. Inflows to tech and outflows from cyclicals look to be at extremes.

As such, we continue to see cyclicals holding better from here.

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This article has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and the information contained within is current as at August 11, 2021. It is not to be published, or otherwise made available to any person other than the party to whom it is provided. This article is for general information purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient's personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation.

The information in this article may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information in this article is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information.

Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance.

Any projections contained in this article are predictive and should not be relied upon when making an investment decision or recommendation. While we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections.

Jamieson Coote Bonds - August 2021 Market and Performance Review 

Channel Capital

August 2021

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Opportunities and risks for investors in the latest UN climate change report

Edwina Matthew, Pendal

11 August 2021

The latest UN climate change report offers important clues for investors seeking to understand portfolio risks and investment opportunities. Pendal's Edwina Matthew explains

Key points

• The latest IPCC report increases risk of climate activism or litigation against companies. A number of climate cases have referenced earlier versions of the report. Watch also for litigation against governments which could affect regulatory approvals

• There is heightened focus on methane. The EU wants curbs and the US is planning tighter emission rules. This could bring risks and opportunities.

• Carbon removal is a vital -- and potentially investable -- net zero tool from afforestation to wetland restoration to carbon capture and storage and ocean fertilisation.

THE UN's latest Climate Change report made headlines this week with predictions of irreversible global warming, rising sea levels and climate change affecting every corner of the planet.

But it also provides evidence-based information to help investors better understand portfolio risks and identify investment opportunities such as carbon capture and methane-reduction technologies.

The 3900-page report from the UN's Intergovernmental Panel on Climate Change (IPCC) -- the United Nations body for assessing the science related to climate change -- is the gold standard for research on the science of climate change and options for adaption and mitigation.

Government and corporate decision-makers worldwide rely on the IPCC's findings to inform their climate risk assessments and emissions reduction strategies

The report -- which was unanimously endorsed by the governments of all 195 country members including Australia -- is based on a three-year analysis of 14,000 peer-reviewed scientific studies.

It will be the central terms of reference later this year at COP26 -- the upcoming United Nations climate conference in Glasgow.

The report shows unequivocally that human activities are responsible for the warming world. This warming is increasing the frequency and severity of extreme weather events such as heatwaves, droughts, cyclones and heavy rain.

Global temperature rises of between 1.5 and 2 degrees Celsius are expected unless deep reductions in greenhouse gas emissions occur in the next few decades. Regardless of action, changes already occurring due to past emissions are now likely to be irreversible for thousands of years.

Low likelihood, high-impact events such as ice sheet collapses, ocean current changes or Amazon dieback cannot be ruled out.

"It's a sobering read," says Edwina Matthew, Head of Responsible Investments at Pendal.

"And remember that these are averages - different regions, different countries, even different states will be impacted to a greater or lesser degree than this average.

"For example, the report finds that average global warming is 1.09 degrees Celsius above pre-industrial temperatures. Australian land areas are already 1.4 degrees Celsius above pre-industrial averages.

"This is going to increase the probability of extreme weather events, heatwaves, sea surges and drought."

Risks and opportunities for investors

What should investors take out of the IPCC report? What does it mean for portfolio construction?  And how can investors ensure they understand the risks and opportunities posed by global warming?

Matthew identifies three headline risks and opportunities for investors to consider:

1. The IPCC report increases the risk of climate activism or litigation against companies and governments

The most high-profile litigation so far has been a Dutch court ruling that the multinational oil giant Royal Dutch Shell must reduce its emissions because its contribution to global warming violates human rights.

Previous IPCC reports were referenced in the court case and this latest one will likely be used in the appeal hearing.

A number of Australian cases have also referenced IPCC findings.

Sharma v Minister for the Environment [2021] found the federal environment minister owed a duty of care to children who might suffer potential "catastrophic harm" from the climate change implications of approving a NSW coal mine extension.

Investors also need to watch for governments being the target of litigation which could affect regulatory approvals and business permissions in their investments.

2. The report's heightened focus on methane is of interest for investors

A "strong, rapid and sustained' reduction in methane emissions is required to help reduce greenhouse gas emissions and hopefully avoid the catastrophic impacts of climate change, the report finds.

Methane is not only a vastly more potent greenhouse gas than carbon dioxide, but its concentration in the atmosphere has been increasing rapidly.

Importantly, it is short-lived in the atmosphere meaning controls on methane can rapidly reduce atmospheric concentrations.

Governments are already acting on methane. The EU is proposing curbs on methane emissions while the US is planning tighter emission rules.

But it's a tricky problem to solve. Some gas production emits methane. Raising livestock for meat and nitrogen-based fertilisers are major sources. Rotting waste in landfill also emits methane.

"All of these are important challenges that investors can play a part in," says Matthew.

"Investors can engage with companies to better understand how they're thinking about these issues, what they're doing to mitigate the risks and how they're transitioning to thrive in a low-carbon economy.

"Investors can also direct funds to solutions. For example, CSIRO is working with the private sector to commercialise a livestock feed additive made from seaweed, which has been shown to reduce methane emissions in cattle by up to 80 per cent."

3. Carbon removal solutions can also play a role in investor portfolios

"Carbon removal is a vital net zero tool which has a place alongside absolute emissions reductions," says Matthew. "It covers a range of investable methods, from afforestation to wetland restoration to carbon capture and storage (CCS) and ocean fertilisation."

However carbon removal technologies such as CCS need more development to work at the scale required. We need more co-ordinated efforts to advance these sorts of emissions reduction solutions in sectors with harder-to-abate industrial processes such as cement and steel production.  

Future climate scenarios are becoming clearer

We now know more than ever how possible climate futures could play out.

The report is very clear that without "immediate, rapid and large-scale reductions" in emissions, curbing global warming to below 2 degrees Celsius -- the Paris Agreement goal -- will be "beyond reach".

These findings call on us all to accept and act on the reality of the situation, including policymakers, investors, businesses and consumers.

In the words of the UN Secretary-General Antonio Guterres the report is a "code red for humanity".

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This article has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and the information contained within is current as at August 11, 2021. It is not to be published, or otherwise made available to any person other than the party to whom it is provided. This article is for general information purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient's personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation.

The information in this article may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information in this article is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information.

Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance.

Any projections contained in this article are predictive and should not be relied upon when making an investment decision or recommendation. While we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections.

Investment Perspectives: Thinking about office

Quay Global Investors

September 2021

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The Looming Housing Excess

Yarra Capital Management

August 2021

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