Originally published by UBS Asset Management
Let’s start with a fundamental message: don't buy index in Australian small companies. We have found that there are eight key factors that time and again consistently distinguish a truly successful business from the also-rans, allowing for superior performance over the index.
1. Management are owners/founders or otherwise act as if they are
The fund has owned ARB (a global leader in 4WD accessories) for more than five years. The company was listed on the ASX in 1987 and is still run by the same three men who remain large shareholders. While the company may occasionally transgress the current-day politically correct corporate governance standards of a small board and an executive chairman, shareholders have seen earnings grow by 13% pa over the past 10 years. As owners, it's not surprising that senior management also pay themselves very modestly by industry standards ($250,000-$380,000 each). Another recent example is our investment in Wisetech Global Ltd (AX:WTC). We like the high growth and recurring revenue of their cloud-based logistics software, and the fact that the founder and CEO, Richard White, sold very few shares into the recent IPO (about 2.5 million of his 151 million shares). Today he still owns more than 51% of the company.
2. High returns on capital will often dispense with the need for high debt
High returns on invested capital (ROIC) are an investor’s best measure of a company’s business franchise. Technology One Ltd (AX:TNE) is a cloud-based enterprise software business based in Brisbane. Its ROIC is a not-too-shabby at plus 200% pa. By giving Adrian di Marco, its CEO and founder, your $1 of new capital (should he need it), he can earn more than $2 annually. The business is more than self-funding and doesn’t require new equity capital. Consequently, TNE is not only debt free, it periodically pays out a special dividend in addition to its normal dividends, returning cash and franking credits to its shareholders.
Sirtex Medical Ltd (AX:SRX) has a ROIC of over 80%, has no debt and pays a fully franked dividend. It may be in a higher-risk industry (medical technology), but its net cash position and stable yet fast-growing existing business (treating liver cancer using an internal radiation therapy in ‘salvage’ patients) mitigates some of the inherent industry risk.
3. Re-invest profits and don't perpetually raise new equity
Let's look at Technology One Ltd (AX:TNE) again. It has not issued any material new capital (other than minor issues as part of employee incentive plans) in its 16 years or so of listed life. In 2000, it had 303 million shares on issue. Today it has barely 3% more (310 million).
The power of a business with high returns on invested capital and low capital needs translates into a stable share count and high total shareholder returns (plus 800% over 16 years for TNE). With no debt and no need for new equity issues, it is a truly unique business franchise.
Sirtex is another example of the power of compounding shareholder returns on a stable shareholder equity base. It listed in 2000 with a share count of about 54 million, which today is only 57 million. This lack of dilution has helped deliver total shareholder returns of about 1100% or around 12 times its share price in 2000.
On the other side of the coin, there are many companies that don’t sufficiently re-invest profits or otherwise have such low returns on capital that they are unable to internally fund growth without debt. The global aviation sector has a poor industry structure where returns on capital are low and profits are volatile. Contrast then the share count increase for businesses like Qantas Airways Ltd (AX:QAN) (+67% over 16 years) and Virgin Australia Holdings Ltd (AX:VAH) (+210% over 15 years). It’s no surprise that both have high debt levels and poor total shareholder returns (Qantas +48% over 16 years or around +2.4% pa, Virgin -86% over 13 years).
We could go on and on. In resources, some of the worst offenders include Beach Energy Ltd (AX:BPT) (+715% share issues over 16 years) and Cockatoo Coal (an eye-watering +6100% increase in shares on issue over the 10 years since listing).
4. Stable management that often promotes from within
If there is one overriding factor critical when investing in small caps, it is the quality of management (honesty, integrity, and competence).
Some of the good things we like about investing in small companies include; being in the earlier and faster growth stage of their development, being more focused by typically operating in only one industry sector and being better able than larger companies to exploit disruption, innovation and change. However, all these positives can quickly become negatives without good management to exploit them, and a good management team will often grow their own successors.
Contrast this to poorly performing companies who are constantly changing management and tend to appoint from external candidates. These outcomes occur because of thin resourcing or otherwise as a way of bringing in an external change agent to fix existing problems.
Domino’s Pizza Group Plc (AX:DMP) and Flexigroup Ltd (AX:FXL) are examples of the good and not-so-good. Domino’s senior management team are all long serving and internally grown. The CEO, Don Meij, started in 1987 as a pizza delivery driver. Europe CEO Andrew Rennie started in 1994 as a Darwin store franchisee, and CEO Australia Nick Knight also started as a single store franchise owner. Even CFO Richard Coney has been with the company for 20 years. Domino’s is the ultimate textbook example of a stable, high-performing and internally grown management team.
Flexigroup on the other hand is onto their third CEO in five years. An initially successful strategy of growing in point-of-sale finance in Australia was led by CEO John DeLano. After he left in 2012, an ex-Telstra executive as CEO did not fully understand the unique culture built up by DeLano and he had neither a sales nor finance sector background. The problemsjust kept mounting with growth stalling due to failed initiatives. Another change of CEO saw the appointment of an ex-CBA executive as the current CEO. This time it’s a case of the right industry background but the wrong culture (they need a CEO with a challenger mindset, not an incumbent’s mentality).
5. Do not needlessly diversify a good core business
Diluting a good business by adding a lesser business is not a risk diversifier. Proper focus trumps poor diversification every day of the week. Consider the divergent strategies adopted by two mostly similar businesses, AP Eagers Ltd (AX:APE) and Automotive Group Holdings Ltd (AX:AHG).
APE has remained focused on exploiting opportunities within the auto retailing sector (check out their latest initiative to disrupt used cars at carzoos.com.au), while AHG has diversified into… wait for it … the transport and logistics sector.
We all know how tough this sector can be, with the likes of Coles and Woolworths Ltd (AX:WOW) to contend with. AHG shareholders have seen more than five years of management effort and $300 million of their capital spent on a bunch of (mostly distressed) refrigerated transport businesses. We are left with a division that is highly capital intensive, offers low returns on capital, continuously misses earnings expectations and has little growth. All the while, their original core business has continued to grow and prosper.
The operating performances of these two companies have significantly diverged in recent years.
6. Earnings are all-inclusive, not ‘underlying’
Some companies have financial statements that are a breeze to analyse. Their numbers are clean and simple to understand. This in itself is a strong quality signal. Their reported earnings are their earnings. Their invested capital is their invested capital – no adjustments are needed. Examples that come to mind include ARB, TechnologyOne, and AP Eagers.
Then there are the companies that engage in the (usually repetitive) practice of offering a range of adjustments to their reported earnings. They call this their ‘real’ or ‘underlying’ earnings. Rarely do such adjustments reduce a company’s reported earnings, a warning sign in itself.
Recent examples of businesses that are enthusiastic promoters of ‘underlying’ earnings include Super Retail Group Ltd (AX:SUL), Fletcher Building Ltd (AX:FBU) and the aforementioned AHG.
Just like AHG, SUL started with an outstanding core business in the Super Cheap Auto chain. It then diversified with acquisitions of lesser-quality businesses. Some have worked well, such as its investment in sports retailer Rebel. Most have not, including Greencross (bicycles), Workout World (fitness equipment) and Rays Outdoors (leisure products). The need to explain underlying earnings is a sign of management's failed past strategies and poor capital allocation decisions.
FBU has a mixed recent track record of acquisitions. The result has been a number of ‘non-cash’ asset impairments and other one-off costs over recent years, all added back to derive underlying earnings. Shareholders would surely argue with management’s use of the descriptor ‘non-cash’, given that management has paid out real cash in the first place to buy these businesses.
7. Do not rely on a ‘gifted moat’, it may fade
Some companies have no obvious ‘moat’ around their businesses to protect them from competition, yet they succeed nonetheless (think ARB, Domino’s Pizza and TechnologyOne).
Yet other companies are gifted a strong moat and then see it fade away. SAI, with its standards and assurance business, has relied on its monopoly position to diversify into lesser businesses only to see the moat weakened and threatened. Sky Network Television in New Zealand has seen its previous monopoly for showing All Blacks games eroded by streaming technology.
Our many years of investing experience have taught us to look for businesses that are successful without, or perhaps despite, a strong moat. As Andy Groves, former CEO of Intel (NASDAQ:INTC), once said, “Success breeds complacency and complacency breeds failure. Only the paranoid survive.”
8. Remuneration aligned with shareholders
Owners are always more interested in benefiting from a higher dividend and rising share price than from the stipend they can draw as CEO. A remuneration policy that closely aligns the amount that management are paid with shareholder returns will greatly enhance the management agency outcome.
On the other hand, misaligned remuneration will not tie a CEO’s rewards to shareholder returns. In these cases, the temptation is to make short-term decisions that are not in the longer-term interests of shareholders.
In the sad case of Dick Smith, management was incentivised to reach ambitious profit targets in the first year post IPO. Unfortunately, we discovered that management only achieved their financial targets by favouring certain suppliers who paid them the highest short-term rebates. The rebates were booked to profits, thus boosting the result for that year (even if the stock remained unsold).