Microcaps – Long Term Capital Growth

Originally published by UBS Asset Mangement

Most investors have some exposure to Australia's largest listed companies in their portfolio. The dividend yield on offer combined with exposure to well known franchises provide a level of comfort and stability to the core component of a portfolio. However our domestic stock market is concentrated around key industry segments – the major banks and insurance companies, the large resource companies, Telstra Corporation Ltd. (AX:TLS) and retailers Wesfarmers Ltd (AX:WES) and Woolworths Ltd (AX:WOW). A significant portion of the markets value is incorporated in the Top 20 companies in what is concentrated in a number of specific industry segments. As a result this area of the market dominates the financial press and is the focus of much of the attention of the professional investment community. There exists a long tail of listed stocks outside these household names that can bring benefits to your overall portfolio in terms of capital growth and diversification. The lower the market capilitisation as a general rule the less research by stockbrokers, the fewer funds that are able to invest and the less mainstream media coverage create an opportunity to uncover the successful business of the future when combined with a disciplined investment process.

Change is happening rapidly, technology is providing the catalyst for increasing competition across all facets of the economy. Many large companies are facing disruption to their business models from much smaller and more nimble competitors. The demise of once large companies like Nokia (HE:NOKIA), Kodak (NYSE:KODK), Borders, Blockbuster and BlackBerry (NASDAQ:BBRY) are examples of businesses that did not adapt to change. The arrival of large international companies such as Aldi, Zara (AM:ZARA), H&M, Uniqlo and the expected market entry by Amazon.com Inc (NASDAQ:AMZN) are further examples of increased competition facing Australian companies. TPG Telecom Ltd (AX:TPM), Domino’s Pizza Group Plc (AX:DMP) and Rea Group Ltd (AX:REA) were once small business that competed aggressively with much larger competitors and are now Top 100 stocks themselves. Along this journey investors have been rewarded as these once emerging companies take advantage of structural change and build successful business franchises. Identifying these businesses at an early stage of development is the opportunity for Microcap investors. Often these businesses are less dependent on the health of the overall economy as they are taking market share or creating new market opportunities. These businesses can often give you far more granular sector exposure to positive investment themes.

In light of this increased competition and general benign economic growth globally it's worth thinking about areas where investors can seek long term capital growth for their portfolios. The microcap segment is one worth considering if you have the appropriate risk tolerance and long term horizon. This part of the market (which we define as below $250m in market value at initial investment) is often overlooked owing to its size. On offer for a fund manager focusing on this segment is a very large investable universe (in excess of 1500 companies with a market value below $250m) that is exposed to diverse parts of the economy (both domestic and offshore). This provides investors the combination of some of the fastest growing and nimble businesses in addition to a lower level of focus by the professional investment community. The opportunity to seek out undervalued business, well positioned for the trends of the future provides the ingredients to deliver long term capital growth as these businesses build over time and become of greater interest to more market participants.

We like businesses that offer a solution to a problem or provide a better outcome for the consumer that can be scaled and address large market opportunities. The ageing population brings with it many challenges around expenditure on healthcare and providing support for an ageing population. People are living longer and this trend will only accelerate over the coming years. A business while in its infancy like OneView Healthcare (ONE) offers a solution relevant to hospitals and aged care facilities that improves the patient experience while also providing great efficiency benefits to the care provider. As the company increases its reference sites we see significant growth potential as the product will become a differentiation point for organizations who implement it. The market opportunity is one where there seems to have been no significant improvement in the product offering for some time. OneView have created an innovative solution, relevant to a large market which addresses both patient experience as well as operating efficiency.

The harnessing of the internet and mobile technology has disrupted many industries in a relatively short period of time. From social media, marketing and engaging with customers the way in which we consume entertainment (streaming services v "the video store") to the impact on print media, free to air TV and CD sales there are countless examples of major impacts to the value of businesses and industry outlook. This remains a key area of focus as this will continue to create opportunities for microcap companies using technology to deliver a better offering. While not every company offers a better solution to a large problem – some are just well managed businesses with attractive long term growth profiles. Nick Scali Ltd (AX:NCK) the furniture retailer, Beacon Lighting Group Ltd (AX:BLX) and MotorCycle Holdings Ltd (AX:MTO) are examples of businesses that fit this mould. Microcaps offer a diverse universe from which to build portfolios that cover a range of industry sectors and business models.

The UBS Microcap fund offers investors a portfolio of emerging businesses that seek to capitalize on structural changes, changes that impact where an economy is going, not where it has been. Small businesses run by capable and credible management with a sensible business strategy to deliver significant growth in earnings (and market value) over the medium term. Our fund takes a long term view aiming to identify those investments which will be the winners of the rapidly changing environment. We use the same proven investment process that has been successfully applied to the UBS Small Companies Fund since 2004. Investing in microcaps does carry risk in that the companies tend to be at an earlier stage of development, liquidity is an issue and performance can be volatile as a result. While it can be tempting to buy into the hype of the supposed "next big thing" (a business promoted as on the cusp of a major transformation), in microcaps it pays to take a portfolio approach to reduce risk.