How to invest in small-caps and reduce your volatility

This article was first published on Livewire Markets on 7 March.

Investors often steer clear of small caps, fearing volatility and loss. But that’s exactly the hunting ground to focus on for Richard Ivers, Portfolio Manager of the Emerging Opportunities Fund at Prime Value.

While some managers look for growth with a result of higher risk to generate their returns in small-caps, Ivers has maintained his emphasis on quality.

We're focused on businesses that have predictable earnings and relatively low risk

To put it mildly, it’s an approach that has paid off for the Prime Value team. The Prime Value Emerging Opportunities Fund has continued to beat its benchmark every year for the last five years.

So what does the average punter need to know about stock selection when it comes to Australian small-caps?

In this edition of Expert Insights, Ivers shares the process his team uses to identify stocks, how to manage volatility in a small-cap portfolio and the triggers that he uses to sell stocks.

Edited transcript:

What is your definition of an emerging Australian company?

We invest in companies outside the top 100. Effectively from 101 down in terms of size and that means a market-cap of about $4bn or less. We invest in Australian and New Zealand companies. That's our universe but we do screen out a number of sectors and specific types of stocks. We don't invest in mining companies and we have rarely ever invested in loss-making companies. We tend to focus on the more quality end of the small industrial sector.

Why do you exclude mining companies?

We're focused on businesses that have predictable earnings and relatively low risk. Our mining companies tend to be driven by the commodity price. In the small-cap space, they're often single mines exposed to one commodity. So the relative risk of the small miners is quite high and it doesn't really fit the focus of the fund.

What is your process for identifying companies?

We get out and talk to a lot of companies. There's three of us in the team, myself, the co-portfolio manager, Mike Younger, and then Ben Melody, who's the analyst in the fund. Between us, we see around four unique companies on average per day. Over a thousand companies per year. That's where we do a lot of our screening. We strip out mining companies and loss-making companies. 

We determine whether a stock is going to go into the portfolio by having a hurdle of 10% per annum return. We determine that 10% by doing an IRR (internal rate of return) calculation. 

We forecast earnings out over the next three to five years and we put a multiple on those earnings and we get the dividend stream that comes through as well. Then you can work out the internal rate of return, which is basically the compound annual return that you expect to generate based on the purchase price that you make today. So that's the way we determine whether a stock qualifies to going in the portfolio. 

We're a little bit unusual in the way that we construct the portfolio though.

We are very much focused on downside protection. Stocks that might have a lower IRR or potential return over the next few years might actually have a higher weighting in the portfolio because they'll typically have a lower risk and a more certain return over those years. Whereas a company that might have a high IRR or potential return might actually be a low weighting in the portfolio because it may have a potentially higher level of risk. 

Risk focus and capital preservation is a big, big part of the way we construct the portfolio. 

The portfolio typically has low volatility. How do you achieve this?

The low risk profile is due to a number of different factors. We screen out a lot of the more volatile areas like mining and loss-making businesses.

We have a quality bias and the portfolio construction plays a big role as well. So, you know, big weightings in companies that have relatively low risk and small weightings in companies that have potentially high returns but may have higher risk associated with them. 

Can you share an example of a high quality company and how you selected it?

NIB Holdings (ASX: NHF) is a company we would consider as a high quality business. 

It's a private here in Australia, most people would know the brand name. It's in an industry that has a lot of carrots and sticks to encourages people to take out private health. It's fundamentally important to the future funding of healthcare costs in Australia. So it's got those positive industry dynamics. It has about a billion dollars of liquid assets on its balance sheet, which provides some support and it's a business with a high ROE as well. It has about 23% return on equity.

We first invested in the stock about three years just after covid hit. There were some concerns about the sustainability of the earnings. It become quite apparent early in covid that the earnings they were generating were very high because people weren't able to take elective surgeries. The cost side of the profits were relatively low and therefore the margins were relatively high. 

There was a big focus on the un-sustainability of the margins which we agreed with. But we did a relatively simple analysis and worked out the long-term average margins of the business. Using those long-term average margins, we developed the view that the stock was in a relatively low earnings multiple, a pro-forma through the cycle type earnings.

They also had a couple of kickers with a couple of divisions that were impacted by COVID as well. For example, travel insurance and inbound international insurance as well through students and international workers who were coming in. These were heavily impacted by covid and borders being closed. But you had a good visibility of the earnings pre covid, so you could normalise that and work out that what the earnings would look like in a normal environment, which has played out. 

What triggers would lead you to sell a position?

It's either the price goes up for stock we like, but it just doesn't provide such a good return potential. So we'll de wait slowly. Or we'll exit quickly if there's a fundamental change in the outlook that's different to the way that we expected that business to perform. 

Have you exited any positions recently?

We exited Mainfreight (NZE: MFT) recently.

That's another high quality business that we really like and we expect to reinvest in again in the future. But that stock has earned very high margins through covid and performed very well. Freight rates from sea and air were very high and that meant the earnings of the business were very high and its done very well. There's a risk that could unwind. When you look at the business on the potential earnings on a normalised basis, that valuation is getting a bit stretched.

So we like the business, we like the fundamentals but as we've seen with a number of different industries through this covid rebound period, the ones that were earning very high profits through that stage often rebate lower. 

We're wary of any business that has super profits through that period if the earnings don't stack up on a normalised basis. We love the business but at the moment, we're happy to sit back and just wait.