The secrets to picking a winning small cap (and 2 fundie favourites)

There is no perfect recipe for generating profits. 

Value, growth, quality, momentum, long, short, large-cap, mid-cap, small-cap, conservative, moderate, aggressive - the list of investment styles goes on. And the factors fund managers use to identify stocks that meet their investment style can be equally elaborate. 

So in this episode of Buy Hold Sell, Livewire's Chris Conway is joined by two small-cap managers - Ben Rundle from Hayborough Investment Partners and Will Granger from Airlie Funds Management. 

They discuss their favourite factors when assessing small-cap opportunities, as well as those that are misunderstood or overused by investors.  

Those factors are then put to work, with our guests each naming a stock that ticks all their boxes. 

Note: This episode was recorded Wednesday 26 July 2023 and first published for Livewire Markets. You can watch the show, listen to the podcast, or read an edited transcript below. 

Edited Transcript

Chris Conway: Hello, and welcome to Livewire's Buy Hold Sell. My name is Chris Conway. As they say in the classics, there are many ways to skin a cat. Equally, in markets, there are many ways to analyse stocks and make profits. Today we're asking our fund managers which factors they like to focus on and those that are perhaps a little bit misunderstood or overused by investors. To do that, I'm joined by Ben Rundle from Hayborough Investment Partners and Will Granger from Airlie Funds Management. Gents, thanks for being here today.

What factors should investors be looking at?

Aside from traditional factors like price to equity, return on equity, and earnings per share, what do you believe are factors that investors should be looking at? Ben, we'll start with you.

Ben Rundle: We tend to try and look at some factors that might not be as obvious. So I mean, you can start with things like director's interests, for example. We believe in alignment in companies. So if a director's buying a certain business, there's usually a good reason for them doing so. They know more about the business than we do. And one of the other more unique factors we look at is culture inside a business. So every company you look at is going to be competing with someone else, whether a similar size or larger, and what we want to understand is, why is that company going to take market share and going to be able to grow and expand their business? And often, any business you look at is made up, really, of the people inside it.

So the more we try to understand why those people are on the same page, what sort of goal they're driving towards, what makes them unique, gives us a little bit of a competitive advantage in knowing how that business will look in say five or six years' time.

Chris Conway: Will, what about you? What's a factor that you like to look at that's not a traditional one?

Will Granger: Yeah, if I had to pick one non-traditional factor that we look at, it is insider ownership. So we have a real focus on finding founder-led businesses. We really love owning those types of businesses, because they often come with a culture of long-term decision-making and shareholder-friendly capital management.

What metrics do investors get wrong?

Chris Conway: Will, I'll stay with you. What do you think is a metric or data point that investors often rely on too much, misuse, or overstate? What's one that you think fits the bill?

Will Granger: We think that investors spend a bit too much time focused on short-term earnings outlooks, trying to predict what next quarter or next half earnings look like. Whereas, we have more of a long-term focus. If you think about it, for any growing business, the majority of its intrinsic value is going to come from cash flows generated more than 10 years into the future. So that tells you that business durability matters, not short-term movements and earnings.

Chris Conway: Right. Ben, what about you? What's a metric that you think people often get wrong?

Ben Rundle: I think that's a great one from Will. I think the market is a lot very short-term in nature these days. So having a longer-term lens is a real competitive advantage. I think underlying EBITDA is completely overused. I think it's just such a farce these days. And some of the line items that management teams try to slip into those figures, I think is just absolute rubbish. So taking the EBITDA number from a presentation is often the wrong way to look at it, and I think it's just an incredibly overused metric.

What are your favourite factors and why?

Chris Conway: All right, let's focus on some metrics that both of you do like to employ in your investment strategy. Ben, what are two factors that you and your team use when analysing stocks?

Ben Rundle: Well, I think the most important two are probably return on invested capital and balance sheet strength. But then, if I look outside of that, some of the more unique things that we try to look at, one of them is shares on issue and how that changes over time. There are great examples of companies that have grown their earnings and their shares on issue haven't changed, and it's really, really powerful in terms of what a shareholder return can get. Some of the best examples of those are Mader Group (ASX: MAD), which is doing very well at the moment, Objective Corp (ASX: OCL), which has got a fantastic track record, Lifestyle Communities (ASX: LIC). These companies don't issue more shares each year, and it really makes a powerful difference to earnings per share.

Chris Conway: Will, what about you? Two factors that you guys use early in your process?

Will Granger: Yeah, I think Ben's spot on. For us, the two most important factors are return on capital and balance sheet strength. When we're thinking about return on capital, we really think it's the best quantitative measure of a business's quality, and we're really looking for businesses that generate high returns through the cycle. So, regardless of the economic backdrop. In terms of balance sheet, we're really focused on downside protection and ensuring we're not going to get ourselves in a situation where there's going to be a dilutive equity raise that hurts shareholder returns.

Chris Conway: We've asked the gents to bring along a stock each that fits the bill of the two criteria that they were just talking about. Will, we'll stay with you. What's the stock that meets those criteria?

Premier Investments (ASX: PMV)

Will Granger: Yeah, we think Premier Investments looks really interesting here, and it fits the bill. You've got a business with a great track record of high returns. It's got perhaps the best balance sheet of any listed retailer with 1.1 billion in net cash and liquid investments. That's around 34% of the current market cap. And you've got one of Australia's most successful retail investors presiding over that balance sheet, in Solomon Lew. So we really like Premier here.

Chris Conway: He runs a tight ship, doesn't he?

Will Granger: He does.

Chris Conway: Ben, what about you? What's your pick?

Netwealth (ASX: NWL)

Ben Rundle: Look, in terms of companies that fit those sort of metrics, I've mentioned a few, being Lifestyle, Mader and Objective Corp. Netwealth's probably another one too, which, very high returns on capital, very strong balance sheet, and fantastic management team running the business. It's not screamingly cheap at the moment, so I'm not calling it a buy at these levels, but I do think it certainly fits the bill in terms of all of those metrics.

Chris Conway: Ben and Will, thanks for your insights. If you enjoyed that episode of Buy Hold Sell as much as I did, make sure to give it a like, and don't forget to follow our YouTube channel because we're adding great new content every single week.