3 small and mid-caps catching this quality-oriented fundie's eye

One estimate suggests there are more than 50,000 publicly listed equities around the world. From unprofitable tech to the Magnificent Seven mega-cap tech stocks, emerging market banks to developed market healthcare names, there are ideas and landmines everywhere you look. 

Nick Cregan and the Fairlight Asset Management team are faced with this humongous opportunity set every day. But they have a process that narrows down 50,000 names to a select group of just 200. 

From there, they pick 30-40 global small and mid-cap companies. The list of names needs to pass a rigorous earnings quality and valuation test. And while that amount of work might turn off some investors, Cregan and company lean right in. It's a process that must be doing something right, given it has returned 14.6% in the last year and 11.6% since inception. 

Given the torrid nature of equity markets in recent times, especially at the small end, that's no mean feat.

In this wire, I'll introduce you to the Fairlight Asset Management flagship Global Small and Mid Cap fund as well as the man who helps run it. In our conversation, he shares some winning companies that he has backed in the past and the stocks he's now hoping will join that winners' list. 

Why global small and mid-caps

It's no secret that Australian investors like a punt, but rarely does that punt leave our shores. Cregan argues that's a big mistake. 

"It's quite rare [for advisors] to have an allocation to global small and mid caps despite that opportunity set being some 40 times larger than the Australian equivalent," he said.

"If you go over long periods of time, global small and mids have delivered a return profile of one or two percent better than global large caps over the last hundred years," he added. 

Beyond performance, Cregan enjoys two other traits associated with small and mid-cap investing:

1. There is an information edge that comes with small and mid-cap investing: "Where you tend to have 20 sell-side analysts covering Apple (NASDAQ: AAPL) or Google (NASDAQ: GOOGL), it's not uncommon for us to find a $3 billion company with zero analysts covering it. There's less eyeballs on these opportunities which provides a bit more opportunity to carve out some extra alpha," Cregan said.
2. Small and mid-cap companies have longevity on their side: "We're not buying the newest of new things in the small and micro-cap end of the market, we're really buying established companies. Around 70% of our companies were listed during the GFC and all those businesses that were listed during that period have not made a loss," he added.

Add to that the natural growth potential that comes with small and mid-caps and you have the foundations of an exciting fund.

The Fairlight investment process

But foundations don't mean anything if you don't have a strong investment process. Fairlight Asset Management prioritises buying high-quality growth stocks at disciplined valuations. As my recent two-part series on quality investing proves, different investors can have different interpretations of what makes a "quality" company. 

For Cregan's part, he argues that some definitions of quality investing can be "fluffy". He and the team prefer to use a list of hard metrics for determining the durability of these all-weather investments.

Metric 1: Return on cash - a similar calculation to "return on invested capital" but the number also includes amortisation, depreciation, and write-down costs. If a company can generate a 15% return on cash over five years, that is the minimum benchmark.

Metric 2: Cost of capital standards remains stagnant in the Fairlight Asset Management portfolio whatever the economic cycle. "We don't drop our cost of capital depending on prevailing interest rates," he said. 

Metric 3: Pricing power, which is measured by revenue growth, its ability to recur revenues, and general earnings stability. 

Metric 4: Whether revenues are recurring or not

Metric 5: Management turnover 

Fairlight has backed...

The Fairlight team is unapologetic when it comes to the sectors they find opportunities in. These are the four sectors they avoid:

1. Companies with low return on invested capital (utilities, agriculture, REITs)
2. Cyclical or macro-dependent stocks (banks, miners, oil and gas stocks)
3. ESG-absent names (Tobacco, weapons etc.)
4. Single points of failure (biotech, unproven technology)

Instead, they prefer companies with strong pricing power and market leadership (oligopolies, quasi-monopolies, and the like). One of those companies which they have backed has been online vehicle auction platform Copart (NASDAQ: CPRT). The stock is up 45% so far this year alone.

"There's two massive barriers to entry for Copart. The first one is digital - so you need the digital flywheel of having buyers and sellers on each side of that transaction. And as we know from consolidated auction houses, they tend to become quite consolidated business industry structures over time. The second part of the barrier to entry is physical land lots around major metropolitan cities, which gives them a cost advantage on towing and storage which is unsurpassed in the industry," Cregan noted.

Copart has only one other major competitor and Cregan said that the company has been able to compound its EPS "in the teens for a long period of time". The company was also family-run for a long time and has a long-term CEO. They also regularly buy back stock.

Copart is still a part of the Fairlight Global Small and Mid Cap Fund, but is not one of the fund's top five holdings.

And now, Fairlight is backing...

When I asked Cregan about a high-conviction stock the fund is now backing, he gave a surprising response. He calls it an "anti-bubble" stock because the company has had an exposure to AI and machine learning well before the craze started. 

Italy-listed Reply (BIT: REY) is what Cregan calls a "picks and shovels" style of technology business.

"They are consultants that help large companies integrate the newest technologies into their businesses. So whether it was cybersecurity or the requirement for cloud computing or whatever it is making that transition," he said. 

"The reason why we're quite excited by that is that unlike some of their counterparts, we're buying that business on a 6% free cash flow yield and it's very much exposed to the themes that everyone's excited about. But they don't have the risk of actually having to pick a winner because they're clipping the ticket of the growth of that industry," he added. 

The stock is down 4% year-to-date and trades on a P/E ratio of approximately 20.

Fairlight would love to buy...

Finally, I dared (read: gently encouraged) Cregan to nominate a company he would love to buy if the right price presented itself. After a little deliberation, he settled on IDEXX Laboratories (NASDAQ: IDXX), a company that specialises in animal veterinary, water testing, and other livestock-related goods and services.

"It has a huge recurring revenue stream and is absolutely a market leader. They provide great returns on invested capital and have fantastic growth opportunities ahead of the business," he said. 

The only problem? It rarely trades below 40 times earnings (as of writing, it has a P/E ratio of 59). 

"We have a high valuation discipline and so unfortunately, it hasn't become cheap enough yet for us to initiate a decision," he said.

IDEXX Laboratories is up nearly 21% year-to-date.