Fairytale small cap growth isn't just a tech story

Investors love stories like that of global e-commerce giant Amazon – which two years ago became the first company to hit a trillion-dollar market cap. Far from its current share price north of US$3,000, Amazon’s stock price at IPO was just US$18 – meaning US$10,000 invested in 1997 would now net you around US$1.6 million.

The technology sector comprises a high proportion of such stories relative to others, because such companies tend to have lower running costs, be less capital intensive and sometimes tap into “viral” growth opportunities. But rags-to-riches growth isn’t exclusive to technology firms, and zeroing-in on this or indeed any other sector is a bad idea – whether you’re investing in micro-, small-, or large-cap stocks.

Each of the following portfolio managers – Matthew Booker, Spheria Asset Management; Dawn Kanelleas, First Sentier Investors; Simon Conn, Investors Mutual; and Harley Grosser, Capital H Management – emphasised the importance of diversification when picking small-cap stocks. 

When asked where they see the best small-cap opportunities, they also acknowledged that the lines between technology and finance, media and consumer are increasingly blurred.

Not every ball clears the boundary

Matt Booker, Spheria Asset Management

We think the Australian listed technology sector is crowded with tech wannabes that, for the most part, will amount to very little except a capital loss in the greater fool’s tax return at some point in the future. Generally, tech start-ups have poor (if any) free cash-flow, so very few make it through our screening process.

Is it possible to grow a company very quickly from a zero base, outside of tech? For sure, anyone that wants to sell a product or service at a loss will invariably find a buyer. 

The success of that strategy in the long term will depend on the business gaining enough scale to begin selling the product or service on a profitable basis and create barriers to entry for competitors who could do exactly the same - otherwise it is essentially a race to the bottom. We believe that in the long term, investing in such concept stocks tends to be a very low probability of winning, akin to trying to hit a boundary off every ball in a cricket test match.

We don’t favour any particular sectors; however, market structures are important to us and hence we tend to invest primarily in industrial companies that have a level of pricing power rather than commodity producers. Where the risk reward is compelling, we will buy resource companies with Mount Gibson (MGX) being a great example of a successful investment for us. We bought it below cash backing when iron ore prices were at a cyclical low with a free option on the re-opening of its iron ore mines.

"We don't favour any industry"

Dawn Kanelleas, First Sentier Investors

While we have seen a number of technology companies undergo rapid growth in recent times, it’s not limited to the IT sector.

Growth can come from all areas of the market, for example ARB (ASX: ARB) in consumer discretionary or Fisher & Paykel Healthcare (ASX: FPH). This is why we don’t favour any particular industry sector. Instead, we identify companies using a bottom-up investment approach with a focus on downside risk.

But also, technology can often be misconstrued as just being software, whereas it’s much more than that. 

Even some of the healthcare companies in our small caps portfolio – Nanosonics (ASX: NAN), Polynovo (ASX: PNV), Fisher and Paykel Healthcare and ResMed (ASX: RMD) – all are businesses that are technology-based.

And the likes of ARB. They’ve spent three to four decades investing in R&D and design every year on one niche segment, which is 4x4 accessories. And you may say “well so what?” But if you dominate that category globally, then you’ve created an extremely valuable business that very few people can compete with.

Diverse sectors, sustainable earnings

Simon Conn, Investors Mutual

Our focus is on maintaining a portfolio with sustainable earnings from a diverse range of sectors, by investing in companies which have strong franchises with long duration assets and that can grow under their own steam independently of the state of the economic cycle. On these grounds, we currently see opportunities in sectors such as communication services, consumer staples, healthcare, and utilities. 

We remain cautious about sectors such as “buy now pay later” and medtech companies, where we believe valuations have been driven too high.

Open up for "weird and wonderful" opportunities

Harley Grosser, Capital H Management

Tech, specifically software, scales easier because of the marginal cost to produce, viral nature of growth and the ease of distribution. But other industries have the ability to scale quickly too – finance, for example funds management; media/content; consumer brands; ecommerce – all of these have the ability to grow quickly with enough operational leverage to scale nicely.

We are intentionally industry and sector agnostic. 

To focus on some sectors at the expense of others leads to missed opportunities, as there are so many weird and wonderful sectors in micro caps. In some cases, a microcap might pioneer an entire industry by itself.

At present we have companies in the fund in sectors as broad as recruitment platforms, domains and hosting, out-of-home advertising, resources, finance, royalty companies, alcohol, food and beverages, telecommunications, nutritional supplements and mining services. We never get bored.

An oldie, still a goodie

The adage "don't put all your eggs in one basket" as it applies to investment diversification is hackneyed but no less relevant today. And it also applies to investors seeking early-stage investment opportunities or those at the smaller end of the market cap scale, as the above managers testify.  

Stay up to date

Don't forget to follow my profile to read the upcoming wire in this three-part series, and give this article a like if you enjoyed it. The first instalment discussed how to find the best small cap opportunities; part three will reveal the fundies' top stock selections in the category.