Global small caps key to riding the recovery

Global small caps have had a bonza 12 months, having well and truly recovered from their COVID-lows. And while big tech and speculative investment vehicles like SPACs and NFTs may have caught the world by storm, unique opportunities are still being left behind in the shadows of the small end of the market. 

That's according to Wilson Asset Management's Catriona Burns, the lead portfolio manager of WAM Global Ltd, who believes that further fiscal stimulus, accommodative monetary policy and vaccine rollouts will point to a continued "compelling environment for small caps" in the future. 

In this Q&A, she shares her small-cap strategy for the year ahead; three companies that have caught her eye; as well as her number one tip for finding growth stocks offshore. 

In your recent half-yearly presentation, you were particularly bullish on equities. Can you take us through your reasoning here? 

We think the underlying conditions are highly supportive of global equity markets, and there are a few reasons for that: fiscal stimulus is ongoing, central banks have committed to lower for longer, and vaccine programmes are rolling out. We think the subsequent reopenings will drive economic strength and recovery and that this backdrop is positive for equity markets. 

We are obviously watching the significant rise of special-purpose acquisition companies (SPACs), the pace of initial public offerings (IPOs), and the rise of unprofitable tech stocks. But generally, we are positive and excited by the actual opportunities we can still find away from those elements. In the shorter term, we see unique opportunities in the reflation trade and longer-term in some structural trends that have been accelerated by the pandemic.

Inflation seems to be on the tip of everyone's tongue at the moment. Is it high up on your radar and is there anything else investors are missing?

We do think that inflation is undoubtedly a longer-term concern. The Fed has clearly laid out that they will leave interest rates lower for longer. But we think if inflation picks up and is sustained, then we will eventually see the Fed begin interest rate normalisation, which will impact markets. Putting this through your discount rates for stocks certainly affects long term valuations. The concern will be if that happens earlier than expected. We are certainly watching and thinking about it very carefully, in terms of the stocks we own, what stocks can benefit from rising inflation and what stocks could be hurt, and adjusting the portfolio accordingly.

Are there any other risks that you think investors should be aware of?

We're definitely watching the enormous rise in unprofitable tech stocks and SPAC IPOs. 

I saw a stat the other day that said 70% of the IPOs this year have been cash boxes; these SPAC vehicles. So no doubt we are looking at the tech sector and some of the frothiness that is there. 

The other concern and the risk that we have to be conscious of is vaccine results, virus mutations and ensuring that we aren't overly optimistic about having solved the pandemic. We are certainly optimistic but you have to be aware of where there are risks to your thesis because you do not want to be caught on the wrong side.

I also read that the fund has a cash level under 5%. Is this indicative of the opportunities you are uncovering in the market? 

Yes, it is. We continue to find compelling opportunities around the world. We have a portfolio of companies that capitalise on a number of the longer-term trends that COVID-19 has accelerated, the specific opportunities arising from the recovery and sections of the economy that have been hurt by COVID-19. 

Our investment process is focused on finding individual businesses that have strong industry positions, quality management teams, solid earnings growth potential, combined with a compelling valuation, and then we invest when we have identified a catalyst that we think will drive the share price higher. 

The level of cash that we have is both a reflection of the opportunities that we are finding, and the constructive backdrop we see for certain parts of the market.

Last time you spoke to Livewire Markets, you noted you were shifting away from exposures in the US to explore opportunities in Europe. Is that still the case? 

We are looking at similar thematics and where they could be played to the best valuations. In September, we were finding that a lot more opportunities were in Europe because the US had just had a strong rebound. We did buy a lot more stocks out of Europe and we do have a relatively high weight in Europe now. However, we are still finding exciting opportunities in the US, as there are a lot of stocks that have done incredibly well, while others have been left behind. We continue to find opportunities everywhere.

You have also spoken recently about being bullish on small caps in this environment. Can you take us through your thesis here?

If you look back at the concentration of returns over the last couple of years, it was large-cap tech that led the way. There was a lot of uncertainty; we had trade wars, we had Brexit, we had Hong Kong protests, we had all these individual macro events that led investors to be relatively cautious and move to large caps. 

As long as the vaccine rollout continues as planned, we should see a broad-based economic recovery - and that is a very compelling environment for small caps. 

The uncertainty of wanting to go into large caps for safety goes out of the equation and a lot of these small caps are very tied to the economic recovery of the markets that they serve. These companies should be very well placed to benefit as the economic recovery comes through. We go sector by sector and look at the underlying drivers behind each business, but yes, we are excited about small caps relative to large caps.

With that in mind, could you take us through some of your most recent purchases? 

Yes, sure. The first is Applus Services (BME:APPS) - it operates in 70 countries around the world and is headquartered in Spain. 

• Applus is a leading global testing, inspection and certification company. 
• Applus provides solutions for customers in various industries to ensure assets and products meet quality, health and safety, and environmental standards and regulations. 
• WAM Global invested in the business after the share price fell over 50% with the onset of COVID-19. 
• Its competitive position was enhanced during this period, as it stripped down costs and revenues and earnings are now bouncing back. The company's valuation is still far from its previous trading levels. 

Another business we have been buying is Carrier Global (NYSE:CARR). 

• Set to benefit from structural tailwinds over the coming period, including rising urbanisation, a growing middle class, decarbonisation of societies. 
• The business is very well positioned both with its brands and products. 
• We think that over time as it logs good results, the market will come to appreciate the company in line with its peers trading on much higher multiples.
  

We also like TransUnion (NYSE:TRU).

• It is one of three credit bureaus in the US with exclusive access to a wealth of customer data.
• We believe it is are the most innovative bureau, growing into new geographies around the world.
• It has interesting areas of expansion going into fraud, healthcare, fintech and digital markets.
• The management team under promises and over-delivers, so we are excited about its prospects.

Finding undiscovered gems on the ASX is hard enough, how do you go about finding these companies offshore?

Australia is a wonderful place to live, but in terms of the market, the actual number of stocks and the opportunities are far less than can be found offshore. 

As an individual investor, trying to work out all the companies that are out there and possible to invest in, it can be slightly overwhelming but that's the benefit of having an international manager who can do that for you.

What are the main ingredients that you believe are essential in global growth companies? 

We have a pretty clear investment process. We are looking for those businesses that have compounding earnings, with a clear pathway of future growth. We are looking for businesses with solid barriers to entry, strong balance sheets, low levels of leverage, and management teams with a track record of success, ideally with skin in the game and in many cases founder-led. 

We try to avoid businesses that are value traps; businesses that are cheap for a reason. Those who are using accounting tools, so adjustments and intangibles etc, or are masking underlying slowdowns in their business by M&A.

If you had to give investors one tip for finding growth businesses offshore, what would it be?

I think the one element of our process and the one element which is a great indicator, is analysing how much money the management team have invested in the company. This helps to understand the motivations of management. What are their incentives? What is their alignment with shareholders? And that is a big reason we love founder-led businesses because you are relying on what management tells you and then doing your own due diligence on the results they are delivering. But if their money is invested in the business, or if they have a significant shareholding in the business, then you know that you are aligned with them. If they have skin in the game, it is far less likely that they are going to explore destructive actions that deteriorate value in the business. Management selling their shareholdings can also be a very telling sign. It doesn't always mean that the business has issues, but it can be a good lead for what they are thinking around the valuation of their own stock. Good founder-led businesses tend to never sell and tend to focus on value creation rather than value destruction.

Could you also take me through your most recent sell and why you lost conviction in the company? 

Sure, we have sold a couple of stocks recently. Firstly, Unifirst (NYSE:UNF), the number three uniform rental company in the US. 

• We owned the stock as a good reopening trade based on recovery in mobility and employment. We thought we would be a longer-term holder but the thesis played out much quicker than we thought. 
• The company very quickly went from being on a 23 times PE to a 32 times PE in the time we held it. 
• It was clear that the market was starting to more than appreciate the merits of the business and so we thought the price was too high for a business that is a mid-single-digit grower and we were finding better opportunities elsewhere, so we sold.
  

Another company that we sold was Aon (NYSE:AON), an insurance broker. 

• We have owned the business since 2018 and it has been a great performer for the fund. It is a very good business; they are the number two global risk insurance broker with strong positions in employee benefits, retirement and advisory. We held, thinking it would be a winner into the reopening of economies and that it was not getting enough credit for this. 
• It had a good result in February, which was well received by the market. They have announced the acquisition of Willis Towers Watson. We think there are going to be some issues with antitrust regulators and that it will be forced to take some remedies around that. 
• We think there is just too much complacency around the risk. The stock was back trading on all-time highs, so we took the opportunity to take some money off the table. 

I want to get your take on the speculative investing that we have seen in the market this year. Are we witnessing a new investment landscape driven by social media? Or will this subside over time?

It has been very fascinating watching markets and the movements in stocks like Gamestop and AMC and the power of social media. The Reddit and Robinhood crowd are an interesting consideration for market structures going forward. We go back to fundamentals and think that ultimately, they will win out; these positions will unwind, one way or another with potentially some casualties. We think that it is well placed to have some enhanced caution around the power of social media and retail investors when they combine. We have not participated in the trading in any of these stocks, so it hasn't directly impacted us. But we do think that pre-social media and the internet, this wasn't a phenomenon that market players had to deal with. But it is the reality of today.

In terms of retail interest in markets, we certainly expect this will continue, potentially until we see a significant market correction.  

I saw a stat the other week that retail had accounted for 23% of all US trading in 2021, which was more than twice the level of 2019.

A lot of people have made money as the market has risen, particularly in the high-flying tech stocks like Tesla, Zoom and Nio. The data coming out of the US in relation to how much stimulus money has moved into equity markets is interesting. But we think that whenever there is an asset class making significant gains, it creates a fear of missing out for those on the sidelines, so additional money flows there. But if prices get too out of kilter with reality, the bubble usually bursts. I think it is great overall that retail investors want to invest in shares, but be careful you aren't following the crowd.

American investor Jim Rogers said a great quote:

"A mania first carries out those who bet against it, and then those who bet with it."

We'll see how it all plays out, but yes we think it pays to have some caution if you are just following the trend and not focusing on fundamentals.

You have shared a few great stats in our chat today, are there any other stats that you think investors should be aware of? 

One that is really interesting is that nearly 25% of all US dollars in circulation were printed in 2020 alone. The US Federal Reserve has printed unprecedented amounts of money to support the economy since the coronavirus hit. When you look at the data from the Fed, it shows that a broad measure of money supply, which is known as M2, rose from US$15.34 trillion at the start of 2020 to $18.97 trillion in December, which is equivalent to an increase of 24% of the total supply of dollars.

What inspired you to work in investment management? 

There is a reasonably long line of female investors in my family on my mother's side. Her family grew up on a farm near Oberon, in regional New South Wales. I would spend my school holidays watching my grandmother checking her stock prices in the newspaper every morning, which sparked an early interest in the market. My grandmother was taught about stocks from her mother, who used to invest in international stocks, which in that era was quite unusual. That was a great foundation. And then I have been incredibly lucky to have been presented with fantastic opportunities which allowed me to transfer this passion into a career. 

You started off as an intern at WAM and then moved abroad. Can you briefly take us through your career journey? 

I did some work experience at WAM during my final year of university. On completion of my studies, I was hired as its first full-time analyst. So at the time, it was Geoff Wilson and Matthew Kidman. I spent three years there as an analyst working directly with Geoff and Matthew at a relatively early stage of the business, and they were really pivotal in teaching me how to analyse small and mid-cap companies and understand market trends. And then in 2007, WAM supported my move to London to ultimately become a portfolio manager at Hunter Hall. My role there was investing in global stocks across various sectors. This really opened my eyes to how many more companies and sectors there are outside of Australia. 

Living in London and working through the Global Financial Crisis was a fascinating period. It provided invaluable lessons in terms of managing investments during downturns and was extremely formative in my investing career. After five years, I transferred my global role back to the Sydney office of Hunter Hall and was subsequently offered a role with Airlie Funds Management - John Sevior and David Cooper were just starting the business. I was fortunate to be involved in that from the start, to be involved in the growth of that business. Then in June 2018, I was offered the opportunity to return to WAM to launch WAM Global Limited (ASX:WGB), which has been a wonderful combination of all the experience that I have had and being able to apply it and launch a fund from scratch has been fantastic.

And finally, what is one piece of advice that has stayed with you throughout your career that you think would be helpful for other investors? 

Surround yourself with people that support you, challenge you, and develop you. I've been very lucky to have supporters and mentors throughout my career - I think that is very important. Also, be curious and ask questions.