How quality leads to growth when you find the right niche

One of the pillars of Elston Asset Management’s Emerging Leaders Fund is “above-average quality leads to above-average growth”, which for portfolio manager Justin Woerner means a higher focus on value factors – like profitability, returns and gearing - to support Elston's Emerging Leaders strategy.

‘If you look at a lot of the research houses, they would bucket us in the ‘growth’ manager … but it’s the quality metrics and characteristics of these companies which leads to the superior growth in the portfolio.’

With a concentrated portfolio of around 20 businesses, that lean toward quality can also help to provide added portfolio diversification and protect against risk, especially when it comes to selecting small-cap stocks.

In this wire, Woerner highlights how quality leads to growth and provides an example of a standout addition to the portfolio that's right under the nose of breakfasting Australians everywhere.

Edited Transcript

What criteria are used to find high-quality small-cap businesses?

Our investment universe is all ASX listed businesses outside of the top 100 with a market capitalisation of greater than $150 million. That gives us a universe of about 500 businesses, so we can be very selective and just focus on the higher quality businesses. So the kind of metrics that we're thinking about here are metrics involving profitability, returns on invested capital. We're looking at gross margins, we're looking at return on equity, return on assets, return on invested capital, and also, metrics around gearing. We prefer conservatively geared businesses, so we're looking at metrics like interest cover, net debt-to-EBITDA. So that's really the quality type of metrics that we're looking for within our emerging leaders strategy. This differs somewhat from the large-cap strategy that we've got, where we're focusing more on value and growth to be more style neutral.

What are the advantages of running a concentrated portfolio?

We think there are several advantages to running a concentrated portfolio. Firstly, we think it provides us with a really strong ability to outperform, so our active share or our difference to the index is very large. Active share runs at about 90%, so that means that there's only 10% of our portfolio that's actually included in the benchmark. We think that gives us an ability to outperform longer term. However, we think we can do that with an adequate level of diversification. Holding 20 businesses, we think, provides enough diversification. Research tends to suggest that with between 15 and 30 businesses, you can obtain in excess of 90% of the diversification benefit available. And then finally, we think it's a good risk management tool. Only having 20 businesses in the portfolio allows us the time to truly understand these businesses. We can understand the industries they operate in, the drivers of their revenue, the drivers of their expenses, the potential risks and opportunities that these businesses face. Overall, we think having a concentrated portfolio allows us the ability to outperform whilst getting enough diversification and adding to our risk management strategy.

Your holdings are largely made up of technology stocks – why is that?

The portfolio currently has about 25% allocated to information technology. We also have quite large overweight positions to consumer discretionary and healthcare. We're a benchmark unaware manager. We basically just hold the businesses that we want to hold. And it's in these sectors where we're really finding the opportunities at the moment. It's in these sectors where we're finding the structural tailwinds, the competitive advantages, the opportunities for growth that we seek inside of the portfolio. On the flip side, there's probably sectors that we're very unlikely to ever hold, or at least hold in any material way. If you think about sectors where the industry's in decline, where there's more intense competition, regulatory influence, lower growth, commodity-based sectors, you're thinking about materials, energy, utilities, real estate, these sectors we'd be very unlikely to ever hold in any material way within the portfolio.

Can you name a standout addition to the portfolio?

One of our recent additions to the portfolio is Breville Group. I think most people would be familiar with the Breville brand. It's a very strong brand with Australian consumers. It's got a very robust track record, but we also think it's got a very strong outlook for future opportunities. And one of the things we really like about Breville is this investment-led flywheel which it has had in place for probably about the last five years. 

So through increasing revenue growth and operating leverage, management has been able to continually increase the amount of investment that it has in research and development and marketing.

This leads to product development, market leadership, and geographic expansion.

We think that this provides both an increasing value proposition with growing profits. Domestically, the market's more mature for Breville, so we have a lower growth outlook. But we're really excited about the potential for Breville to be able to expand and grow its international sales. So basically, grow international sales as its leveraging its global platform, its strong product offering, to be able to sell more products to more customers in more markets.

Why is the portfolio skewed to growth companies?

We would probably suggest that we're quality investors, but quality companies generate growth characteristics. So if you look at a lot of the research houses, asset consultants, they would bucket us in the growth manager category, but we're really focussing on the quality. But if you think about the quality attributes that we're looking for, structural tailwinds, competitive advantages, lack of regulation, superior earnings growth, then these are all the characteristics that allow these businesses to generally fend off competition, weather any storm that comes their way, and basically expand their sales and their earnings at higher levels than the industry for longer periods of time, which leads to the superior growth within the portfolio.

Australian Emerging Leaders

Elston Asset Management strive to identify businesses which fall into their identified sweet spot - high quality, lower risk and purchasable at a reasonable price. Find out more here.