How this fundie unearths small-cap winners (and one stock for the year ahead)

An emphasis on under-researched companies and setting high standards for the small- and mid-cap companies that make it into the Fairlight fund are some of the standout characteristics emphasised here by portfolio manager Will Dowd, CFA.

An emphasis on quality stocks means its average holding period is longer than some managers in the space. 

In the following Q&A, Dowd explains some of the other aspects of Fairlight’s investment process. He also touches on some of the top-performing stocks of 2023, his biggest lesson of last year, and reveals one of the three new companies recently added to the portfolio.

We also learn what drove Dowd to become a money manager and find out where he might be now if the finance bug hadn’t bitten him early on.

What’s the biggest lesson you – or the broader Fairlight team – learned last year and how does this influence your investing in 2024?

At the end of each year, the team reviews the top contributors and detractors to the Fund’s performance. In 2023, three of the top performers were:

• Copart (NYSE: CPRT),
• Constellation Software (TSE: CSU), and
• Auto Trader (LSE: AUTO).

Interestingly, all three have been held continuously in the fund for five years and have all previously featured in the top contributors in prior years.

At Fairlight, it’s not unusual to see long-tenured holdings amongst our best performers and leads to two interesting lessons for us as investors:

1. Quality companies tend to resist reversion to the mean and outperform for longer than expected, and
2. Patience is required to fully reap the benefits of a successful investment thesis. One of the most damaging mistakes investors make is selling winners too early and reinvesting the proceeds into their losers.

As we enter 2024, this serves as an important reminder to us that once we have purchased a truly great business that is compounding earnings the best thing we can do as investors is get out of the way and not interrupt this process unnecessarily.

How do you sift such an immense universe of stocks to arrive at a list of 30-40 global small- and mid-caps?

Our investment process is very clear on the minimum quality hurdles required for a business to be investable and we are disciplined in steering clear of sectors and geographies that are outside our circle of competence. 

Focusing only on businesses with a track record of being profitable in good and bad economic times, high returns on capital, limited or no debt and in developed markets only whittles our investable universe down to around 200 businesses around the globe.

From a process perspective, we use a quantitative screen to do the first layer of filtering and then each stock that passes is assigned to an analyst who undertakes a rapid due diligence process (1-2 days) to find any reasons to say no quickly. A business that passes both these filters enters the full diligence process which in some cases can span several years from idea to first investment.

What new names were added to the portfolio in 2023 and what are your investment theses for them?

Of the three new names, we have only disclosed one publicly, which is Ulta Beauty (NYSE: ULTA), a US-based retailer of beauty products.

We are generally looking for businesses where the market has missed, under-appreciated, or perhaps temporarily forgotten their quality characteristics. In Ulta’s case, we believe the market has categorised it with other low-quality retailers; a sector that is famous for razor-thin margins, fickle customers, incredibly high competitive intensity and ultimately low shareholder returns.

Despite these headwinds, Ulta has managed to compound revenues at 17% p.a. and earnings at 28% p.a. for the past two decades, placing it comfortably amongst some of the best wealth compounders in recent history. We believe the root of this strong performance is an intangible and hard-to-analyse competitive advantage built upon the company’s unique culture. We have seen firsthand that staff love to work in these stores, and customers are unusually loyal.

We were able to purchase our position at a valuation of 16x earnings when the stock was caught in a broader retail sell-off. For a company that has close to 100% cash flow conversion, no debt, and a long track record of more than 15% p.a. EPS growth, it looked attractive to us.

If you had one word to describe the financial market environment of 2023, which would it be and why?

Unexpected. With the benefit of hindsight, it can be tempting to think a large rally in equities in 2023 was easy to predict, however when revisiting sentiment at the time in late 2022 it was almost universally gloomy.

In our view, this reinforces the dual difficulty of a) making correct macroeconomic or market forecasts and b) correctly positioning a portfolio to profit from that forecast. This is why we spend our time focused on the fundamentals of our investee companies and prefer to be fully invested.

What is your outlook for small and mid-caps in 2024?

We don’t attempt to time the market by making market or macro forecasts. However, we can observe that currently, small and mid-cap companies globally are trading on some of the largest discounts versus large caps seen in several decades. Despite the recent market rally, our index – the MSCI World SMID Index – is still trading on a PE below its long-term average.

We don’t claim to know the direction of markets in the next 12 months but our view is those two factors are supportive for long-term investors in global small caps.

What attracted you to an investing career, specifically the small- and mid-cap segment?

I started my career as a data analyst, however my side hobby of investing was soon consuming all my spare time and some work time. The challenge of analysing a business, forming an investment thesis and the satisfaction when it works out is highly rewarding and when the opportunity presented to pursue my hobby as a career it was impossible to turn down.

At Fairlight, we wanted to focus on the area where we could add the most value for our clients and give ourselves the best chance of outperforming over the long term. Global small and mid-caps are one of the most under-researched asset classes with many of our portfolio holdings having little or no analyst coverage.

It is not uncommon for us to visit multibillion-dollar companies who inform us we are the first Australians to have made the trip to their headquarters. It's generally a good start to uncovering a hidden gem.

If you weren’t managing investor money, what other job would you be doing?

Nowadays, most of my time not spent investing is spent cycling. If I couldn’t invest then I imagine running cycling tours across Spain, France and Italy would also be a rewarding way to live.