How to beat the market long-term: Secrets of small-cap investing success

From hard-core science and academia to funds management, First Sentier Investors’ Dawn Kanelleas has walked a slightly unorthodox path. But more than 25 years after she first swapped her lab coat for a business suit, the head of small and mid-cap companies at First Sentier Investors has enjoyed huge success.

And as she reveals in a recent Livewire Markets podcast interview, her background in science has proven useful in a multitude of ways. Not least of which, Rare Earths was the topic of a thesis Kanelleas authored in one of her (many) academic pursuits.

During the chat – which you can access in full on the link below – she bamboozled Kidman (and me) with a precis of her paper on “mono-dispersed colloids and the kinetics of their formation”.

Though the topic is highly complex, it’s certainly topical – you might’ve heard a little something about the huge investment opportunity Rare Earths now presents, which has Gina Rinehart and Andrew Forrest piling $200 million into the space.

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The Aussie miner upsizing its stake in the rare earths space

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And indeed, as Kanelleas mentioned in passing, the product of the lab work is now employed by global industrial chemical firm Incitec Pivot (ASX: IPL) in its manufacture of urea pellets.

Why science matters

Kanelleas’ background is also useful in helping spot the fakes that might otherwise slip through. The case of Theranos and Elizabeth Holmes in the US is a prominent example that springs to mind.

“When biotechs or other businesses with new technology – such as Calix – come in…we can ask questions that go to the heart of the subject,” Kanelleas said

“Because as we’ve seen globally, people can get hooked into investing in what they believe are new technologies that are not fraudulent. It’s very important that you’re sceptical about these things.”

Some of the most hallowed halls of academia feature in Kanelleas’ background, including Oxford University where she and colleagues were, “bouncing neutrons off surfaces in the physical chemistry lab”. Kanelleas also – without a hint of ego – speaks about conducting experiments at the CERN accelerator in Grenoble, France and research nuclear reactors in the UK and US, including Long Island and Washington, D.C.

A fundamental financial lesson

This came during a 12-month stint at Merrill Lynch, a firm Kanelleas joined when the McIntosh Securities broking firm she worked at was acquired by the century-old US wealth manager and investment bank in the mid-1990s.

“My role was exclusively to model everything, including oil and gas. That was like my university education in modelling – and it was also resources, a field in which I’m still the expert within my team,” said Kanelleas.

She describes this period as an excellent lesson in metrication. That’s because one of her first responsibilities at Merrill involved working on BHP Group's (ASX: BHP) $3 billion acquisition of NYSE-listed miner Magma Copper.

As Kanelleas explained, the star portfolio manager she worked under here, Elaine Prior, tasked her with modelling Magma after the transaction closed.

“I modelled it, bottom-up, mine-by-mine and then did a scenario analysis. And it didn’t take much of a fall in the copper price for that business to be loss-making. Elaine and I then went out to the market with this research, which showed the sensitivities," Kanelleas said. 

On the back of this, the share price of BHP  – which was then Australia’s largest company – fell around 20%.

“I was getting calls from ASIC, who were trying to work out what I’d done. And from the board of BHP. And a year or so later, the CEO and the entire board of BHP were gone on the back of that decision," she said. 

“It showed, at that very early point in my financial career, just how powerful numbers and facts are.”

Lessons from the buy- and sell-side

During the interview, Kanelleas also reflects on other lessons learnt during roles that spanned both the buy-side and sell-side of the financial sector. This included working as a small companies analyst at Ord Minnett, where her team was involved in the 1999 listings of some major technology firms.

“We listed Technology One (ASX: TNE), which is still one of the largest positions in our portfolio, and recently turned in a good result for the half-year,” Kanelleas said.

“We also listed MYOB (ASX: MYO). That role taught me a lot about IPOs and the whole process there.”

Not long after – following around five years at ABN Amro and Deutsche Asset Management (after the former was acquired) – she landed at Colonial First State, now known as First Sentier Investors. And it’s here that Kanelleas reflects on how her working-class roots – the daughter of Greek immigrants, including a fitter-and-turner, trade union leader father – proved useful.

Working under legendary Colonial investor Martin Littler, both Kanelleas and her podcast interviewer Kidman remember him as a polarising character. “Those that worked with him enjoyed it but the people who dealt with him found it quite challenging,” recalled Kidman.

But as Kanelleas said: “Remember, I’m a working-class girl, the daughter of a trade union leader, so Marty wasn’t too difficult for me to deal with. He’s the son of a painter and docker, so I knew exactly where he was coming from.”

How to build billion-dollar portfolios

During the interview, Kanelleas also delved into the investment process employed by her team at First Sentier Investors. Within the Australian equities division, this includes funds focused on Growth, Small and Mid-Caps

Around 70% of the circa $2.6 billion invested in the First Sentier Small and Mid-Caps Fund is invested in large caps.

Kanelleas also touched on the group’s long-short strategy that launched in October.

“Because it’s less than half a billion [in FUM] it has a more constrained capacity, so we’re able to use the funds generated from shorting to invest in microcaps,” she said.

“You can go longer on your long positions, and you can apportion some of that money on microcaps… They’re some of the vagaries of investing in small and micro-caps.”

Desirable company traits

In small and micro-caps, Kanelleas' team focuses on owning single-industry businesses, which can be riskier because they’re often Growth companies that need capital to grow.

“You need to understand their capital needs, their ability to generate free cash flow, and what’s on the balance sheet – do they have privileged assets?” she said.

ASX-listed industrial firm CSR Limited (ASX: CSR) is one company mentioned here.

“It’s a leveraged company with a fixed cost structure. But in this case, it’s a net cash company, with very high margins in gyprock because it dominates that market, so has pricing power,” Kanelleas said.

“These are the lenses you use to think about companies and your ranking of them.”

Oz Minerals (ASX: OZL) is another company example Kanelleas mentions, alluding to the period when its share price traded at $18.

“It has world-class assets, low costs, a 50-year project potentially in Musgrave (Western Australia), and mines two critical metals: copper and nickel. And it gets de-rated from $25 to $18 because it misses a quarterly,” she said.

“That’s the opportunity to take an extremely high weight in that stock because you have an excellent management team, an excellent operator, and world-class, long-life assets.”

Data centre provider NextDC (ASX: NXT) is another company she mentions here.

While also touching on the importance of knowing when to sell out of stocks entirely – which is admittedly something her team rarely does – Kanelleas emphasises her view that there is “a lot of alpha to be made in small caps.”

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