How to invest in small-caps and reduce your volatility

While some managers look for growth with a result of higher risk to generate their returns in small-caps, Ivers has maintained his emphasis on quality.

“We're focused on businesses that have predictable earnings and relatively low risk,” says Ivers.

To put it mildly, it’s an approach that has paid off for the Prime Value team. The Prime Value Emerging Opportunities Fund has continued to beat its benchmark every year for the last five years.

So what does the average punter need to know about stock selection when it comes to Australian small-caps?

In this edition of Expert Insights, Ivers shares the process his team uses to identify stocks, how to manage volatility in a small-cap portfolio and the triggers that he uses to sell stocks.

Edited transcript:

What is your definition of an emerging Australian company?

Why do you exclude mining companies?

We're focused on businesses that have predictable earnings and relatively low risk. Our mining companies tend to be driven by the commodity price. In the small-cap space, they're often single mines exposed to one commodity. So the relative risk of the small miners is quite high and it doesn't really fit the focus of the fund.

We determine whether a stock is going to go into the portfolio by having a hurdle of 10% per annum return. We determine that 10% by doing an IRR (internal rate of return) calculation. 

We forecast earnings out over the next three to five years and we put a multiple on those earnings and we get the dividend stream that comes through as well. Then you can work out the internal rate of return, which is basically the compound annual return that you expect to generate based on the purchase price that you make today. So that's the way we determine whether a stock qualifies to going in the portfolio. 

We're a little bit unusual in the way that we construct the portfolio though.

We are very much focused on downside protection. Stocks that might have a lower IRR or potential return over the next few years might actually have a higher weighting in the portfolio because they'll typically have a lower risk and a more certain return over those years. Whereas a company that might have a high IRR or potential return might actually be a low weighting in the portfolio because it may have a potentially higher level of risk. 

Risk focus and capital preservation is a big, big part of the way we construct the portfolio. 

The portfolio typically has low volatility. How do you achieve this?

The low risk profile is due to a number of different factors. We screen out a lot of the more volatile areas like mining and loss-making businesses.

We have a quality bias and the portfolio construction plays a big role as well. So, you know, big weightings in companies that have relatively low risk and small weightings in companies that have potentially high returns but may have higher risk associated with them. 

Can you share an example of a high quality company and how you selected it?

NIB Holdings (ASX: NHF) is a company we would consider as a high quality business. 

It's a private here in Australia, most people would know the brand name. It's in an industry that has a lot of carrots and sticks to encourages people to take out private health. It's fundamentally important to the future funding of healthcare costs in Australia. So it's got those positive industry dynamics. It has about a billion dollars of liquid assets on its balance sheet, which provides some support and it's a business with a high ROE as well. It has about 23% return on equity.

We first invested in the stock about three years just after covid hit. There were some concerns about the sustainability of the earnings. It become quite apparent early in covid that the earnings they were generating were very high because people weren't able to take elective surgeries. The cost side of the profits were relatively low and therefore the margins were relatively high. 

There was a big focus on the un-sustainability of the margins which we agreed with. But we did a relatively simple analysis and worked out the long-term average margins of the business. Using those long-term average margins, we developed the view that the stock was in a relatively low earnings multiple, a pro-forma through the cycle type earnings.

What triggers would lead you to sell a position?

It's either the price goes up for stock we like, but it just doesn't provide such a good return potential. So we'll de wait slowly. Or we'll exit quickly if there's a fundamental change in the outlook that's different to the way that we expected that business to perform. 

Have you exited any positions recently?

We exited Mainfreight (NZE: MFT) recently.

So we like the business, we like the fundamentals but as we've seen with a number of different industries through this covid rebound period, the ones that were earning very high profits through that stage often rebate lower. 

We're wary of any business that has super profits through that period if the earnings don't stack up on a normalised basis. We love the business but at the moment, we're happy to sit back and just wait.

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