The Aussie small and micro caps taking over the world

Is it just us, or is global domination perhaps easier than Hollywood villains would have us think? 

Over the past few months, Squid Game has taken over the world. Meantime, every man and his neighbour can now tell you the total addressable market of Tesla (without being invited, I might add). And what's more - and I don't know where they are breeding them - but lately, it seems like there are more real estate agents popping up down under than homes themselves.

While we are on this train of thought, we have also witnessed a never-ending number of local micro and small caps expanding overseas in recent times, with companies encouraged to take an international risk in their quest for growth. And investors, also hungry for growth, can't get enough of them. 

So in this episode, Livewire's Ally Selby was joined by Wilson Asset Management's Tobias Yao and Ausbil Investment Management's Arden Jennings for their insight into identifying these local growers. 

In the process, they identify eight stocks on their radars, as well as two they believe can kill it on the global stage over the year to come. 

Note: This episode was filmed on Wednesday, 24th November 2021. You can watch, listen or read an edited transcript below.

Edited Transcript

Ally Selby: Hey, how are you doing and welcome to Livewire's Buy Hold Sell. I'm Ally Selby, and today we'll be taking a deeper look at what it takes for the country’s small and micro-caps to make it on the global stage. It's an interesting area of the market as just a few years ago, small caps that had plans of global expansion were avoided like the plague. Now, the market can't get enough of them. So to discuss why that is and everything else you need to know about investing in this area of the market, we're joined by Tobias Yao from Wilson Asset Management and Arden Jennings from Ausbil.

Tobias, I might start on you. What percentage of companies in your portfolio have global exposure and how has that changed over the past five years?

Tobias Yao: In our micro-cap strategy I would say over 50% of the companies now have offshore earnings, which is materially higher than five years ago. One of the key reasons for this is the fact that the market has continued to gravitate towards growth companies, and we are now seeing a lot of Aussie success stories overseas. Accordingly, management teams are encouraged by shareholders and the board to take on more risk and to expand overseas. Finally, it's becoming much easier to attract the capital when you have a global growth story to tell, so a lot of the IPOs and capital raisings are now focused on companies with overseas operations or that are looking to make international acquisitions.

Ally Selby: Same question to you, Arden. What percentage of your portfolio has global exposure and how has that changed over the past five years?

Arden Jennings: Looking at our small-cap and micro-cap funds, around 60% of the portfolio is oriented domestically with roughly 40% offshore. But then if we look at where the companies are deriving their revenue and growth, it's probably about 60% offshore and 40% domestically. What's changed over the last five years is a digital transformation taking hold, allowing businesses to increase their total addressable markets by going offshore; and good examples of that are through models such as e-commerce. But it's really those companies that have embarked on digital transformation programs - even if it's at the sacrifice of short term profits for long term gain - that have really benefited. A good example of that is IDP Education, which has pivoted their English language programs to computer-based testing as opposed to paper. So they're really benefiting from that project now.

Ally Selby: If you had to narrow it down, what would be like the key attributes of companies that can make it overseas?

Arden Jennings: Well, plenty do make mistakes. It is fraught with danger at times, and I think focusing on what not to do can help answer this question. Some companies that go overseas too early and too quickly can risk destroying shareholder capital. What we like to see companies do is really focus on mastering their craft here domestically, if that's where they're currently orientated. If you want to do some homework, using Porter's Five Forces can help you assess each of the companies and their strategies. We like to see companies expand into global markets in a measured and prudent way, taking it slow and ideally in a capital-light manner because the execution risk of going overseas can lead to significant capital loss, which can result in them divesting and retreating back to Australia in the end. We've seen plenty of companies embark on a global expansion, but those are the areas we look for.

Ally Selby: Arden's just run us through what not to do. What are some of the key characteristics of companies that can make it globally?

Tobias Yao: I think for us management is always number one, namely their ability to take calculated risks and execute on the strategy that they've set out. If the company is looking to expand globally in an organic manner, then it really comes down to whether its competitive edge holds up on the global stage and how quickly it can scale. A company such as Afterpay (ASX: APT) is an obvious success story - they replicated their model in the US and scaled so quickly that it was hard for a lot of their competitors to catch up. If the global expansion strategy is inorganic, then it comes down to the ability for management to conduct the due diligence and then figure out how to extract revenue and cost synergies as a combined entity.

Ally Selby: A lot of people have been talking about this reopening play, in your view has that already played out or where are you finding opportunity at the moment?

Tobias Yao: We have quite a few companies exposed to the reopening theme, the obvious ones are the brick-and-mortar retailers, entertainment and travel companies. From our point of view, it's all about whether these companies can continue to grow in the medium term, even after reopening. We've been investing in companies that have fundamentally changed the quality of their business during the COVID-19 period, such that they're emerging from COVID on a much higher revenue or earnings run rate. One good example is Ardent Leisure (ASX: ALG). The chairman and the management team went in a few years ago to fix the business, now they are travelling at a much higher earnings margin as well as rolling out more centres in the US, which provides that short-to-medium term growth.

Ally Selby: Same question to you, Arden, where are you finding opportunities at the moment?

Arden Jennings: The reopening part of the market is an area of focus for us. We are eyeing retailers similar to what Tobias said, but particularly those that are focused on fashion and apparel. Lovisa (ASX: LOV), City Chic (ASX: CCX) and Universal Store (ASX: UNI) are all focused on apparel and have bricks and mortar stores that will benefit from a reopening of economies as people want to socialise.

Another area is travel and tourism where we have holdings in Corporate Travel Management (ASX: CTD) and Experience Co. (ASX: EXP) accross our small and micro-cap funds. 

We are also not ruling some of the companies that have already benefited-19 from COVID, particularly around digital transformation. A company such as Data#3 (ASX: DTL), which helps other companies upskill their workforce while also enabling the company’s systems processes to be more digital, is certainly going to benefit from tailwinds going forward. Once people get back to work, the company will then look to increase their market share and entrench their market position.

Ally Selby: Arden, in this world of cheap debt, there's been a general acceptance of losses overseas for small caps. Companies without profits have become commonplace as have buzzwords like total addressable market. Are there any risks that you see going forward?

Arden Jennings: There certainly are. For both our small and micro-cap funds, we have an investment-grade filter - We actually filter out the vast majority of unprofitable, illiquid companies within our portfolio. We think that serves us well in the long term for both of our funds, but really record low-interest rates have pushed an incredible amount of money into high-risk asset classes as they search for growth. Eventually, we do know that interest rates will rise and that liquidity will draw just as the tide will go out. In this case, we believe that those unprofitable companies that do not have sustainable business models won't be able to support themselves and grow into the future, unlike they can now, given how cheap capital is.

Ally Selby: Tobias, where are you identifying risks in this global market at the moment?

Tobias Yao: I agree with Arden. It's very hard for a lot of these Aussie companies to succeed overseas over a long period of time. In terms of the buzzword of total addressable market, the question we ask management is to try and break that down for us into components. We need to understand whether it's realistic, how much is it going to cost and ultimately whether the unit economics or the return on capital will depreciate over time as they expand further and further into the market. What we don't want is shareholder value destruction, or for the overseas division to dilute the quality or the growth rate of the base business.

Ally Selby: Okay, I'm really excited for this. We asked you to bring along one stock that you think can really kill it on the global stage over the next year and beyond. What have you brought for us today?

Tobias Yao: My pick today is iCandy Interactive (ASX: ICI). Post its recent capital raise and acquisition, it is currently the largest game developer in South East Asia and supports some of the top tier brands globally. The reason we find it so exciting is that the company now has the strategy to delve into games and platforms on blockchain. Accordingly, we think that is going to play into the Web 3.0 trend, which is certainly here to stay. One of the reasons we got interested in the business is also Animoca Brands, which is one of the leading investors in blockchain projects, came on board with a $10 million investment and will be a substantial shareholder in this business. The company is profitable, so we think shareholders will be getting the potential blockchain upside for free.

Ally Selby: Same question to you, Arden, can you beat iCandy Interactive? What stock have you brought for us today?

Arden Jennings: It's probably one of our favourite stocks still. We've been invested in this company since 2018 and that's City Chic Collective (ASX: CCX), led by Phil Ryan who I think is one of the best CEOs in the small-cap market. They've been expanding successfully offshore in a really prudent and measured way. They have a clear strategy, which is plus size, digital and global. They've made acquisitions offshore with Avenue in the US and Evans in the UK, but they've paid really good prices for those. They have also been responsible and walked away from some opportunities such as Catherines, which was a public auction that went on last year. The business has been executing really well on their global expansion opportunity in a prudent way, and all these businesses are profitable. So it's one we think you should do more homework on if you haven't already.

Ally Selby: Well, that's all we had time for today. We hope you enjoyed that episode of Buy Hold Sell. If you did, why not give it a like and subscribe to our YouTube channel. We're adding new content every week.

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