Where Chris Stott is investing in the new bull market

Small-cap specialist Chris Stott is no stranger to adversity, having launched his 1851 Emerging Companies fund in the early throes of the COVID-19 pandemic.

Less than three weeks after opening the small- and micro-cap fund, global financial markets plummeted as the virus spread around the world. In Australia, the S&P/ASX 200 fell more than 32% in the space of a month and the Small Ordinaries fell by nearly 35%.

While this early period was a nervous time for Stott and his team, the bold move left him ideally poised for the surprising market rally from the end of March 2020. In fact, the fund blew past Stott’s initial five-year goal of raising $400 million before “soft closing” – meaning only existing investors can buy more units – achieving this within 18 months of launching.

“You need a bit of luck on your side too…and on 22 March 2020, it certainly didn’t feel like the share market was going to rally the way it did,” Stott says in the latest episode of The Rules of Investing.

Stott and the 1851 team have weathered another difficult market environment recently. Australian small caps have been in the doldrums for the last few years, with a dearth of IPOs and a shortage of liquidity in the local market. That’s been especially so within ASX Industrials, which form a core focus for Stott and his team.

“The last three to four years have been some of the toughest I’ve seen in my 20-odd years of investing in small caps,” Stott says.

He notes that in the period since the launch of 1851 Capital, the Small Ordinaries Accumulation Index has returned 3% per annum.

“In the period before launching the fund [the index] was 10% per annum…it’s been difficult, a lack of IPOs and secondary listings, IPOs that have struggled, and investors that are more selective,” Stott says.

Stick to what you know

And yet, the fund has beaten its benchmark by a staggering 50% since inception. This is even more impressive when you consider the fund staunchly avoids the resources sector.

This sector makes up around 25% of the ASX Small Ordinaries by market cap and as Stott explains, the materials sector has outperformed the ASX Industrials by 60 to 70% in the last four years.

“That’s been a major headwind in terms of relative performance…so to be able to sit here and say we delivered 10% net of fees since inception is very pleasing for us.”

Stott maintains his decision to avoid the sector is the right one, adamant in his team’s focus on areas where they have an information edge. This is a key underpinning of his investment approach: focusing on your core competencies.

“Investing in resource companies didn’t fit the criteria [of investing in companies where you have an expertise or an edge], we’re not geologists. It’s not what we set out to do, it’s not what we sold investors when we launched,” Stott says.

A new bull market

Australian small caps have now entered a technical bull market, with the benchmark index gaining more than 20% since late October.

He observes that rate cuts – when they eventually come – should favour his core area of focus within ASX Industrials, “which typically do better in a loosening rather than a tightening cycle.”

“Taking a step back, the last two years have seen 13 rate hikes, the most since the early 1990s. We can’t underestimate the level of tightening we’ve had here in Australia,” Stott says.

“To be frank, the RBA has done a good job…are they going to achieve the soft landing? It looks as though we are going to get that.”

How he’s positioned now

Stott says that 1851’s benchmark-agnostic investment approach means his team is solely focused on picking stocks.

A key focus throughout the interview is his emphasis on the track record of individuals running companies, recognising that corporate leaders who already helped build one or more successful companies have a high chance of emulating this in future businesses.

Some of the highest conviction stocks in his portfolio currently include:

Light & Wonder (ASX: LNW)

“A big part of our process is backing the people, the management teams, and that’s a large part of the company for us,” Stott says.

Gaming stock Aristocrat is a company Stott has successfully backed in the past, before launching 1851. He notes that the Las Vegas-based firm is headed by CEO Matt Wilson, formerly a senior executive at Aristocrat alongside several other members of the management team.

“We think this is Aristocrat mark 2… It still trades at a discount to ALL and we expect it will grow higher than the market rate in the next few years,” Stott says.

Iress (ASX: IRE)

A market darling over many years, the financial services software firm has run into trouble in recent years, with high debt levels and some questionable acquisitions.

But he’s firmly backing the new CEO, Marcus Price, who formerly headed up successful property software firm PEXA. Since taking over in February, Price has embarked on a program of cost reduction, deleveraging and rightsizing the business by selling off non-core assets.

Stott notes there is also the potential for a private equity takeover, something that’s been discussed in the financial press in recent years.

GQG Partners (ASX: GQG)

Within the financial services space, Stott calls out boutique asset manager GQG Partners, a company he’s held for around six months.

Noting his experience of investing in the earlier success of Magellan Group, Stott believes he knows what to look for in this space.

“We’ve seen this before, with good performance bringing strong inflows. If they can execute, from a sales perspective, we think their FUM and inflows can be quite material over the next couple of years,” says Stott.

While recognising the challenging environment for active fund managers, particularly those that are listed, he notes GQG’s competitive fee structure.

“They’ve essentially undercut their competitors but also delivered really strong outperformance…we think they’re in a terrific position in the next couple of years and will be a standout in that listed fund management space,” Stott says.

Red flags to watch for

Because successful investing in the smaller end of the market is often as much about what you avoid as what you buy, Stott also highlights some red flags.

Insider selling: “90% of the time, you want to be going with them” when senior executives sell down their own stock, says Stott.

Leadership changes: Citing culture as another key attribute of successful companies, Stott notes the strong role CEOs play in building this. On the flip side, it can present challenges when they leave, often taking other key executives with them.

A recent example is automotive parts manufacturer Bapcor (ASX: BAP). Its share price has fallen more than 30% since mid-April on the back of a profit downgrade and leadership challenges. This includes incoming CEO Paul Dumbrell bowing out of the new job just days before he was due to start.

“Daryl Abotomey left a couple of years ago and now we’re starting to see a bit of the pain…because changing management means changing culture,” Stott says.

More from The Rules of Investing

Listen to the full interview with Chris Stott, including his five-year stock pick, by clicking the link at the top or via the video player below.