Beyond the ASX 50: The Case for Small(er) Caps

Hello and welcome to the Investment Markets podcast, where we aim to discuss investment matters that impact self-directed investors. I'm your host Darren Connolly, CEO of InvestmentMarkets, and today I'm joined by Robert Miller from NAOS Asset Management. We're going to discuss emerging companies and small caps. But before we get into it, I need to remind you that this is all general advice and general information only, and nothing in this podcast should be construed as an investment recommendation. You, as always, will need to decide what is right for you. Welcome, Robert. Thanks for having me on, Darren. It's a pleasure to have you here. A part of the market that is probably increasingly coming to the forefront of investors considerations given a lot of ETFs and index tracking that seems to be going on at the moment. Do you believe it is such a compelling investment opportunity?

Sure. So I think the fundamental way to look at emerging companies and of course small caps and emerging companies, you know, one in the same in this instance.

Would you just call them small caps?

Well, call them small caps, that's easy. Yeah, not a problem. So if you think about it, by nature, they are small businesses. And by very nature, the large caps are large businesses. And stating the obvious, what was once small businesses turned into large ones being the successful ones, right? So the future leaders of tomorrow are baked in the early days, and the big gains are baked in where there is small caps. And that's where you want to be ideally having some exposure to be able to really run with those quality businesses through their lifecycle as they do grow. Early in their life cycle. Early in their life cycle when the growth rates are still substantial and you also get the benefit of not only organic growth and potentially mergers and acquisition growth for the individual companies but you get the multiple expansion that can occur with quality becoming more quality and bigger and if it gets more eyeballs, more people know about it, it starts off as an area that's under-owned and under-researched and soon that can change for the successful businesses in that space.

I think under research there's probably a point I'd like to just touch on because if you look at small caps depending on your definition of where that starts and where that ends, there can be quite a lot of companies, right? How big is the universe that you look at, for example?

Yeah, I mean, it's a massive universe relative to the ASX 50, as an example. But in our definition of what suits our kind of quality filters, and I doubt we'll touch on that later on, let's assume there's roughly, give or take, 2,000 odd companies that are listed on the ASX. If you funnel them down through what we might exclude and certain industries that we don't touch, in our opinion, there's probably a couple of hundred that fit within our parameters of what we would consider reasonable small caps that when we then do more work on. But the fact of the matter is the industries that those particular companies and many of those 2,000 out there are very different from the exposures that you get within the ASX 50, ASX 100, where it is clearly dominated by banks and mining. You know, you don't get exposures to a lot of the things out there that investors want to get exposure to. There are a lot of good industry tailwinds out there that you can't simply get within the top 10, 20 companies on the ASX.

Because the thematic or the story seems to be that Australia is commodities and banks and commodities swing and banks maybe viewed as a low growth opportunity or low growth option. So what type of other themes or thematics do you get exposed to when you're looking outside of the top 50?

So obviously there is a very large element of the small end of the market, which is resource and energy exposed. So that industry itself, you might not get the wide breadth of commodity exposure you might get with BHP or Rio as an example, but you can get select specific commodities for whatever you're after. From a NAOS perspective, we don't do anything in the mining and resources space. And can you just touch on why that is the case? Yeah, sure. So, I mean, we just fundamentally believe it's outside of our circle of competence has always been to date. And we're not focused on things that we don't think we can have value add to our investors by investing in those other experts out there. and much better us in the resources and commodity space, and we're happy to stick to industries that we would, for want of a better word, probably characterise as industrial, boring type businesses that are real businesses that produce real cash flows that can be coming back to your question around industry exposures. Anything from, if you're looking in the ASX50, you probably can't get exposure to the fact that there is a growing use of road freight in Australia, as an example. And the average age of the truck fleet in Australia is increasing by year and year and year.

And that's one of the oldest in the Western... And the average age of the truck drivers as well, I think I saw.

That is actually a true fact as well, unfortunately. But if you come back to the average age of the truck fleet, if that's increasing... more trucks are driving more kilometres on our roads, there's more stress on older vehicles. What does that mean? There's more maintenance and there's more replacement parts that are required to keep those trucks on the road and keep them going for longer and longer, as an example of an industry.

So that's an interesting thematic that I think, while certainly wouldn't surface within the ASX50, How do you find those stories? How do you, that one for example, how do you know that that's out there?

So we spend a lot of our investment process and our time is on identifying firstly what we consider to be strong industry tailwinds. I think boiling that down is you want to invest in businesses that aren't fighting the tide, that aren't fighting with one hand behind their back. They're growing in growing industries.

Tailwinds are always important.

Absolutely, and there's obviously the mega thematics out there, AI, renewable energy, things like that that are known widely globally and you can get exposure through the ASX 50, ASX 600 in many ways. But if you really want to take that to a second derivative or a third derivative, or many other industries such as the ageing population, yes that's a mega trend but there are ways to get exposure in far more isolated, far more highly leveraged and I'm using the word leveraged not in a financial debt sense but in terms of leverage to a tailwind. How that comes about look, ideas can come from anywhere and anywhere and often the businesses that we look at for five, six, seven years, we look at a tailwind and we think that's a good business that fits within that tailwind but that doesn't necessarily mean that business is right to invest in. Today we might have to grow in confidence with a particular management team or a business model per se before we get exposure or get comfort to get exposure to a certain tailwind.

So you're matching the thematics with the in-depth company level research going in deep with the management teams looking at the businesses themselves to make sure you're comfortable that they hit your quality criteria?

Yeah, definitely. And I think it doesn't just stop with speaking to the management teams, which certainly we do and many others do in the market as well. It's about trying to find and speak to key industry stakeholders, former employees, competitors, anyone within a certain industry that can provide a general level of understanding that you can pick up the nuances of how certain industries work, what makes them tick, what are the dynamics that will make them change, who may have pricing power in a certain industry, and all that just comes from you know, speaking to people and attending conferences and all sorts of ways just to wear out shoe leather and build confidence over time.

And do you find that the universe outside of that top 50 or maybe even the top 100, there's more opportunities to find those hidden gems? It's not such a well trodden path that everybody's across the trend, like maybe it is for AI or the ageing population, for example.

So, I think even if you do consider the mega trends out there, I still think there are ways to invest in businesses that are small caps that, as I said earlier, might not necessarily be the first derivative or the logical way to look at an exposure, but it might be the second derivative and they still get such a significant up. a benefit from a tailwind that might be a mega tailwind, but they're getting it as a second order effect. And those ideas are far more under-owned and far more under-researched than what you find in the top 50.

And maybe just sort of going back to the top 50 for a second, what impact do you think the rise of passive investing and ETFs index funds is having on proprietary research?

So I think maybe taking it not necessarily just to the ASX 50, but even wider, I mean, what you're saying with index investing is more momentum on the upside and more momentum on the downside by the very nature of how index funds work is that that is a creation of or byproduct of how they invest. So, I think if you're focused on index funds, which are very low cost and a very good asset to invest in, but you might not necessarily be able to get the exact exposures at the percentage ownership or the allocation you want within a certain portfolio that you can within an ETF. It's all in, all out and with the crowd. And it creates more inefficiencies, in my opinion, in the smaller end of the market. As an example, if there's an ASX 200 ETF, obviously that's going to have to own what's in the ASX 200 and a lot of the index momentum follows what's in the index. If you're a business that was in the ASX 200 and you've fallen out for whatever reason, you then have a potential for a significant amount of selling pressure from index funds obviously re-weighting away from you because you're not a company in the ASX 200 anymore.

Which isn't necessarily because you've become a worse company, for example.

You may have had a bad 12 months or whatever it might be. There may be a catalyst for that index removal. But the fact remains is that there's more volatility in the sense of if you're in an index or not in an index, There's probably a heightened level of lack of liquidity for things that aren't in indexes relative to what it used to be five to 10 years ago.

So does that volatility create opportunities for somebody like yourself? If you're seeing it day in and day out, what type of opportunities might it provide?

Yeah, I think it does, definitely. But it depends on your perspective or your lens, your investment horizon, I suppose. So using that theoretical example of a company coming out of an index, if you have a fundamental belief that that particular company is short-term issues potentially, but it's got some really strong long-term investment principles and fundamentals behind it,

So it's just been mispriced on the short term?

Yeah, you might see it as an opportunity to think, well, I know that there's going to be a lot of passive income or passive investing that comes out of said business, and that can be an opportunity. So, yes, I think the mispricing is becoming more pronounced over time. But I don't think that's the be all and end all in terms of the way to look for good quality small caps. I think there's Fundamentally, it's all about looking from our perspective, bottom-up research married with identifying the strong industry tailwinds that we've talked about already.

I just want to go back to the example of the company coming out, because sometimes there can be a fundamental issue with the company. How do you identify what's probably we would call a value trap versus something that's just been mispriced?

So I think first and foremost volatility is part of the course. If you're not willing to put up with volatility in investing generally in equities, but certainly more in small caps than large caps, then this is not the area for you, because there will be drawdowns, there will be ups, there will be downs, and there will be mispricing opportunities. Not every day, but they do occur.

So Robert, going back to the example where a company might just have dropped out of an index for a particular reason, what separates what might be a great company that has just come under a bit of short-term pressure from a value trap?

So yeah in our opinion companies are living breathing things not every day is going to be great not every day is going to be terrible regardless of what business you are so I think you need to take that framing for anything you look at but coming up to your question around what can be a value trap and what can be just a mispriced opportunity or a short-term blip on a long-term growth trajectory is probably comes down to a lot of the fundamentals that we would look for in a business is, A, do they have a high quality management team that have a track record of delivery, regardless of the particular issue that we're facing at the moment? Are they backable and will they get through whatever is happening at the moment? If you've got trust in management and they've got a track record of delivery through certain periods of volatility, that is a great spot to start. B, is the business model broken or fundamentally changed from what it was prior to Yeah, the certain event that has occurred. And C, has the industry changed and the dynamics changed in such a way which should penalise that business for whatever particular reason? And I come back to, you know, overlaying all of that framework, what's the value track versus what's maybe a mispriced opportunity. is fundamentals around their financials. So if their balance sheet is not healthy, and I'll use that by extension by saying if there's significant debt on the balance sheet when they're going through an issue, clearly debt can be an evil for all sorts of reasons, and it's probably the biggest company killer out there. If you're highly geared going into a period of volatility or a period of where a business is struggling, that is not a good spot to be. That has identified potential characteristics of a value trap.

So that would be a red flag for you?

Yeah, well, red flag is a strong word. But yeah, look, in terms of our filters and our criteria, a high cash flow generation business that's generally spending a lot, you know, not much on CapEx, capital expenditure, and also as a lowly deed balance sheet, if any debt at all, are all factors that we certainly put top of top of our list in terms of a quality filter. Coming to the answer of what is a red flag, I mean, yet the way that our filter works that these hopefully we avoid those things to start with. But if we're in a particular business and I won't name names, but things in the past where we believe are red flags that occur is what we always ask for from the management teams or the companies we invest in is you've just got to be consistent. Whether that means you're consistently good or consistently bad, you've got to be transparent with what is occurring and own up to issues and problems and not try and hide it, right? I think the worst thing you can do is try to hide it. So as long as you're consistent and the messaging hasn't changed and your fundamental business and your strategy hasn't changed. So when there's been a drastic change in strategy, That is for us a warning sign whereby that why has that occurred? Yeah, that can be hard to explain. So I think that number one, that is certainly something that we would look for. Obviously, director movements in terms of buying and selling shares. Obviously, directors can sell shares for many reasons, tax, personal obligations, whatever it may be. As the old saying goes, there's lots of reasons why directors may sell shares, but there's only one reason why they buy them. So a buying signal, in our opinion, is probably You're far stronger than a selling signal, but equally you've got to be able to read the tea leaves and look at what's going on.

So all of these signals are indicators of trust that you would have in the management team at the company. Is that a fair summary?

Absolutely. I think that's a very fair summary. And if you think about we're entrusted to invest other people's capital, you want to be doing that by trusting people that you trust yourself, right? So if it's not allowed to that standard, then we certainly don't look to invest.

Are there other qualitative signals or maybe governance or risk issues that you would look at when it comes to a management team?

Yes, yes, definitely. We're a B Corp business ourselves, so naturally that provides a lot of filters and screens which rule a lot of things out. I come back to the point around trust around management teams, and trust is earned. It's not something that you get day one, so you've got to either have a track record where you've proven yourself to be trustworthy, or you haven't done anything to justify not being trusted over a period of time. So I think there's a lot of red flags and governance issues out there. But if you see them as red flags, I think there's some obvious ones out there that we would and a lot of other people no doubt would look at and consider and pause and really kind of reflect on as to why you would invest in those businesses. But ideally, if you've got a management team that you trust, and they're good ones, and the world's not perfect. This doesn't happen all the time. you want to be investing behind what we would describe as winners. And hopefully governance takes care of itself in good quality businesses because it's part of the culture.

How do you stay invested through the cycle then? So a lot of the media commentary around small caps is it's in favour or out of favour depending on sort of market cycles. So I assume much more you've got a longer time horizon. It's a high conviction approach. How do you stay the course over a longer period of time?

So, our personal view is we're not really paid to sit in cash. Our investors pay us to invest in small caps, so that's what we do. And this is certainly not advice in any way, but let's say you have a portfolio of $100. We're not here to say that you should put all of that $100 into small caps. a small meaningful exposure to small caps can be a great way to balance out a wider portfolio. So the way that we would think about investing through the cycle and staying invested is the worst thing you can do in investing generally but certainly in this end of the market is getting kind of scared out at the bottom or selling out when everything is doom and gloom. And there's clearly been some examples of that late, like COVID by far was, in terms of a short, sharp volatility period, like it was remarkable in that no one wants to kind of think about that. that period again but yeah I use an extreme example here with one within our portfolio and at the time the general thematic was everyone get to cash as quickly as possible was something you would see across the investment community and just generally like everyone you know naturally you think it's time to be risk averse I'm going to go to cash and sell everything and You're crystallising losses at the time when you shouldn't be crystallising losses. And I use this specific example, there was a business within our portfolio at the time that had exposure to, it was a tourism related business. Obviously the worst spot to be in COVID and maybe outside of airlines, there are thereabouts. This business got to the point where it was trading below the value of its planes on its balance sheet. So that's ignoring all other assets, all other operating businesses, which in a normal environment producing a strong free cash flow. It was literally trading for less than the asset backing of those planes in a fire sale. It overcorrected? It overcorrected, as things do. And the rest is history in terms of what happened after that. But if you were selling around then, not just in this specific business, but across the board, that's where you're... No one can pick markets, regardless of what people say. Maybe you can pick them once, but you're probably not going to be consistent at picking them. It was luck, right? Like if you're not going to be consistent at doing it year after year, cycle after cycle. So by avoiding putting yourself in a situation where you're trying to time markets and being there for a long term to let compounding take its effect, that is why that is where you make the real gains over time. So it's always time in the market rather than trying to time the market.

As cliche as it sounds, that is the facts. And when we look at this particular part of the investing universe, when you look at your portfolio now, so we've obviously moved on from COVID, we're in a, I'd say there's still probably market upheaval out there. volatility is the price for being invested I guess. What are the particular themes that you really believe will outright any of the volatility that we're seeing at this particular moment in time? Which are the probably maybe two or three themes that you're really quite keen on?

So I might go a bit of a contrarian one at the moment. And yeah, obviously AI is everywhere and the return, the benefits it's providing the world. The motherhood statements are true, and they're true on an individualised basis. This is changing the world. But what it has also done, it has absolutely put the under the microscope software companies, good quality enterprise software companies in Australia. We all know the Wyze Techs and the Zeroes and all of those pro medicuses of the world. And they're, you know, they're in the bigger end of town and the sasspocalypse which occurred.

That was another great headline.

One of the greats, whoever came up with that and SASSMageddon, they've some great headlines out there. Yes, it's kind of been put to one side with everything that's going on in the Middle East, but the facts remain a lot of these businesses, their terminal value is basically have been reduced because of the uncertainty around the future of software companies. And the market, generally speaking, likes to shoot first and ask questions later in the sense of they'll reprice everything down and see who wins later on rather than take a selective approach day one.

Fair enough. So you're winnowing everybody out and the survivors will buckle up again.

And there will be survivors. There will be businesses that are not survivors in the software space. Yeah, but there will be plenty of businesses, high quality companies out there. And we've seen a lot of the meetings we've had of late and a lot of the rhetoric you hear out of you know, the good quality enterprise software companies, they stand to benefit from what has occurred, not only from being able to monetize their products better and offer new solutions to their customers, but also improve efficiencies around their own business and actually do more with less.

So the software sector, that's a great example, it's probably over-corrected and the winners will rise to the top again and the people who've stayed invested in them will probably do quite well. What other similar incidences or examples can you provide, but you see on a day-to-day basis?

So a very specific one is what is occurring in the lead-ups of Brisbane 2032 Olympics. But some facts around this is there is a start date for the Brisbane 2032 Olympics that needs to be met. And what is typically the case in the building industry is there are delays and whatnot. And there's always cost overruns in Olympics. If you look at the empirical evidence, there's always been cost overruns in the build out for Olympics. There's a start date and you can't mess that up. So working backwards from that, businesses that have exposure over the next few years as a five or six year lead up cycle to a traditional build for an Olympic Games, there is a significant amount of money and spend that is going to be funded by the federal government, the Queensland state government and obviously as well as all sorts of other private businesses and infrastructure that is going to go into investing in the Brisbane Olympics.

And I can tell you they haven't started the stadium yet.

No, they have not. I think early contractor engagement for some of the projects is where you get the sense of starting reading from some of the rhetoric from the companies with exposure is kind of late this calendar year, if not first half calendar year 2027. So, there is a bow wave of... building and construction activity that has to happen in South East Queensland over and above what is already a buoyant population. So we believe some businesses that have certain industry tailwinds and exposures to South East Queensland that are providers of concrete, timber form ply, labour services into this Brisbane 2032 opportunity is a medium to long term tailwind. And then the subsequent effects of that after the Olympics, but it's a long way down the track from now, is typically there's a rollover period. Things are quite buoyant for a few years afterwards.

So while the population demographics moving into South East Queensland alone, let alone the Olympics, you know, there's a struggle to development of housing, right? So there's, I'm from Brisbane, Not originally, but live there at the moment. I can tell you now, trying to do a renovation or any work on a house in Brisbane is impossible. You cannot get trades. It just doesn't happen. And anecdotally, a friend of mine who is doing a renovation trying to get concrete poured. His builder had to book the concrete pour four months in advance and pick a day for it to be delivered. So you can imagine that if that goes wrong or if something else happens, there's a delay or whatever. If you miss that window, you lose it.

That's remarkable.

And that's now before any of the other stuff is about to happen.

And you're also going to see for the labour shortages, which Construction Skills Queensland is predicting is going to be very significant in 2028, 2029 type timeframe, it's going to be a massive, I suppose, pull factor or a drain on resources in the southern states, because it's a very compelling opportunity where there's guaranteed work. So I think that labour shortage might get better for Queensland in the medium term, but it'll hurt.

It might hurt other markets out there which are already in labour shortages in certain sectors. So that ends up pushing up labour prices where you can get the resource in other states? Yeah, possibly. It looks like more people are coming to South East Queensland. Not a bad place to be, I don't think. Not a bad place to be. So going back to maybe sort of the portfolio that you construct, for an investor who maybe is looking at this part of the market for the very first time, what does a high conviction portfolio, what does that actually mean and what does that look like in practice?

So I think different people will have different definitions on what they construe to be high conviction. In our case, we think between that 10 to 20 companies type range is what we consider to be high conviction, where you've got meaningful stakes that have the ability to meaningfully outperform, if they do so. Where conviction, I suppose, needs to be clarified further is you might have conviction and look 10 people might jump at seeing 10 or 20 stocks within a portfolio but it's about in our opinion about having industry diversification within those particular companies so a bad example but let's say you have 15 stocks you probably don't want to have five companies that are all exposed to say the automotive sector right you you might have one and then you have something that's completely different and you build a portfolio in terms of resilience and diversification through industry diversification as opposed to the quantity of businesses within that kind of framing. And I suppose taking it one step further is, again, conviction, people may consider that risk. But risk, in our opinion, you can look one step further than the number of companies that you hold or even the number industries you've got exposure to and looking at the underlying fundamentals of the businesses within a certain portfolio. So, if you've got a company, a portfolio of 15 companies, but they've all got really strong balance sheets and then net cash positions and they're generating a lot of free cash flow relative to the size of those companies, that's a far more risk adjusted opportunity than a business that has a very high level of debt, regardless of how many companies you've got. If you've got 100 businesses in a portfolio that are all highly geared, I would argue that's a more high risk proposition than a portfolio of 15 companies that, regardless of what size they are, are high quality businesses.

You might as well just buy yourself an index trucker. Exactly. So what Would an investor looking to invest in this sector, what should they again generally just consider? Are there any sort of, I won't use the term red flags again, but you know, are there any things that you would recommend they watch out for?

That's a good question. I think Yeah, there's a lot of people out there that say, if you start with investing, start with things you know and you see in your day-to-day life. And that's the Peter Lynch theory. If you see something three times or you use it every day, then you probably consider yourself to be a customer of that business and you've probably got a reasonable idea on the quality of what they produce.

And therefore, if you're continuing to use the product on a day-to-day basis, they've probably got a reasonable product market fit.

Yeah. So, you know, I remember and again, this is years ago, but I remember a lot of people were using Afterpay in their daily lives and then they became shareholders because they use it. They realized it was such a good product for what they needed it for and then they became shareholders and hopefully some of them were happy shareholders. So coming back to your question, I think really comes down to finding areas where you've got interests in and then looking for or identifying tailwinds like we do. Yeah, it's not hard to read the papers and see what are some of the kind of big kind of thematics out there that are going to drive not only GDB growth but all sorts of improvements across all sorts of areas over a long period of time and then looking and trying narrowing that down into businesses and you can use all sorts of screens around quality in terms of financials etc to narrow that down further.

And if I'm looking at a professional or a fund manager who's in this space, what are the things that differentiate NAOS for example? When I'm looking at a fund manager I'm entrusting them with my capital, there's obviously got to be some trust there. What else should I consider when I think about the manager?

So I think a few things that we like to consider about ourselves and we think are important for investors to look out for you know for anyone is as I said earlier on if you're investing in this area you probably want to have a long-term mindset so investing versus speculating clearly two very different things so I think you want to look for investment professionals in this area which have a long term mindset about the way they go about investing. Because if they don't, then volatility and if they're trading volatility in a small cap end of the market. that is a recipe for disappointment, I suppose, because you're not banking and you're not giving companies enough time to be able to compound their growth and potentially experience significant multiple advantage over time, like we come back to the large caps of tomorrow are born in the small caps of today.

And it's the compounding over time that makes them so.

Absolutely and I think secondly as well is something that we like to be is very transparent and I've talked a lot about I suppose trusting management teams and looking to identify and invest behind people we believe are quality. So if we're doing that then we should ourselves be investors within our own vehicles and be transparent and consistent with our investors as much as we hope to be treated in the same way by yeah, by the companies that we invest in.

So skin in the game always grows?

Skin in the game, yep, yep. Being transparent, consistent and not changing a strategy. Just basically everything we've said about the companies we look for, we try to adopt and use the same framework for how we run our own business as well.

Well, that's a great way to sum up things for investors to think about when they're investing in this side of the market, Robert. So, Robert Miller for Meos, thank you very much for your insights on the small caps today.

Thanks for having me on, Darren. Appreciate it.

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