Why now is the best time to invest in small caps.

Our last speaker of tonight's Australian Perspectives is the founder and chairman of Montgomery Investment Management, Mr. Roger Montgomery.

Montgomery Russin's investment philosophy is guided by fundamental research and analysis.

Small market capitalization companies are relatively under-researched, and when markets misprice securities,

This creates investment opportunities.

They see to be a portfolio of high quality, undervalued, small and emerging companies with a strong growth potential and likely to benefit from secular trends, industry change, and with substantial competitive advantages

Roger Montgomery founded Montgomery Investment Management in 2010.

He has over three decades of experience in funds management and related activities, including equity analysis, equity and derivatives strategy, trading and stockbroking.

Prior to Montgomery, Roger held positions at Altmanet, Jordan Fleming,

BT Australia Limited, and Merrill Lynch.

Roger is the author of best-selling investment book, Value Dog Able.

Roger also appears regularly on television and radio and in the press, including ABC's statewide drive radio program, The Australian and Auspice.

Roger's topic is why now is the best time to invest in small caps.

Welcome, Roger.

Thank you very much.

Great to be with you.

Really appreciate the opportunity to be talking with everyone today.

My presentation is really an argument for investing in small caps right now.

Now, we only have a few minutes together, so I won't be able to present all of the data, particularly some really compelling arithmetic around why investing when PE ratios are low

is almost certain to provide attractive returns, especially in small caps.

We won't have time for all of that, but what I will do is I'll present the outline of the arguments for investing in small caps now.

Our small cap fund, the Montgomery Small Companies Fund, is run by Gary Rollo and Dominic Rose, and they have a significant number of decades of small cap specialist experience.

And so in the back of my mind, as I present to you, I'm thinking about what they're doing, what stocks they're interested in and the fund that they manage.

So with that, let me proceed.

Very importantly, I don't know your financial circumstances and needs.

So the information I share today is not specific individual advice.

Rather, it's general in nature.

Any returns that I talk about are past returns.

They're not a reliable

guide to future returns.

And perhaps most importantly, if I speak about a stock, it's not a recommendation to go and buy that particular stock.

It is a company that we already own.

And so if you rush out and buy it, you'll be assisting us by pushing the share price up.

And of course, I won't be coming back to you to tell you when we're no longer buying the stock or when we're selling the stock.

So keep that in mind.

So why small companies?

Well, one of the big things that changed in Australia earlier this year is the Future Fund, our sovereign wealth fund, if you like, switched from having a very, very large focus on index funds and index investing to becoming a stock picker again by actually investing in active funds.

with a particular focus on small caps.

So one of the arguments is that if the very successful and very large Australian Future Fund is willing to invest in small caps again, it's worth prosecuting the argument for doing so, or at least exploring why they might be doing that.

Firstly, we can see globally, not just domestically, but globally that we're looking at one of the widest dispersions between large caps or mega caps and small caps that we've seen in a very, very long time.

In fact, we have to go all the way back to the tech wreck to find a period back in 2000 to find a period where small caps had underperformed by as much

as mega caps or just prior to the tech wreck rather.

And you can see now the gap, the dispersion if you like, or the gap between the performance of small caps as measured by the S&P 600 index and the mega caps.

And this is, by the way, just the largest seven companies in the S&P

500, but you can see that dispersion is very, very large indeed.

Now, typically what happens, there is a mean reversion, we'll talk about that in more detail, but what often happens is the large caps are pushed to a level, and we'll talk about why they've been pushed up as much as they have in just a moment, they get pushed to a level where their valuations or their pricing is no longer reasonable nor attractive.

And so investors then move down

the spectrum of valuation and perhaps the spectrum of capitalisation, to find companies with similar themes that are better value.

And then they follow, they start to rise in price as well.

And so perhaps that's a scenario that we're on the cusp of seeing.

I don't know, but it is a compelling argument for investing for better returns in the future by investing in the cheaper small caps now.

And locally valuations are also extremely attractive.

In recent months,

investors have moved towards large caps because, number one, they're more liquid, obviously, and there's a sense of safety or a perception of safety there.

And also, with the expectations of a recession, there's a belief that the broader revenue streams being generated by large-cap companies will render them more defensive.

and so they'll tend to perform better if a recession does ensue.

And we might have a technical recession in Australia, but I'm not sure we're going to have the kind of recession that I witnessed back in the early 1990s, when quite literally in Melbourne, for example, one of every three shops was boarded up, unemployment was close to 11%, and short of tumbleweed blowing across the street, many suburbs in Australia were ghost towns.

or many shopping strips in those suburbs were ghost towns.

We're not expecting a recession anything like that.

Remember employment both here and in the United States is above full employment and so any recession that we have is likely to be by definition only

rather than that sort of experience that I just described in the early 1990s.

Nevertheless, the fear of those recessions has driven many investors to large caps and consequently small caps, which are perceived as riskier and less liquid.

And they're more leveraged to economic cycles have been left behind.

And in fact, if we look at the Australian data and this chart shows it here,

The gap, if you like, or the dispersion or the relative undervaluation of small caps is the largest it's been since the year 2000.

Remember what I said earlier, I should say we're not talking about investing in the indices here.

I'm going to be talking about individual small companies.

And if you're investing in high quality small companies, it's worth remembering that the lower the price you pay, the higher your return is going to be.

The higher the price you pay, the lower your return.

So it makes sense to be a contrarian and to be investing in companies that are on the nose, so to speak, that are out of favour.

And this chart shows that small caps

are definitely out of favour and the most out of favour relative to large caps that they've been in almost quarter of a century.

If we look at a shorter period of time, just over the last 12 months, then what we can see here is that in terms of factors, the worst performing factor has been being small.

Simply being a small cap has been the worst performing investment or investment characteristic and that will eventually mean revert and we'll talk more about that

in just a moment.

So we've got global small caps, relatively the cheapest they've been compared to large caps since 2000.

In Australia, the same thing, the valuation of small caps is the relative cheapest.

It's been to the top 100 for a quarter of a century.

And as a factor, smalls have underperformed the most of any factor.

considering quality, momentum, growth, dividend yield and so on, just being small has been the worst burden for a company's share price in the last 12 months in Australia.

So now is the right time to be thinking about small caps simply because they are relatively cheap.

But again, I press the point that I'm

thinking about high quality small companies, not just a shotgun approach, invest in small companies because they're small.

You have to be investing in quality businesses and by quality I mean businesses with competitive advantages.

Competitive advantages are measured by a high rate of return on equity, a sustainably high rate of return on incremental capital.

The most valuable competitive advantage of all is the ability to raise prices without a detrimental impact on unit sales volume.

So when I talk about investing in small caps, I'm referring specifically to high quality businesses, those that are generating high rates of return on equity, they perhaps have little or no debt, they have long runways for growth, large total addressable markets and so on.

With that in mind, what are some of the benefits of investing in small caps?

Firstly, there's something we call reversion to the mean in financial markets.

They tend to revert.

If small caps are underperforming, at some point in the next 5 or 10 years, small caps will be outperforming again.

They will outperform large caps.

If you wait for that to appear, it will be too late.

You'll be paying a relatively or absolutely high price for those shares.

The time to be investing is when the market for small caps is mispriced on the downside as I believe it is now.

The other benefit of course is diversification.

Given the massive underperformance of small caps versus large caps, clearly they're uncorrelated or

there's a low correlation to large caps and that will stand an investor in good stead in terms of diversification because if large caps go sideways or underperform in the next two, three, five years and small caps outperform, that lack of correlation or that low correlation will benefit from a diversification perspective.

And of course, we know that there's inefficiencies in small caps.

Quite frankly, stockbrokers don't make as much money broking small caps because they are smaller.

There are fewer investors who are interested in them, so they're not as closely followed.

That can lead to mispricing and market inefficiencies, which we believe is the case right now.

And, of course, there's the potential for outperformance because small caps tend to be leveraged to economic recovery.

And I mentioned earlier I think this recession will be a shallow recession.

I've been saying that since November last year.

I write for the Australian newspaper every fortnight and in an article in November last year I said the time

to invest in small caps is now.

It will be a good year for markets this year.

That's certainly been the case for innovative technology companies.

They're up, the Nasdaq's up over 30% this year.

And I also said that I don't think we'll see a deep recession.

We may not see a recession at all.

Best case scenario or worst case scenario, I think, is a shallow recession.

So once we come out of the other side of that, it will be risk on again.

Investors will start wanting to adopt risk

and they'll be looking for opportunities amongst small caps and we'll see that mean reversion play out.

Ultimately, a balanced portfolio with a mix of funds that are invested across different asset classes, different sectors and different company sizes is usually the best strategy for wealth creation.

So I think now is an excellent time to be investing in small caps.

Couple of companies that I think are worthy of investigation.

I've got two here that I'm going to present.

The first one is Macquarie Technology Group.

We love this business.

We know management very, very well.

Gary and Dom meet with the Tudhope brothers frequently, and it's important to note that they are the largest single shareholders

in this company.

This is an operator of data centers.

Data centers obviously leverage to the enterprise move to the cloud, which is leveling the playing field for businesses, large and small.

And so we're seeing a lot of smaller businesses and medium-sized enterprises move to the cloud.

These guys are at the forefront of that particular trend.

And there's a lot of talk of AI at the moment.

Again, this business is leveraged to that because AI sits in the cloud.

All those powerful computers that drive large language models are sitting in data centers.

And those data centers need to be relatively close to their customers.

And so geographically, it's important to find data centers that are close to those major customers, which Macquarie Technology Group is.

They've doubled their footprint in a relatively short space of time.

They're continuing to expand and perhaps most importantly,

We think that there's takeover potential for this business once they're fully developed and those data centres, those three major data centres that they own are fully tenanted.

It will become a property trust, if you like, with a very attractive rental yield that we think will be attractive to overseas pension funds, for example.

We think that could be an exit strategy for the Tude Hopes when they look to exit.

The second business that we like and is leveraged to one particular trend that we're fond of is Breville.

Breville is priced like it's a retailer, but it doesn't own any retail, it doesn't have a retail presence.

It doesn't own stores, it doesn't lease stores.

It is a designer, an inventor, and a manufacturer, and it sells through other retail stores.

In the United States, which is where we think much of its growth is going to come from, it's leveraged to the trend of the home barista.

In Australia and across Asia, for example, we're familiar with good coffee.

The United States is not familiar with great coffee.

And for many years, it's only really on the East Coast and the West Coast that they care very much about quality coffee.

But obviously, over time,

that will change and people will want to bring that really great coffee experience home.

That means they'll be buying coffee machines and putting them in their homes.

It's normal in Australia.

It's normal in Europe.

Doing that has been around for half a century in Europe or more, 75 years or more in Europe.

But in the United States, it's a relatively new concept.

and Breville is leveraged to that particular theme.

It's growing very, very well.

It has high rates of return on equity, which suggests it's got a competitive advantage.

We believe that that's embedded in its brand and the perceived quality of its products.

and its share prices off considerably given how disliked small caps are at the moment.

So there's two examples that we really like in the small cap spaces I noted right at the beginning of the presentation.

It's important to note we own these businesses, so please don't rush out and buy them without seeking personal professional advice.

And that's all I've got time for.

I do hope that you enjoyed the presentation.

I look forward to your questions.

Thank you, Roger.

I do have a couple of questions for you.

Thank you.

First one is to summarise for our viewers, what are the top three reasons people should invest in a small-cap fund right now?

Diversification, growth and

And many funds, many small cap funds have underperformed.

If that performance is due to undervaluation, then that is a compelling reason to be investing in small cap actively managed funds today.

And if I can give you a fourth, the Future Fund, which has been very successful timing its investments with active managers or in passive, has just switched to active small cap management.

Right.

And when researching a small company to invest, what are the characteristics and competitive advantages of the small cap companies that you and your team are looking for?

Well, I think with small caps, one of the most important things, and I didn't talk about this in the presentation, but it adds to what I've already said, the management is really, really important.

It's worth spending some time conducting due diligence on the people running the business and having a look at what their previous experiences have been.

In many cases, CEOs and management teams of smaller companies have been with other small companies in the past, they've grown those businesses and unsold them.

And a track record of doing that is a great sign and something to look out for.

Yep, makes sense.

Well thank you Roger, great to see you.

Take care.

It's a great pleasure to be with you and thank you for having me as part of your conference.