Why you should be looking at Quality Australian Small Caps?

Elston Australian Emerging Leaders Fund manages a concentrated, high-conviction, quality-focused portfolio of companies outside the ASX 100.

Our speaker is Mr. Gary McHale, the Associate Portfolio Manager of Elston.

Gary's topic today is why should we be looking at quality Australian small-cap?

Welcome, Gary.

Thank you.

Yes, my name is Gary Merkle.

I'm the Associate Portfolio Manager at Elston Asset Management and one of the team members from the Elston Australian Emerging Leaders Fund.

Really appreciate the opportunity today to present.

The discussion topic we are presenting on is we think the time is right to invest in a fleet of quality small companies.

Said in other ways, we think the time's right to be looking at

small cap ASX with companies that have quality attributes.

Before we begin, this is just a standard disclaimer.

This material has been prepared for general information purposes only and not as specific advice to any particular person.

So we wanted to set the stage by making a case for why quality small caps are a good investment on a standalone basis.

Firstly, hopefully everyone's familiar with this small cap premium.

There's been a lot of academic research in the past that has looked into how smaller companies can outperform.

Similarly, there's been academic research around how quality companies also tend to outperform.

So we think combining those two factors are a good exposure to have long term investors.

I wanted to note that

Now, particularly for the ASX, the smaller end of the market is an under-researched universe.

There's not a lot of analysts cover the companies in this part of the market.

And so we think that creates pretty substantial disconnects between market prices and intrinsic value, which is really good for the diligent investor that's willing to do the work.

And then finally, we take a concentrated portfolio approach.

We think you can get an adequate level of diversification with as few as 20 to 25 holdings.

The reason why we like this sort of concentrated portfolio approach is it allows us to maintain a very high level of quality in the portfolio.

And it also allows you to fill the portfolio up with really your best ideas.

So there's a,

a few academic papers that are listed at the back of the bottom of this slide for anyone that would like to do any sort of follow up reading around diversification and portfolio concentration.

So it shouldn't come as any surprise that small companies and the economy more broadly are facing pretty big headwinds at the moment in very high levels of inflation, increasing interest rates, the war in Ukraine,

fluctuating asset prices and potentially a softening consumer.

This has led to a very volatile year for the small ordinaries.

So if you look at the bar chart on this slide, the light blue is the XSO, which is the small ordinaries index, and the dark blue is the XTO being the ASX 100.

So now there's a couple of interesting things to note.

Firstly, calendar year 2022 was one of the most volatile years over the past 20 for the small order index.

But more interestingly, the differential in volatility was the biggest in the past 20 years.

And that sort of segues us into this next chart.

So what we've done here, we've grouped the index into buckets.

So you've got the top 50 being that

darker orange, the mid 50 being the gray and the gold yellow colored line being the small odds index.

And as you can see, the top 50 has held up really well since December, 2021.

Then when the outlook for inflation and monetary policy changed pretty materially.

The mid cap 50 had a pretty significant drawdown through to June, 2022.

The post that has recovered pretty well.

the small ordinaries index have sold off more aggressively and then it's really range traded off the bottom.

So we think that this shows that there's been risk off in small caps and there's a pretty material sort of discount that has emerged as investors have sort of taken covering the larger counterparts.

And we think it's presenting a tremendous opportunity.

And this,

This next slide also looks at it, the ASX 100 relative to the small ordinaries.

And we're looking at it from an earnings perspective.

So it's the relative PE between the top entries.

And this is also suggesting when you look at it from an earnings perspective, that the small ordinaries is trading at a discount at the moment and further suggesting that

there's a pretty good discount and opportunity that has emerged in this part of the market.

So far we've talked about the emerging discount within the small ordinary space relative to the broader market.

Now we wanted to move to why we think companies with quality characteristics are best suited to deal with the macro headwinds that we alluded to earlier.

And it really sort of starts with the sustainable competitive advantages that high quality companies tend to have that allows them to invest capital at high rates of return, which typically leads to taking market share and generating high organic growth rates, which is we think really important in potentially what's going to be a low growth environment as the economy slows.

They also are generally able to generate

high gross margins, which is really important when you're dealing with fluctuations in input prices.

So it allows them to sort of manage the inflationary pressures better.

Strong pricing power.

That's been something that's been very evident over the past 12 to 24 months in the quality companies that we follow.

They've been able to push on those inflationary pressures quite well and sort of manage their margins.

And then finally, quality companies tend to be capital light.

So, conservative balance sheets, low levels of gearing.

This reduces the risk of high interest rates, creating a greater sort of debt burdening obligation for these companies.

There's a lot of their counterparts that will be feeling the pinch from higher interest rates.

That's not the case for quality companies.

They'll be able to manage that quite well.

So,

On this slide, we've listed six high conviction ideas, high quality companies, Templin, Webster, Nanosonics, Ordinate, Polinovo, Megaport, Breville.

They have all the characteristics that we talked about on the prior slide.

We think these businesses are really well positioned to manage their way through the economic challenges over the next 12 to 24 months and come out the other side stronger.

One company that I would particularly suggest having a look at would be Ordinate.

We think that they've got an incredibly strong, sustainable competitive advantage and the opportunity ahead for that business is really appealing.

But after this, if anyone would like to talk about these companies or any of the other companies that we hold in the portfolio, we'd be very happy to chat.

And then just to finish up, I wanted to introduce

Elston for people that aren't familiar with the business.

Elston's navigated ups and downs for over a decade.

When I joined Elston, it was back in 2015.

We had less than a billion in assets under management at that point.

Since then, the assets under management have gone up fivefold, which I'm tremendously proud of the success of the business.

There's a lot of factors that have contributed to that, but we like to think that it's the growth mindset and focus on continual improvement that the business has that has really sort of been the driving force behind the success of the business over that period.

Today we've talked about, this presentation has been in relation to the Elston Australian Emerging Leader Strategy, which is actively managed, small cap strategy, quality focus,

long term fundamental approach is concentrated with high active share.

But we wanted to also highlight that we have other Australian equity capabilities, being in the Elston Australian large company strategy, which is style neutral, top 100 strategy, low cost, transparent, actively managed, it works really, we think it fits really well as a core exposure when it within an

Australian equities portfolio.

And we also think that it blends really well with other small cap managers and long short managers.

And then just finally, just wanted to finish up with this photo of the broader asset management team.

It takes a big team of skilled and experienced people to deliver high quality investment products.

So on that note, just wanted to

thank everyone and pause for questions.

Thank you, Gary.

I do have a few questions for you.

You mentioned quality a few times in your presentation and we see different interpretations of quality in the market.

So what does quality really mean to the Alstom emerging leaders?

Yeah, that's a really interesting question.

So if you look at quality from a quantitative perspective,

it's generally high returning businesses, businesses with high gross margins and conservative ballot sheets that are characterized as quality.

But the issue you have with that is it's all backwards looking.

And so we have qualitative and quantitative attributes that we look at to assess whether or not a business is going to be able to maintain quality throughout our five-year investment horizon.

And so some of the things that we look at is supportive industry structure,

wide moats.

We look for businesses with financial strength, so conservative balance sheets, robust organic growth rates, good management, good corporate culture.

And generally we try to avoid businesses with ESG risk.

And in your portfolio, I see that you hold some consumer facing type of businesses.

Do you have a concern about a slowing consumer environment?

Yes.

Um, look, it's, it's, it's an incredibly dynamic environment at the moment.

And, you know, we like to sort of prepare for, you know, I guess a badder scenario.

So, um, you know, we are forecasting and expecting a pretty challenging period for consumers.

Um, but the consumer facing businesses that we have in the portfolio, you know, all have structural tailwinds and robust balance sheets that, you know, really give us confidence that,

they'll be able to sort of navigate their way through this challenging period and then come out the other side stronger.

And we think the ones that we hold in the portfolio will make a very attractive return over our five-year investment horizon.

Well, thank you, Gary.

Have a good night.

Great to see you.