Investors looking for opportunities in the small cap end of the Australian equity market should focus on companies that include international expansion as part of their business strategy.
This is the approach that has been taken by a couple of successful small cap equity managers, Ophir Asset Management and Clime Asset Management.
In a new research paper, Ophir says that in the past international expansion could be a graveyard for Australian companies. The big banks, AMP and Wesfarmers, to name a few, made moves offshore through acquisitions and ended up destroying billions of dollars of shareholder value.
Ophir’s research paper, The Offshore Growers, argues that in recent years a new generation of companies has moved offshore and achieved success. They include a2 Milk, Afterpay Touch, Domino’s, litigation funder IMF Bentham, retailer Lovisa, accounting software provider Xero and nearmap.
“Offshore growers” have outpaced the broader Small Ordinaries Accumulation Index by a wide margin.
“These companies are a vital component of investors’ portfolios because they are delivering growth at a time when the domestic economy is slowing,” the paper says.
They have benefited from a number of developments, including globalisation. While investors are focused on the US-China trade war, it is worth keeping in mind that Australia has 11 free trade agreements, which make it much easier and cheaper for Australian companies to do business internationally.
Technology makes it easier for companies to expand overseas because they have better means to control their global operations.
Social media allows companies to build their brands quickly around the world.
And companies that have made the move offshore successfully say they have had the benefit of boards whose directors are younger and have not been scarred by failed offshore ventures.
The Ophir High Conviction Fund invests in companies outside the S&P/ASX 50. Over the 12 months to the end of August the fund has produced a return of 6.4 per cent, compared with 1.4 per cent for its benchmark – the ASX Mid-Small Accumulation Index.
Over the past three years it has returned an average of 16 per cent a year, compared with 9.2 per cent a year for the index.
Its top holdings are Afterpay Touch, Cleanaway Waste Management, NextDC, Resmed and Xero.
Clime Asset Management’s smaller companies portfolio manager, Jonathan Wilson, agrees that there have been a number of structural changes that account for the successful offshore expansion of a number of local companies.
But Wilson says there are other factors that distinguishes small companies moving offshore from big ones. “A lot of small companies have owner-managers. They are very conscious of share capital,” he says.
Another factor is that some small company offshore moves are demand driven. They are asked to go offshore. An example is audio networking company Audinate.
“When you have that demand led expansion you have a better chance,” Wilson says.
He says large cap company earnings grew only 2 per cent in 2018/19 and are under pressure this year as well.
Small caps are forecast to grow their earnings 20 per cent in the current financial year and 8 per cent in 2020/21
“There is a substantial growth opportunity in small caps for a small premium,” Wilson says.
Most of the stocks in the Clime Smaller Companies Fund have international growth profiles. The fund has an overweight position in tech stocks, including Audinate and EOS a space technology and defence technology company. It also holds Jumbo, the online lottery business.
A number of its holdings were small caps when they first invested but have since entered the ASX 200. They include Bravura, Collins Food, HUB 24 and Afterpay.
The Clime Smaller Companies Fund was launched in April 2017. Over the 12 months to the end of August, it has produced a return of 17 per cent, compared with a 12.3 per cent gin for its benchmark, which is a blend of the Small Ordinaries Index and the Emerging Companies Accumulation Index.
Over the past six months the fund is up 24 per cent, compared with a 7.2 per cent rise in its benchmark.