Small caps investing: what's the big idea?

12 July 2011

Small caps stocks represent just over 8 per cent of the Australian equity market. Due to limited broker coverage and company data, these stocks can be difficult to value without the right tools and insights. John Campbell and Jeremy Bendeich, Portfolio Managers of the Bennelong Avoca Emerging Leaders Fund, discuss the principles guiding their investment decisions and what sets them apart from other small caps investors.

As seasoned small-caps investors, we have deep knowledge of Australian smaller companies. With a proven investment process anchored on fundamental research, we're well-positioned to exploit market inefficiencies and calculate a stock's intrinsic value. Using rigorous analysis and financial modelling, we aim to add value by investing only in companies we believe can generate alpha.

While fundamental research is at the core of our investment process, there are eight investment axioms that also guide our decisions and shape our portfolio.

Avoca's eight investment axioms  
1. We only invest in businesses we understand 2. Management honesty and quality are paramount
3. The business model must be financially sustainable 4. We seek out non-consensus information
5. Good businesses will usually struggle in poor industries 6. Market structure changes are powerful drivers of returns
7. We rarely participate in IPOs 8. High conviction plus cheap stocks equals portfolio inclusion

We explore some of these principles and how they're applied to the management of our portfolios.

Sound management, robust business models paramount

As professional investors, we have access to company management. Company visits and dialogue with management allow us to deepen our understanding of businesses within our investable universe. The insights and data we glean from these meetings assist idea generation.

Over time, we've witnessed a vast spectrum of management quality in the small-caps sector. We've seen how it affects business performance and ultimately, returns. Consequently, we reject companies with arguably poorer quality or untested leadership and only invest in businesses whose management we deem credible. We believe businesses with proven leadership who can clearly articulate their business vision and demonstrate success have greater potential to generate alpha.

Similarly, we consider companies with robust business models likely to outperform. Before considering a stock as a candidate, we must fully understand the business franchise, appreciating how it intends to generate revenue and create shareholder value.

The Babcock & Brown stable of companies illustrates these principles in practice. Despite our meetings with management, we were unable to form a clear view of the business' financial sustainability. On this basis we didn't hold the stock, which proved a salient decision. During the global financial crisis, Babcock & Brown's share price fell sharply, the business model failed to hold and eventually, the company liquidated.

Clear paths to profitability

We favour companies with maintainable cash flows and generally avoid negative cash-flow companies unless they can demonstrate clear paths to profitability in the near term. Cash-flow positive businesses mean we can value them on a discounted-cash-flow basis.

Conversely, we discount companies with ‘blue sky' thinking. In our view, these businesses are untested with limited data points with which to determine their innate value. Speculative exploration resource companies are prime examples. Relying on luck, they're generally unable to demonstrate past performance or their future earnings potential. Investing on chance is not part of our philosophy. We do, however, invest in resources stocks that meet our strict investment criteria.


We rarely invest in Initial Public Offerings (IPOs). Given our experience on both the buy and sell sides of investing, we have a healthy degree of cynicism regarding vendors' motivations to sell, particularly those of private equity sellers. Typically, we find vendors know more about the value of a listing company than what we as buyers can ascertain, making it difficult for us to determine the stock's intrinsic value.

Given our experience and empirical testing, we believe IPOs to be problematic in generating returns. To illustrate this point, we back-tested every float in Australia over $100 million since 2000. We found that on a one-, two- and three-year basis, the median IPO did not add alpha.

A case in point is Silicon Valley technology company, Arasor. Wanting to develop components for a laser television, Arasor sought funding through an IPO choosing to list on the Australian Stock Exchange. Not only did we fail to understand their intention to list overseas or the idea behind the laser TV, our analysis uncovered poor management, unsustainable business practices and a history of floats during the technology bubble that lost significant value. As result, we did not buy at IPO or subsequently hold the stock. The company has since been delisted.

Not swayed by momentum

We're acutely aware of momentum in the market. However, our fundamental valuation anchors ensure we value companies based on discounted cash flows rather than sentiment or market impetus. Our strong buy and sell discipline ensures we enter or exit stocks trading below or above what we believe to be their intrinsic value. We don't simply hold stocks in the hope they'll outperform. We consider momentum to be like investing in musical chairs: we don't want to be the last one holding the stock when the music stops.

Market structure changes can drive returns

The economies of arguably the world's two super powers, USA and China, have significantly impacted world asset values. Quantitative easing in the US and loose policy in China have led to near-zero real interest rates in both countries. As a result, investors have invested in other assets, including equities, whose values we believe have become artificially inflated. In particular, we've seen momentum cause commodity stocks to look overvalued. Consequently, we see this as an opportunity to consider undervalued industrial stocks for inclusion in our portfolios.

Risk/reward trade-off

Every investment carries risk. Small caps are no exception and are arguably more risky than large caps. Individual investors may therefore find investing in the small-caps sector difficult compared to professional investors because:

  • small caps stocks lack broker coverage and market information compared to large caps;
  • achieving a reasonable degree of diversification may mean investing in at least 20 stocks; and
  • small caps stocks can be harder and more expensive to trade due to wider buy/sell spreads.

Despite the risks, small caps have the potential to grow in value quickly thanks to their size, ability to react faster to external change and exploit opportunities larger companies cannot afford to chase due to larger overheads.

Managing risk in our portfolios and being considerate of economic factors is paramount. We construct portfolios aware of the inherent risks and apply a strong risk-control framework to balance the risk/reward trade-off.

Professional investors with unique insights

Small caps stocks present significant growth opportunities. With a proven process, extensive experience in the sector and guided by our investment axioms, we're well-positioned to deliver alpha. As operators and owners of Avoca Investment Management, Bennelong's small caps boutique, we're empowered, not employed, so our interests are therefore culturally aligned with our clients.



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