The microcap opportunity

For this week’s fund manager interview we’re speaking with Carlos Gil, who is the Chief Investment Officer and CEO of Microequities Asset Management. We last chatted with Carlos in August last year, so we’ve got him on again to discuss how he’s navigated through 2020 in the microcap space and what he’s looking out for next year, plus a few of his favourite microcap stocks currently.

Here’s Carlos Gil, the CEO of Microequities Asset Management.

Table of contents:
Benefits of micro and small-caps
Navigating through COVID
Investment criteria
Deep Value Fund performance
Global Microcap Fund
High Income Value Fund
Outlook for 2021

Carlos, you’re obviously specialised in the microcap end of the market. Could you start off by explaining what unique benefits there are of investing in this area?

Yeah. We manage both small-caps and microcaps as a specialised asset class and the reason why we’re attracted to investing in this asset class is predominantly because the asset class presents investors with the best long-term growth prospect. If you think about your overall long-term investment returns as being highly correlated to the underlying growth that businesses can engender and achieve, then it is a true generalisation that small companies and microcap companies will outgrow both mid-sized and definitely large companies.

Some of the largest companies today in the ASX100 have their origins in our asset class. This is a fertile hunting ground for investors that are looking to park long-term growth capital and we think ultimately if you choose wisely and can deploy your capital wisely, you will achieve better long-term rates of return than say, investing in mid-cap or large-cap companies.

The second element why we like this asset class is we are value investors and that means that we look to ascertain companies that are going to grow over the long-term but also identify businesses whose intrinsic valuations are well ahead of their market cap prices. The part that we like about our asset class is that it is pricing inefficient, that is market prices do not necessarily equal intrinsic valuations and there is mispricing of businesses and therefore we can identify and find businesses that have very much larger intrinsic values than their current market prices. There are other reasons but those are the two principal reasons that we think this asset class is attractive to long-term investors.

You just mentioned there you describe yourselves as long-term value investors. I just wanted to get your perspective on what you think is happening in the market following all the vaccine news and this sort of rotation from growth stocks back into value stocks, is that something you take notice of?

It’s interesting, we’re always a little bit confounded when there is this large misconception that value investors are at one corner and growth investors are at the other corner. We’re growth investors that happen to also have a very strict value doctrine. Whether you’re buying a large fast-growing business or a business that’s growing at low single digits, the reality is that every equity investment needs to be valued and so you better have an understanding of value. Some investors will pay whatever price for that growth in order to get exposure to that growth, that’s not us. We will only buy a business if it’s got a credible and more importantly, a probable chance of growing over the long-term, but we are value sensitive, i.e. we look at the price versus the valuation.

This concept that value investing doesn’t seek to identify growth assets I think is incongruous. I think whether you’re buying a high-growth asset or a mid-growth asset, you need to understand what the company or the asset that you’re buying is worth. Value investors happen to have more sensitivity around the intrinsic value versus the market price. Specifically, in answer to your question, what we see is that there is still very strong bifurcation in our market. There are growth assets that are significantly undervalued for a number of reasons and there are growth assets in our asset class that are way overvalued. There is still – that, to us, is a signal of marketing efficiency and both the overvaluation and the undervaluation, so there is still very large tangible evidence of pricing inefficiency.

Do you feel as though you’ve had to alter your way of thinking in terms of the metrics you’re using to value companies throughout this year given the market volatility and what’s happened throughout COVID?

What we can say is not really this year but over the last four or five years with central bank rates and the risk-free rate being lowered, that inadvertently pushes all the asset classes up because there is an inverse relationship between the long-term risk-free rate and valuation, so it is logical and rational that asset prices have risen, particularly since the GFC where we’ve had central bank rates and risk-free rates being depressed for a very long period of time and furthermore, during the COVID crisis we’ve had signalling from our central bank that long-term low rates are going to be here possibly at least for three to five years. And so that washes through the valuations and you generally have to pay a higher price for assets than you would have had maybe 10-12 years ago.

I just wanted to ask you in terms of this year and the COVID crisis, how you’ve navigated it? Because interestingly, on your website it points out that the microcap area isn’t entirely reliant on economic conditions. Would you say it’s been worse hit or a bit more protected than the larger companies in the market?

It’s very much on a company level because COVID didn’t affect all the industries the same way. If your business was in education or tourism, no matter how great you are, no matter how capable the management team, no matter how solid the business model, no matter how competitive, it wouldn’t matter what competitive advantage you had, the reality is you had a transformative leftfield event that had a severe impact on your revenue lines, your cash flow and your earnings. They’re all businesses where hugely adversely impacted. Then, if you were dealing with business enterprise software on a SaaS business model and the end enterprises were not particularly exposed to education and tourism, you probably didn’t feel the impact of COVID at all.

Retail was surprisingly strong post the shutdown, and we’ve had a shift in consumer behaviour and a substitution effect of spending from going to restaurants, taking overseas trips to consumptions in products and services and household appliances, household renovation. By and large, retail exposed businesses have fared quite well. There hasn’t been one glove that fits all. What we did as COVID hit is we looked at every single investment that we owned and ask ourselves, first and foremost, was there any going concern risk given the uncertainty of COVID and its material impact in some businesses over the 12 months.

The second was to look at the financial stability of all of our businesses and we have a very conservative investment doctrine with respect to leverage. Most of the businesses that we buy and own have either no net financial debt or if they do, they have low levels of financial debt, so by and large, COVID didn’t really put any financial stress on the balance sheets that we own. The third question that we ask ourselves is, on the assumption that this too shall pass and we know that these large tumultuous market events are transitory in nature and do offer a small window of opportunity for long-term investors like us. Which out of the businesses we own do we want to buy more of, keeping this set of opportunistic prices? Then there are businesses that before we couldn’t buy because of our strict value doctrine that during the months of February, March and April, all of a sudden became significantly undervalued and we were afforded this fugacious opportunity to acquire high quality long-term growth assets at prices that were deeply discounted to our assessment of the intrinsic value. We managed the COVID crisis through looking at a bottom-up analysis of every company we owned and looking at companies that we didn’t own that we wanted to own for a long-time and we were conscious and cognisant that this would be a passing event, and therefore the window of opportunity would be short and my experience tells me that rebounds, when you’ve had a GFC, you’ve had a 1987 stock market crash, you’ve had September 11. These rebounds tend to be aggressive and so we knew that window would be short.

You touched on it there – you’re looking for highly undervalued businesses that meet a demanding investment criteria. Could you elaborate a bit more on what filters you’re using to decide on whether a microcap is worth investing in?

Yeah. First, let’s go back to the notion of growth. What ultimately drives – the biggest driver of your investment returns is the underlying growth that a business can engender, both organic and/or inorganic. We need to look at a business and say, “Do we think that there is a high probability that this business is going to be sizeably bigger in five, six, seven years’ time?” and if the answer to that is, yes, then that’s an important tick in that box. We look at the underlying quality of the business model, how does the business actually generate its revenues and what risk factors could adversely affect their revenues?

How diversified are its customer base, how sticky is their customer base? And that comes down to the products and services that the company provides and sells, what is their end customer value proposition? What is it that they actually provide that makes them compelling and makes it compelling for the customer to continue to do repeat business with a company? That is about competitive positioning and value proposition of the products and services. The underlying business model, how good is the business model? How much visibility is there in the earnings? What is the nature of the revenue? Are these contracted revenue streams or are they cyclical, are they recurring? What type of revenue quality underpins the business?

Then the competitive positioning, what does the competitive landscape look like? No business that we own is a monopoly, so they’re all exposed to some levels of competition and how intensive that competition is will depend upon the underlying might that the company has around – does it have unique intellectual property? Does it have a unique value proposition? Is there a strategic overlay in terms of the products and services that the company provides its end clients? These are notions of identifying quality parameters.

Then we also look at the management team that runs the business, what’s their capability set like? Are they capable, are they proficient, do they have the technical confidence to lead the business and the strategy? And so, we make assessments on the quality of the management team as well, because they’re also an important ingredient in the overall investment outcome.

And more specifically, a bit about your funds, could we speak firstly about the Deep Value Fund which has between 15 and 40 ASX-listed small-caps and microcaps? How have you seen that perform this year?

It’s performed very well. We had a very good performance leading up to COVID. I think our Deep Value Fund had done a close to 30 per cent net return. The fund’s been running for close to 13 years, it’s had an annual compound rate of return of just over 19 per cent, net of all fees. What we found pre-COVID is that there was heightened levels of merger and acquisition activity within our portfolio, within our Deep Value Fund. I think that comes down to growing undervalued assets and we saw that both industrial competitors and private equity were interested in acquiring some of those assets at large premiums with respect to the market price and that sort of drove our pre-COVID returns. Then during the COVID epoch, particularly February, March, April, we did a minor level of restructuring of that portfolio to account for the sense that there was this fugacious window and we bolstered the underlying quality of the portfolio. As we’re coming out of COVID, we’ve seen a very strong rebound in the mark to market performance of our fund, I think we’re up just over 15 per cent over a 12-month period which includes that COVID period. We’ve just breached an all-time high and we’ve delivered very strong returns with respect to the market. I think strong double digit outperformance at both a Small Ords Accumulated Index and the All Ords Accumulated Index.

We’re confident looking into the future that we’ve got a thesis around private equity and merger and acquisition. We think 2021 is going to be a record year of M&A and we’re starting to see as we come to the close of this calendar year, merger and acquisition events within our portfolio re-emerge. Recently, we’ve had a number of transactions in the portfolio that have been triggered by either private equity or industrial competitors.

What kind of stocks are you liking in that area currently, going into the new year?

We own a number of assets that we think look vulnerable to merger and acquisition activity. We think iSelect, for example, is a company that is trading well below the book value of the asset base. We think it’s a business that the current market price doesn’t make any sense and we think that the business does look likely to have suitors over the short to medium-term.

You mentioned as well in March that you’d sort of restructured the fund. Did you mean that in terms of adding more holdings to what was there going into COVID, or what did you mean by that?

We made a number of decisions in our fund. We both eliminated or dissolved some investments and added some new ones. I don’t want to at all say that there was major restructuring. I would define it as minor restructuring, we made changes to about 15 to 20 per cent of the composition of the fund. It wasn’t wholesale because the reality is we had built a quality portfolio pre-COVID to thrive over the long-term and the reality is that COVID didn’t really threaten the majority of the businesses we own. What we did want to do is take an opportunity of some of the bargains that were there during COVID and we reduced or divested out a small component of our portfolio that was in tourism and had some education exposure.

We still own education businesses, but we own a lot less and we’ve got a very small component of our portfolio in tourism, though we think that tourism is not going to go away and we’re confident that tourism, as the vaccine gets distributed in the developed world, tourism’s going to bounce back very strongly because there’s huge pent up demand and tourism is a lifestyle choice of modernity, people like experiences, they want to travel, they love seeing the world and tourism is not going to go away. In a post-COVID world, we think travel will come back and it’ll come back in a strong way.

I’m also interested to hear about the Global Microcap Fund because obviously there’s a number of microcaps across developed share markets around the world, how are you able to sift through and pick appealing ones? Do you look at geographic locations or how do you approach that?

We really just stick to the developed world, which means Western Europe, maybe a little bit of Eastern Europe, United Kingdom inclusive of Western Europe, and North America and that’s really about it. We do filter, so all the businesses we own both in our domestic and our global fund have to have reached a level of EBITDA or operational profitability. That really cuts down the small-cap and microcap world probably to about a third, so about two-thirds of businesses out there that are smaller than micro don’t actually deliver EBITDA profits, so it does really sort of shrink the addressable investment universe. Then what we do is we stick to our circle of confidence. We have a lot of confidence around enterprise software, we’ve invested a lot in enterprise software, we’ve got confidence around retail business models. We look at retail business models, we’ve got confidence around professional services. We know, for example, online travel agency businesses because we’ve invested in the past and will invest in the future, so we look at business models that we already have a strong confidence in and we look to invest within that circle of confidence. It really does require filtering through various stages and then doing what we do for our domestic funds which is a lot of elbow based financial research, a lot of reading.

Then we reach out to the management teams of these international companies and meet with them via Zoom, via a conference call and go through a whole set of pre-prepared questions to really understand the business, the industry and the competitive dynamics in a much greater level of detail, and then we make an investment decision jointly with the investment management team. But the global value microcap fund really is really the same investment process, the investment doctrine of say it’s deep value applied to the developed world.

Then you’ve also got your High Income Value Fund. Could you discuss why this would be an appealing fund for investors looking for those consistent dividend payments, especially in the current environment where it’s quite hard to find regular income stocks?

Yeah, it’s a pressing question, because if you owned banks and banks have historically over the last 30 years been very consistent in paying out their dividends. But the reality is, if you owned a whole portfolio of banks and maybe Telstra, if you looked at the industrial diversification of that strategy, it’s really quite poor and that actually reflects most equity income funds in Australia are really just the banks and Telstra. From an industrial structure perspective, they’re really poor and they’re very risk weighted on the Australian banking industry, which up until COVID had been a pretty secure and reliable source of dividends and quite consistent.

What you had happening in COVID is that you had APRA put forward a directive to banks to either suspend or limit their dividends to not more than 50 per cent of the NPAT and that had a massive effect on both dividend payments where some banks suspended and most of them severely reduced their dividend payments. And the consequent share price. Banks had been one of the subset sectors that have really performed badly. Our high income fund takes a multi-industry approach to sourcing secure streams of dividend income and we’ve got over 10 industrial sectors with no concentration on the Australian banks.

Therefore, we’ve got this record of paying uninterrupted distributions for the last eight years and we in fact make those cash distributions on a monthly basis. The reason why we’ve got that perfect track record of distribution history is we really have a structural industry diversified fund and we’ve got interests in professional services, financial services, software businesses, retail businesses… It’s just highly industrially diversified and therefore, if a particular event effects one of those sectors it doesn’t tarnish or affect the entire fund and the fund can continue to meet its distribution obligations.

We think structurally, if you’ve got a strategy to produce consistent dividend or consistent income, it makes a lot more sense to be sectorally or industrially diversified than putting 90 per cent of your eggs in the Australian banking market. We think that strategy showed up and the shortcomings showed up during COVID where the banks were affected very adversely both from a share price objective but also from dividends.

And just finally, Carlos, I wanted to get insight into how you’re feeling about the microcap market heading into the new year, we’ve got a vaccine being administered in the UK and it’s looking promising from that sense, but there’s also surging cases in America. Are you feeling positive going into the new year or how do you think you’ll approach 2021?

We’re excited because what we see is that this bifurcation of market pricing and this inefficiency still exists. There’s a lot of overvalued companies in our asset class but there is this pocket of undervalued high-quality businesses that are growth businesses that can still be purchased at very compelling prices. If you look at our cash positions across our funds, most of them are sitting below 1 per cent, and the reason we’re doing that is we’re getting net inflows but as soon as we get the inflows from our investors we’re deploying that capital. We’re doing that because we can still find highly undervalued assets with very good growth dynamics and so that’s a good problem to have.

We don’t always have that problem, we’ve had issues in the past maybe four or five years ago where we just couldn’t find quality businesses at undervalued prices, but at this point in time, we’ve got plenty of opportunity within our funds and that’s why our cash positions are so low. So long as that continues and we still have this bifurcation of market prices and this pocket of high quality undervalued assets, we’re going to feel pretty good about it.

Overall, looking at the macroeconomic picture, we think there’s a credible and growing case that the world economy looks set to have a strong recovery throughout 2021, and obviously the success of the vaccine rollout and getting that vaccine out to as many people as possible as quickly as possible will accelerate the recovery. But we think central bank rates are low, corporate balance sheets across the world are in a good position. There’s pent up demand in terms of consumer spending and we think unemployment across most countries in the developed world will start to come down as they move out of a lockdown phase and look to reopen or get many of those industries that were affected by COVID into a state of normalisation. It’s difficult to find a bear case for the macroeconomy, barring some unknown external shock, 2021 looks like it’s going to be a good year.

Carlos, thanks very much for your time.

Thank you for having me.

That was Carlos Gil, the CEO of Microequities Asset Management.