With market attention focused recently on mega-caps and new trillion-dollar AI listings SG Hiscock portfolio manager Rory Hunter is looking the other way. The micro-cap expert explains to Stewart Hawkins the joy (and dangers) of discovering mispriced stocks, how you navigate the risks among the unknown and the importance of giving your portfolio a fat head and a long tail.
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What are your fundamentals?
Ultimately, it’s based on mispricing. We feel quite blessed to operate in Australian small companies because, when you spend a bit of time looking at the underlying stocks, you realise all it takes is to start doing a bit of work and have the right conversations to see that there is a lot of mispricing in those stocks.
You’re looking for decent assets – they might be in resources companies, IP for technology companies – and you need good management teams that can generate decent outcomes. But ultimately, management can ruin a good asset, but management can’t make a bad asset good. Also, we’re looking for stocks or exposures with the potential to surprise the market.
The small end of the Australian market is under-researched relative to its global small-cap peers. Last time I looked, there were about 60% more large-cap managers than there were small-cap active managers. Those large-cap managers focus on a hundred companies. Small-cap managers typically focus on companies between the [top] 100 and 300 [companies by market cap on the ASX], and then there are a select few that look outside the 300.
There is a lot of turnover in the 100-300 space. You’ve got fewer people looking at more companies and a universe that turns over more significantly. That creates opportunity; that creates mispricing.
Talking about mispricing, what about the valuations of the global big end particularly in tech – because their multiples are interesting.
They’re very important because they set a tone for the rest of the market. A lot of those mega caps, you would’ve seen them trading anywhere between 30 to 35 times [price to earnings], but
growing earnings at 30% I reckon.
When you have a highly cash-generative business generating that level of growth, you can justify those sorts of multiples. The difference nowadays is that a lot of those businesses are just chewing through their cashflow because of their capex programs, and so they’re going to have to generate very significant returns on that capital to justify it. What’s compensating you for that drop-off in free cash flow? Are you going to get additional growth? Are they building out IP that increases the moat around their business? What is offsetting the loss of that free cash? It’s too soon to tell.
Define a micro-cap for me in an Australian context.
A micro-cap is outside the ASX 300.
What’s that space worth?
There are [about] 1500 companies outside the largest 300 companies by market cap on the ASX. The aggregate market cap of these companies is $170bn.
What is the opportunity difference between micro caps and the rest of the bourse?
There are very few institutions that look at ideas outside the ASX 300. If you can find a way to get set in these stocks and find liquidity, there is a lot of mispricing because of the lack of research.
What that means is that you have an advantage in terms of having access to companies, being able to do site visits, access to the management teams, and getting an understanding of strategies, and getting a better look into the quality of those assets to understand a) whether they’re mispriced at this point and b) whether just through stepping through a few hoops or having some success on some strategic outcomes, they can drive really quite significant upside relative to expectations.
Secondly, 1,500 stocks is a huge opportunity set. The best performers in any field tend to have the most ideas, and when you’ve got an opportunity set of 1,500 stocks versus maybe 100 stocks or 300 stocks, it gives you a huge amount of optionality.
What’s your research criteria? You’re talking about companies that aren’t necessarily very old or very big.
We tend to screen the market on price momentum and earnings momentum. What that does is identify stocks that are making potentially early moves.
So, your market screening is looking at what other buyers and sellers are already doing in the market?
There’s a bit of that, but bearing in mind that in micro-caps, it doesn’t take that many buyers or sellers to really move prices.
So, volatility is a factor.
Absolutely a factor. What we do is we say, “Okay, what does the one-month move look like? What does the three-month move look like? What does a 12-month move look like? Does that reconcile with some earnings momentum coming through in the business?”
Then if all those things look like they’re stacking up, then it’s a decent indication for us to start doing some work on those companies. It just acts as a bit of a flag.
On top of that, we’ve been operating in this space as a team for 30 years now, [and have] built up a lot of broker relationships in that time, so we’ve constantly got brokers bringing us ideas.
At least one of us is on the road every couple of weeks, whether that is going to WA, going up north, doing a lot of site visits, conferences and everything else. The starting point has got to be idea generation because there are so many stocks in that universe.
If we think we can see a compelling opportunity at first glance, we’ll immediately get in touch with management and look to organise a meeting.
As long as you’re dedicated, you’re diligent, you know what you’re looking for, and you have a very repeatable process, then ultimately there’s always going to be opportunity.
How many stocks are you invested in right now?
Across the three strategies, I’d say there are about 130-140.
That’s a lot.
It is, but the other thing to bear in mind is that we do things differently from high-conviction investors. We have very diversified portfolios. In terms of our coverage, we run the portfolios with a fat head and a long tail. The fat head [consists of] more high-conviction positions, which would be anywhere between 2% and 5% positions, but then there’s a long tail. The long tail is where you see asymmetry in potential outcomes.
This is saying we found an opportunity at a very early stage [but there may be] a few risk events that the company needs to step through. However, as it steps through those risk events, it significantly de-risks the outcomes, and then those outcomes can drive significant returns. You don’t need a huge holding in those stocks to participate in those outcomes. A lot of those holdings would be at 50 basis points to 1%. Those are not high-conviction holdings.
At times, many of the famous Magellan funds have held hundreds of positions. In terms of the fat heads of our portfolio, you’re only talking 40 or 50 stocks.
What percentage of those companies do you enter into at an early stage of their existence?
We don’t really like to get involved in concept stocks… pre-commercialisation. Where we see it as a sweet spot for getting involved is in the early stages of commercialisation [where] there’s demonstrable commercial traction, but our research effort shows that the market might be underestimating the potential commercial outcomes.
It’s no longer just a concept. There’s real money behind it; real businesses are putting money into it. Then you ask the question – how significant could that commercialisation be? Then what does that potentially mean for earnings? What do other industry participants look like from a margin perspective? What do they look like from a growth perspective? What does that typically mean for cashflow, cash generation, and everything else?
Can you give me an example?
If it were a resources company, we wouldn’t get involved in early-stage exploration. We have a geologist on our team, and so he’s very well-placed to make judgments on what geological structures look like. Typically, in our diversified micro-cap strategies, we would want to see a couple of decent drill hits that said, ‘Okay, this is a very real system.’
And then [the geologist] would say, ‘My geological interpretation would say this could be a much bigger system, judging by that drill hit and my understanding of the structure.’ If it is a bigger system, then it should be trading at, say, five times the valuation it’s currently trading at.
Back to your mispricing strategy.
Exactly.
Straight away, you’re saying, ‘Well, what do we need to see to get it there?’ Maybe one or two more drill holes will show the market that this system’s much bigger. That’s what we call an asymmetric return profile. If they’re not successful, you lose that 50%, but if they are, you make five times your money.
If you seed a position of 50 basis points, for example, and you do five times your money, you make 2.5% in your portfolio. But if you lose that 50%, it’s a 25-basis-point loss. That’s where it’s interesting – that stock research, idea generation, is half of what we do. The other half is execution. Execution is important in any equities portfolio, but it is of vital importance in micro-caps.
What are the biggest risks? How exposed are micro-caps?
Insolvency, to be very frank, and the reality is that in micros, you’re much more exposed to idiosyncratic risk.
These long tail positions are very, very small. It looks after that idiosyncratic risk. What can go wrong will go wrong; it is the rule of the world, and it is especially true when it comes to micro-cap investing, because there is no such thing as high conviction in early-stage companies.
No matter how confident you are in outcomes, you have to be positioned for the risk.
Normally, if you see an abundance of mispricing, it’s important to check yourself and say, “Am I missing something here?”
How important are liquidity issues?
These are companies that are very reliant on equity capital markets funding, as well as debt funding, to continue driving their growth initiatives. Larger companies can fund most of their growth initiatives through cashflow.
It’s not just the cost of capital; it’s the availability of capital. There are so many impacts that liquidity have on the smaller end of the market. When liquidity comes out of the market, it derates valuations, but it also puts growth initiatives on hold because there’s less availability of
that capital.
We pay attention to macro [economic moves]. Potentially monetary policy isn’t going to work in favour of liquidity at the micro end, we will reduce exposure to micro and move more into small, where there’s a bit more liquidity.
There are very few institutional investors at this end of the market. Helpful or unhelpful?
You still need capital to drive the share prices. You need to be early, but not too early. You also need a weight of capital sitting on the sidelines, ready to identify those opportunities once they become more obvious. We are trying to find these opportunities before institutional investors do, but we also want to make sure they eventually get discovered by other institutional investors.
Have you ever got it horribly wrong?
Absolutely. Yeah.
Talk me through what went wrong and what you learned from that?
We lost a huge amount of money in a gold stock, maybe a couple of years ago. We were getting very bullish on gold. We were heavily overweight, gold was just starting to move and we were seeing that as confirmation of our thesis – and that was driving our bullishness. We got an opportunity to invest in this company. They were raising capital, and it looked like it was going to be their last major capital raise before they started to generate some significant operating cashflow.
It was so cheap, and we got way ahead of ourselves because the problem was that they had a significant hedge book and a significant level of debt.
What we didn’t quite realise was that the relationship with the debt provider was very fractured. Sometimes that’s hard to see.
Ultimately, the debt provider just pulled the pin. What did we learn? First, given how bullish we were on the gold price, investing in a producer that had a significant hedge book was a mistake.
Secondly, we saw so much mispricing that that drove our thesis, and that is a major mistake because what it should have been is this stock is so mispriced-what is happening under the surface that we are not observing?
We just got too excited about the potential mispricing and overlooked a few of the risks. I’ve got to say, it was such a painful experience.
They generally are.
But it was such a painful experience that I look back on it favourably because it taught me so much. Ultimately, it’s made me a better investor because you only truly learn these things the hard way. Yeah, [it] made my life a misery for a couple of months… [but] it is that pain that drives those learning outcomes.
On the flip side, when have you got it exceptionally right?
Probably our positioning in critical minerals. 24 months ago, we began positioning in some of these critical minerals because we could see that global defence spending was about to pick up significantly. Elements such as tungsten, antimony, and thallium, for example, have major applications in defence.
And, we got that call absolutely right. Then another demand driver came in over the top as well, which was artificial intelligence and the use of things like tungsten and thallium in chips, so our thesis was correct, but we made a lot more money than we ever expected we would.
What keeps you awake at night?
Either you have a feeling that the market’s potentially going against you, or you have a problem child in your portfolio. It’s quite rare that you don’t have a problem child, and the market’s going with you. If you’re not worrying, I think you’re not doing your job.
There’s a great book called Antifragile by Nassim Nicholas Taleb, and he wrote it because he believes there is no opposite word in English to ‘fragile’. Something fragile is something that’s weakened by shock. There’s no word for something that becomes strengthened by shock. The longer you spend in the industry and the more you face, the more you get hit, the stronger
you get, and the more you’re able to tolerate these shocks. It’s important that you have anti-fragile characteristics in this industry. If you do, you improve as time goes by.
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