“We took a long-term view of the businesses and, by adopting a staged approach to our buying, we were able to become more aggressive as prices fell further,” he recalls.
But such buying could have been reckless if the manager’s conviction in a stock was misplaced.
“In the short term, the market can be quite inefficient, particularly where hordes are being driven by fads or piling into early stage businesses that may not deliver,” he says. “In the long term, we think the market is efficient at assessing the appropriate value of businesses based on quality, financial returns and growth opportunities.”
Andrew Hokin says the best value-add has been from investing in businesses that have continually delivered solid earnings growth, despite a tough environment.  Isabella Porras
Hokin had done his homework on Altium, a stock that has been around since the dotcom bubble burst. It returned to the market’s radar in a big way in 2012 and has experienced returns of at least 60 per cent every year over the past four years before dividends.
“Less than 10 years ago, Altium was a 20-year-old mid-market player struggling to grow revenues, reporting losses and with modest financial resources,” says Hokin. Over the past seven years, through new management with a long-term vision and focus on its core product, Altium became one of the core WAAAX members (WiseTech, Afterpay, Appen, Altium and Xero) and the fund manager says it has “strong growth for many years to come”.
The business delivered compound annual revenue growth of 18 per cent over that period.
“There is perhaps insufficient appreciation for the extent of transformation that has been achieved under the current management team,” Hokin says. “Altium today is emerging as the leader in engineering and design software solutions for the printed circuit board market and has laid out a backable path towards industry domination and transformation.”
Smallco acknowledges that growth businesses have had an edge over the past 10 years. But it’s not as simple as backing companies that are growing year on year, says Hokin. That means putting more emphasis on quality and long-term growth.
“The greatest value-add has been from investing in businesses which have continually delivered solid earnings growth in an environment where many companies have struggled to grow earnings for many years,” he says.
Looking out to 2030, he’s not anticipating any change in investment style at the low-profile boutique manager, which is closed to new investment. Hokin is open to turning over the portfolio when the time is right, which will inevitably mean eventually selling some winners. “Other than price, which stocks remain will depend on management execution and their ability to continue to broaden their market opportunities,” is all he will give away for now.
But how does a growth-leaning investor think about the macro outlook when interest rates have been so favourable for so long that some experts think they’ve bottomed?
“Clearly a world of ultra-low, long-term interest rates changes valuations while it persists, particularly for high-returning businesses with strong long-term growth opportunities. However, this poses two key risks,” Hokin says.
“First, the downside risk for companies that miss earnings expectations is likely increased, particularly if there is a perceived change in structural growth rate. Second, while few are assuming long-term interest rates move back to historical levels in the foreseeable future, a move just back to 3 per cent would likely cause a material reassessment of valuations across a number of sectors.”
Jason Orthman, Hyperion Small Growth Companies
Top small-cap fundie and deputy chief investment officer at Hyperion Asset Management, Jason Orthman doesn’t think much of the majority of small-cap companies in his investment universe.
“The opportunity set in small caps has always been pretty shallow for us. Most of the businesses in it don’t meet our quality thresholds,” he says.
Being selective in only buying the best businesses has helped Orthman’s fund become the best-performing small-cap fund over the past decade.
One key to his outperformance has been an almost neurotic fussiness over the quality of business the investment team will put in the portfolio.
Jason Orthman, of Hyperion Asset Management, is unimpressed by most ASX small caps. Credit: Attila Csaszar
Orthman goes so far as to say that his chief investment officer, Mark Arnold, thinks most ASX small-cap businesses are worth nothing. Literally.
“Mark thinks most small caps have zero intrinsic value in the long term as they don’t have sustainable business models. This means they don’t have sustainable earnings, which means the valuations will go down.”
Pressed on what companies in the All Ords (Australia’s leading 500 companies) he wouldn’t touch with a barge pole, Orthman declines to reveal names.
“I have to stay away from that. I really learned a long time ago that most businesses are pretty average and their intrinsic values are actually pretty low. We want to avoid that permanent loss of capital,” he says.
“People struggle to distinguish between quality businesses and average or below-average businesses. They don’t pay enough attention to the quality of the business model, as they’re not looking forward.”
He says the best fund managers learn the difference between what’s an excellent, sustainable business model, and what’s really nothing more than an exciting story.
“If you’re just looking over a short period, some of these businesses look great. They might be growing strongly, they have management teams that present very well, they have exciting stories,” he says. “But most small-cap companies just fade out over time.”
While learning to spot and avoid the losers is one side of the coin, the other is learning to pick the winners that deliver the outperformance and decade-long double-digit returns.
Orthman also likes founder-led companies due to their long-term approach.  Credit: Attila Csaszar
“The markets long term are led by the winners and you need to be with those winners. You know, if you get it right, it’ll reward you for a long time,” he says.
“Ten years ago, we identified SEEK, REA Group, Carsales, as the next blue chips. They still hold some of the most powerful network effects we’ve ever seen.” Network effects are where an online advertising company’s business model develops a strong moat or competitive advantage. This is because online advertising companies with the biggest marketplaces attract the most buyers and sellers to achieve the best prices.
“Like REA Group, we purchased that in 2004 at 85¢ and you know, 15 years later, it’s trading at over $110 per share,” he says.
REA Group’s network is so powerful that if you want to get the best price for your property or rental, you have no alternative but to pay to advertise. This has given REA pricing power and protected it from competition to deliver 10 years of strong profit growth.
“Basically [it’s about] finding companies with high structural earnings growth. If you can pick them early, on the cusp of strong earnings growth, you can really benefit from significant compounding,” Orthman says of the fund’s success.
The sectors it focuses on to deliver long-term profit growth include digital, tech and healthcare. Current investments include Fisher & Paykel, TechnologyOne, Nanosonics, Xero, Pushpay, Carsales and WiseTech.
“TechnologyOne we’ve had for 20 years. We believe equity investment is all about growth. All about compounding. And we want to hold the best businesses we can for decades.”
The fund’s investment guidelines allow it to continue owning businesses even if they enter the S&P/ASX 100 Index. This is important as it allows the fund to keep holding the biggest winners, rather than be a forced seller.
Orthman says if you want to thump the market as an investor, you must consider business quality above all else and then hold long term.
“We’ve tried to act as business owners and find these structural winners that become the next blue chips. We want to hold them for the next 10 to 20 years.”
*The returns (before fees) are based only on funds within the Mercer universe that have a complete 10-year history; inclusion alone does not constitute a recommendation.
Paul Hannam and Noel Webster, Pendal Microcap Opportunities
Microcaps make up the majority of listings on the Australian Securities Exchange yet rarely rate a mention. And while the lack of light means these smaller companies attract fewer investors, Pendal Groups Paul Hannam and Noel Webster have proven that a disciplined approach can deliver consistent returns in microcaps.
Paul Hannam (left) and Noel Webster lead the team behind the Pendal Microcap Opportunities Fund. Peter Braig
As part of a team of five, the pair manage Pendals microcap fund, which typically invests in companies with a market capitalisation under $150 million at the time of purchase.
Over the past decade, the fund has delivered investors 17.02 per cent per annum net of fees. This compares to 4.13 per cent on the funds benchmark, the S&P/ASX Small Ordinaries Index.
One of the companies that has contributed is Infomedia, a software-as-a-service provider to the automotive industry.
We’ve held it for five years and it has been the third-largest contributor over 10 years, Webster says. It’s got 170,000 users in car dealerships and associated businesses globally, Hannam adds. It’s in 196 countries and supports 31 different languages.
Infomedia has been profitable and operationally cash positive since listing in 2000, in contrast to many of its peers in technology.
Other positives that support the thesis for the stock are its business model and earnings margin, Hannam explains. An early adopter of cloud-based software, 95 per cent of Infomedias revenue recurs monthly and its earnings before interest and tax to sales margin is 25 per cent.
Its share price has risen about 125 per cent over the past five years, which has seen its market capitalisation grow beyond that of typical companies in the funds portfolio.
We believed it was a great business but management and the board changed significantly and multiplied its opportunities, Hannam says, explaining the change in leadership was the catalyst for the investment.
Another [element] is making your mistakes small ones and making them rarer, particularly in this space.
Noel Webster
Other names the fund invested in at an early stage include Dominos, Altium and Beacon Lighting.
The stocks [in the fund] will change over time but the characteristics won’t change, Hannam says. When we started out, it was all about quality, microcap companies that simply werent suitable, due to size constraints, for our smaller companies fund. And that’s what the fund is made up of now high-quality microcap names. In 10 years, it’ll be a similar thing.
One company the fund backed at an early stage was kitchen appliance maker Breville. With a market capitalisation of $2.5 billion today, it is a long way from qualifying as a microcap. But the fund bought in when the total value of its shares was $100 million, Webster says.
Another key factor to the fund’s success has been a strong valuation discipline. “If we do get divergence in the market where we don’t think the fundamental thesis around the company has changed, then having a clear view of what the value of the business is gives you the conviction, says Hannam.
While the concept is obviously not specific to microcaps, it does have an additional significance, says Webster.
They’re small business so more susceptible to changes, particularly short-term changes in their prospects. But if you’ve got a belief in the long term, that can be an opportunity.
“Another [element] is making your mistakes small ones and making them rarer, particularly in this space.
And that segues back to the idea of buying quality businesses, so that you’re biased to getting winners. And that ability to pick good businesses and quality businesses comes with experience and discipline.
*The returns (before fees) are based only on funds within the Mercer universe that have a complete 10-year history; inclusion alone does not constitute a recommendation.