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A lower-risk way to buy local small-cap tech stocks

Glenn Freeman  |  24 Jun 2019Text size  Decrease  Increase  |  
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Individual investors wanting some exposure to Australian technology firms Wisetech, Altium, Appen, Afterpay Touch and Xero without buying their shares directly could consider one or more fund managers.

The following funds, which each hold Morningstar Silver medals, all have some exposure to one or more of these local tech darlings, which are collectively dubbed "WAAAX".

Altium emerges as the most widely held WAAAX stock among this collection of small-cap managers, which have been identified using a Morningstar screener.

Altium is an American software company, domiciled in Australia, that provides PC-based electronics design software for engineers.

Fidelity Future Leaders (19893), Colonial First State Australian Smaller Companies (7006) and Pengana Emerging Companies (12260) each hold Altium in their portfolios, with weightings of 5.6 per cent, 3.47 per cent and 1.96 per cent, respectively.

Ross MacMillan, a senior manager research analyst at Morningstar, says the Fidelity fund stands out from competitors because of its rigorous investment approach applied by portfolio manager James Abela.

Typically, the portfolio contains between 40 and 70 stocks, with annual turnover of the holdings averaging between 60 per cent and 80 per cent.

Before making it into the Fidelity portfolio, stocks that pass the initial screen to determine they are investable are measured for their:

  • viability – pricing power, strong opportunities, and high return on equity
  • sustainability – solid industry position, strong positive cash flow, and ability to withstand competitive pressures
  • credibility – quality of the business and management.

Altium is the fund's top holding at the end of February 2019, alongside biomedical firm ResMed (ASX: RMD), A2 Milk (ASX: A2M) and Magellan Financial Group (ASX: MFG) – which hold portfolio weights of 4.38 per cent, 3.83 per cent and 3.62 per cent, respectively.

Further down its portfolio list, Fidelity also holds Appen, Xero and Wisetech, with weightings of 2.1 per cent, 1.3 per cent and 0.78 per cent, respectively.

Solid supporting player

Colonial First State Smaller Companies concentrates on smaller companies from across the sector universe, including resources.

It includes between 40 and 60 companies, of which Altium ranks fourth in terms of individual company weightings. As of February 2019, private health insurer NIB was the highest individual position, followed by kitchen appliance company Breville Group and financial advice software company Iress.

Though Altium isn't on Morningstar's equity coverage list, NIB, Breville and Iress each hold narrow moats.

Morningstar manager research analyst Anshula Venkataraman notes the Colonial First State fund should only be a "supporting player" in any portfolio – meaning it shouldn't make up more than one-third of an investor's small cap exposure.

She regards the fund's senior portfolio manager, Dawn Kanelleas, as having strong insights across the small cap market.

The fund itself was spun out of the Colonial First State large cap Australian equity fund in mid-2016.

"The focus remains on unearthing companies with sustainable competitive advantages, but the emphasis on balance-sheet strength and cash flow has increased," says Venkataraman.

"Pleasingly, this enhances the quality aspect of the strategy, which we think is useful in the small-cap space."

An excellent small-cap option

Pengana Emerging Companies is described by Morningstar manager research analyst Michael Malseed as "an excellent option in Australian small caps".

He notes the fund's portfolio differs considerably to the benchmark, steering clear of property trusts, biotech and pure-play mining companies.

"The portfolio management team is not afraid to invest at the very small end of the market, although the 50-60 stock portfolio is quite diversified and has a broad spread among mid-, small and micro-cap names," Malseed says.

Its top five portfolio allocations include aged care property developer Lifestyle Communities, real estate investment trust Charter Hall Group, logistics company Mainfreight and salary packaging and fleet management provider Smartgroup Corporation.

Alongside the Pengana and Fidelity small cap funds, Hyperion Small Growth Companies (3344) also holds a stake in logistics software developer, Wisetech Global.

Wisetech is one of only two of the WAAAX stocks rated by Morningstar equity analysts, alongside accounting software firm Xero.

Wisetech is awarded a narrow moat by equity analyst Gareth James, but at its current share price of $22.50 as of 1:30 Monday Sydney time, it's a one-star stock, trading at an almost 300 per cent premium to our $7.40 fair value estimate.

Concentrated, but that's okay

The Hyperion fund is concentrated at both a stock and sector level, with only around 15 to 25 individual companies in the portfolio.

"But we are okay with this, as the team's analys is strong.

"It is that level of analysis that has led the team to early purchases in high-flying stocks such as Domino’s Pizza (ASX: DMP), REA Group (ASX: REA), and Corporate Travel Management – names that have delivered very well for Hyperion and driving top long-run returns in the category," says Morningstar manager research analyst Matthew Wilkinson.

As of May 2019, Wisetech held an 8 per cent asset weighting, with other top five holdings also including REA Group, Hub24 and Nanosonics.

is senior editor for Morningstar Australia

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