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6 keys to picking up good small caps

Morningstar  |  28 Sep 2017Text size  Decrease  Increase  |  
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This expert scours the globe for quality smaller companies. Here is what helps him make smart bets.

 

Greg Dean is the lead portfolio manager of the Cambridge Global Asset Management small and mid-cap equity funds. This bottom-up stock picker is a specialist in picking smaller fare and travels the globe in his hunt for quality.

Here are some of his stock-picking insights he shared in conversations which can be read in more detail on Morningstar Canada, Globe and Mail, and CI's Monthly Review.

1) Look for firms that do not rely on exogenous factors to succeed

Smaller companies that outperform the market are less reliant on macro events and tend to control their own fortunes. It's not so much that they do well in great times, but those businesses that are in control of their destinies suffer less in bad times.

Why would they suffer less? Because they operate in industries with less regulation, are less susceptible to things like interest-rate pressures or political intervention.

You would not look in real estate or mining or oil and gas to find a business that controls its own destiny. The starting point is in industrials, technology, and consumer staples. Though small, through organic growth and acquisitions they can execute well.

2) Look at management

Look for management teams who act like owners. Businesses that control their own destiny and are run by intelligent managers who have an ownership mentality and can very clearly explain their strategy and decision-making process.

3) Look for free cash flow

Look for the ability to generate significant cash flow and convert a high percentage into free cash flow, after accounting for capital expenditures, working capital, and interest costs.

While stocks that Dean owns may have relatively high P/E ratios, he prefers to look at another measure: price to free cash flow.

Earnings and cash flow are not interchangeable for these companies. That's because for every dollar of net income, some generate anywhere from $1.10 to $1.40 of free cash flow. This is because the firms' capital expenditures are lower than their depreciation costs and because they have very low working-capital requirements.

So, Dean's largest holdings could be defined as expensive on a P/E basis, but if you dug deeper to see how much free cash flow they generate, they would look about 25 per cent cheaper than if based on earnings.

This free cash conversion is a crucial metric. It must be high and sustainable.

For example, a company called Auto Trader Group PLC transitioned from a print advertising medium to the dominant web portal for vehicle sales in the UK. This is a data-driven company that tries to help dealers turn over their inventory more often and help determine which vehicles to stock.

Dean's thesis was that in making the transition to the web they were going to grow cash flow much than faster than revenue. That's exactly what's happened. He pointed out that revenue is only growing about 10 per cent a year, but free cash flow is growing 20-25 per cent.

"You can see that you're getting about 20 per cent free cash flow per share growth for 15 times free cash flow," he says, adding that the company plans to use some of its free cash flow to pay down debt and buy back stock.

4) Look at cash flow as being more important than earnings

The first reason is that earnings can be manipulated or "managed," depending on management assumptions and accounting methods used.

They come with a whole host of caveats, exceptions, and noise, whereas cash flow is a "hard" figure that can be evidenced in two different financial statements. The cash on the balance sheet and the cash that goes through the cash flow statement must line up, so it's a lot harder to manipulate.

At the end of the day, you are not discounting earnings when you are trying to value a business; the value of a business is the sum of its current and future cash flows.

The second reason is that income statements are commoditised. Everyone has access to them, they are quick and simple to analyse, and you usually won't create meaningful gaps between what you believe will occur and what the rest of the world believes will occur.

And if you can't identify that meaningful gap, then Dean would argue that you don't have a reason to own that business or are taking on a lot of risk in owning that business.

Between net income and cash flow, there are a lot of things that people are not paying attention to, and that he finds can be valuable. There is very little thought put into net income so most of his analysis is on a business's ability to convert net income into free cash flow, which captures several really important things.

First, it captures all the non-cash items that go through the income statement and that get added back. Second, it takes into account the amount of working capital that the business needs to grow. Many times you see businesses that look like they are growing, but they are not generating any cash.

Lastly, it captures how much capital expenditure is required for a business to grow.

5) Look at bottom-up stock picking

There are four things Dean tries not to predict: commodities, currencies, interest rates, and government policy. If an investment thesis hinges on one of these four levers, you are in trouble.

As a bottom-up stock picker, he doesn't spend a lot of time worrying about elections or macro factors.

6) Look for opportunities in volatile markets or downturns

Dean's fear levels are at their highest when markets are calmest. Conversely, he is most excited when markets are least rational (think Brexit, global deflation fears, et cetera).

If he can help clients preserve their capital when he doesn't see a lot of opportunity, his job gets easier in better markets to compound that capital while taking less risk.

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This article initially appeared on the Morningstar India website.

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