Big returns, big risks: Making money with microcaps

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Lex Hall: Micro-caps are something we seldom talk about here at Morningstar, but the returns are pretty enticing. So I thought today I would catch up with Carlos Gil, he oversees the Deep Value Fund at Microequities.

Carlos, welcome to Morningstar.

Carlos Gil: Fantastic to be here, Lex.

Hall: Oh, that's great. First thing I wanted to ask you was micro-cap, can you define it for us, what are they?

Gil: Yeah, look, there's no sort of objective definition. However, we can agree upon that, for most people micro-cap is somewhere between, a company that has a market value somewhere between $200 million to $300 million below that size. That's where we draw the line, we see a micro-cap as a company that has a market value under $300 million.

Hall: Okay. Is it, I just wanted to elevate, one of the questions I was going to ask you is that, there are fewer fund managers looking at micro-caps, because there's a perceived risk about them, about them being riskier than bigger companies.

Gil: Look, it's a combination of a few things. In terms of funds management, what you generally want to do is you want to have large, scalable funds, and the asset class doesn't lend itself to having multi-billion-dollar funds under management. So therefore, if you're going to be in the funds management industry, and you're looking to set up product, you're probably going to look at much larger companies where you can build up multi-billion-dollar fund sizes, so that's one of the reasons. In terms of risk, there is quite an array broad spectrum of risk, fundamental risk exposure across the asset class. And so there are some highly risky, speculative companies in the micro-cap universe. But there are other ones that are highly established with incredibly sound business models, and we would argue, have far lower risks than some of the larger companies that are in the multi billions in value.

Hall: Okay, and what sort of time horizon would you suggest that an investor stay in your fund to realise the value add?

Gil: That's an important question, our viewpoint on that is whether you're investing in a large company, a middle company, or a small and micro-cap company, you really need to commit to a five year plus investment term, it really is the same across all different sizes of companies. And that's because if you're looking to invest within the context of the one or two-year time frame, the roulette wheel of market timing will ultimately drive your investment outcome. Whereas if you want to have the luxury of not playing or not gambling on that roulette table, you commit yourself to a five year plus time frame, and it will be the underlying operational outcomes that will actually drive the investment outcome. So it'd be how well your companies do, at a fundamental level that determine your investment return.

Hall: Okay. And I mentioned returns and they're pretty impressive since 2009, the inception of the fund, you've returned something like 740%, I think.

Gil: We've returned just under 800%. And we've delivered a compound annual return of just under 19.2% net of all fees.

Hall: Okay. Are you tracking a particular benchmark there? Or is there not a benchmark to track?

Gil: We don't follow a benchmark, but we actually show the outperformance against the All Ords and the Small Ords and the Emerging Companies Index and we've delivered massive outperformance across all those three indexes. But we're not looking to beat the index. It's kind of just an outcome from what we do, but we're not looking to position our investments versus an index it's just the end outcome.

Hall: Okay. And now let's finish up on opportunities. Obviously, I see that your biggest exposures are in software and health care, I suppose there are no surprises there.

Gil: Look, we've historically always been really heavily invested in technology, not because it's flavour of the month this year or last year, we've got decade's worth of experience in investing in information technology. It continues to be a fertile hunting ground, because for us, a lot of these technology companies possess really sound business models that can actually reduce fundamental risk. And so that's an important segment. You mentioned health care. Absolutely. We own health care business, and we'll continue to invest actively in that sector. A little bit around professional services and to a lesser extent retail. But yes, certainly health care, financial services and technology is where we do most of our investing.

Hall: Okay. So I suppose that's a pretty positive statement about the state of technology in Australia.

Gil: We think that Australia punches above its weight in terms of technology leadership, we still think that there are some micro-cap companies that we own today that have very promising long term futures and will become, you know, leaders in their own market verticals. But I think Australia if you really look at the size of the population, versus some of the behemoths that we've created in the technology space like Carsales or Seek, Atlassian. You know, it's really quite an impressive outcome for the country of 26 million people.

Hall: Yeah, indeed. All right Carlos, we'll do a subsequent video in which we talk about a few names in particular, which will, I'm sure be very interesting. But for now, thanks very much for your insights.

Gil: Terrific, Lex. Thank you.

Hall: I'm Lex Hall for Morningstar. Thanks for watching.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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