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[SMALL CAPS] Avoiding land mines in small caps

By Stephen Wood

Since the start of the financial year the Small Ordinaries index is up 3%. Spotless, Slater & Gordon and Dick Smith are down 38%, 67% and 81% respectively. Thankfully we have never owned any of these stocks in our small cap fund. One investment bank this week wrote a note highlighting that despite these rotten apples (their words not ours) that the IPO market has delivered investors a lot of value since the IPO market re opened in 2013. The interesting thing about their short note was that it did not analyse the returns from the individual IPOs based on their individual time in the market. Instead they looked at returns from recent IPOs over set time periods such as 2014 or 2015 to date. The detailed analysis that we have undertaken (and we will shortly update for 2015) suggests that the key variable for IPOs is time in the market not a fixed time period. As a group we estimate that returns vs the small cap index are relatively benign from day one until 12 months when average returns begin to deteriorate. Average returns then decline progressively during the period between 12 and 36 months from IPO. Dick Smith listed in November 2012 so it has now been listed just on three years. It has now become a significant contributor to this poor average. Our thesis, set out in a note in late 2014, was that there were signs that Dick Smith's earnings were increased by non-trading items and that management's incentive structure was encouraging this to occur in the short term.

Spotless noted on 22 October, that subject to economic conditions, that due to the combination of market growth and a unique competitive position that we expect FY16 results to materially exceed FY15. We do not believe that economic conditions have changed much if at all since 22 October. In April 2015 Spotless was advised that Bruce Dixon, the CEO was going to step down after just over one year as CEO post IPO. On 26 August, just after the FY15 results the private equity owner sold their remaining $370m stake in the business as they were entitled to do. In the same transaction the outgoing CEO sold around 6m shares or approximately half of his holding. He still has a holding of just over 6m shares. The trading update that caused the share price to decline by around 40% was announced on 2 December. These are very short time frames relative to our in house six year cash flow forecasts.

Our Eight Commandments are our qualitative overlay that sits across the top of our cash flow based valuation process. This, combined with the detailed IPO returns analysis that we have undertaken, require us to invest in stable sustainable companies that we can understand. In the case of Dick Smith and Spotless various combinations of the of rate of change of management, the speed of changes in the shareholding structure of insiders, concerns about short term management incentives and concerns about cash flow not matching earnings have thankfully prevented us from owning shares in either of these companies.

We believe that one of the advantages of investing in small and microcaps is the large universe of available investments. We don’t get them all right by any stretch, but we are able to pass on situations that we believe don’t pass a reasonable qualitative hurdle. In the instance of Dick Smith and Spotless we would require a period of at least a year from now of steady, uneventful progress before either could pass this hurdle.

Stephen Wood is a Portfolio Manager at UBS.

 

Published on: Wednesday, December 09, 2015

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