Our continued focus on quality in the Australian small cap sector

So if we recap the last year in small caps in Australia, we think a real overriding theme was the outperformance of quality business models. Being some of those industry leaders that have really done well, consolidating their industry positions. And I think in the small caps in Australia, we see enormous dispersion in quality across the universe. So you need to have that quality lens when you look at this part of the market. And when we look at our Australian immersion companies fund, really at the core of the investment process and philosophy is looking to identify high quality businesses that we think offer attractive returns for investors. So the portfolio has done quite well this year, really making sure that we’ve got that quality bias. And when we think about quality in small caps, we’re really looking for some key characteristics in a business. We’re looking for those industry leaders.

Companies that have got good pricing power, a dominant position in their industry, allows ’em to protect returns through the cycle and really compound investors capital over the long term. We look for companies with strong balance sheets, helps to protect the downside when points of stress, which will inevitably come at some points in the future, but also provides a lot of optionality as well in terms of being able to reinvest back into the business and fund growth potential bolted acquisitions or return cash back to shareholders. But also importantly in small caps management is a crucial one. And when we think about high quality management, key area we focus on is looking for companies that are prudent allocators at capital. Do management really understand how to allocate the cash that comes out of the business, reinvesting back into the business at high rates of return, potentially doing bolt-on strategic deals where they make sense, but not trying to empire build.

And we also look for management that are well aligned with us with significant equity in the business. Make sure that they’re really focusing on the long-term success of the company, which is what ultimately as shareholders, what we are interested in. And we look for companies with high earning strength, generating high returns when you’ve got a return on investor capital, well above their cost of capital, they’re creating value for shareholders every year. And that’s how you compound investors capital over the long term and deliver those attractive returns for investors. And it also means they should be generating strong cashflow. Ultimately, the cash is what defines the value of the business and that allows us to value the business when you can see the cash that’s coming out. So to bring that process to life. A current example in the fund is a company called Redox. Redox is a leading chemical distribution business.

It iPod in 2023 and sort of fell through the cracks a bit. It was a difficult market when it iPod, but this is a business that’s been around for a very, very long time, nearly 60 years. It is a leader in its industry. It distributes over a thousand products from over a thousand suppliers to over a thousand customers. So very, very diversified feeding chemicals into multiple sectors of the economy. No customer represents more than a couple of percent of sales. So it’s a really resilient business we think, and very diversified. It’s got a market share, nearly double its next competitor. So very strong market position. And if you look at the balance sheet, very strong balance sheet, net cash backing allows them to do strategic bolt-on acquisitions. And this is a very fragmented market. And small bolt-on deals make a lot of sense. It helps ’em to increase their market show over time and extract revenue synergies out of those deals.

And we really like management as well. This is a family run business, the iPod in 23 and still retained a significant stake in the business. So they’ve got a lot of alignment with us as shareholders as well. And they’re really focused on a long-term clear strategy of continuing to consolidate the market, grow their market share, and gradually expand into new markets like the US where they have a small presence as well. So we like the business, it generates a lot of cash as well. They’ve typically returned a lot of cash back to shareholders in the form of dividends. But that cashflow allows us to value the business and it provides a lot of optionality for them to continue to allocate to small bolt on deals too. So when we look at Redox, it really ticks a lot of the boxes. It’s got those quality characteristics and more importantly as well, we think it’s attractively priced.

This is the business that trades on a market multiple, but yet it is delivering much more superior growth relative to the index, we think has more superior quality characteristics than the index. And so we really like the business and have been adding over the past year. I think when we look at our emerging companies fund as well continues to be quite concentrated, focusing on quality businesses that we believe are mispriced. And if we look at the current market backdrop, small caps are underperformed significantly over the last few years. But when we look at the recovery into a potential interest rate cutting cycle over the next couple of years, we don’t think that the small cat recovery will necessarily be broad based. You’ve got to be really selective. Focus on those quality businesses that offer those attract returns are attractively priced. And I think the past year has been once again, an important lesson investing in small caps that you’ve got to focus on those high quality businesses just given the real dispersion and quality that you see across the index. And that’s really what continues to be a key focus for us.