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Elephants don't gallop: When small caps win

Elephants don’t gallop: When small caps win

By James Carlisle, Head of Research at Intelligent Investor

 

With this quote, Warren Buffett elegantly encapsulated the approach successful investing demands:

"Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down."

So, that’s it then? Hardly. Aside from the fact that saying it is one thing and doing it quite another, there’s the issue of what a quality business is and what makes a good price.

For a business to achieve the coveted status of “quality”, at least in our eyes, it must have a product or service that is cheaper or better than the competition.

Amazon has the cheapest books. Google has the most accurate search results. These features are difficult to replicate. Amazon is the biggest bookseller in the world, allowing it to take advantage of economies of scale that feed back into lower prices, and Google collects the most data. Both are competitive moats that enable enduring market leadership.

This kind of operational superiority inevitably shows up in the financial results. Quality businesses stand out through metrics such as high earnings quality (the degree to which reported profits translate into cash flow), high margins and high returns on capital.

For many investors, the term “quality” is reserved only for large businesses, which is understandable. A larger bank pays lower per dollar funding costs than a smaller one and a large supermarket can buy milk more cheaply than a corner store. Such cost advantages are entrenched, placing smaller businesses at a disadvantage.

If scale is a powerful advantage, does this automatically render the phrase “quality small cap” an oxymoron?

Not in our view. Small market niches can be dominated by small businesses just as large markets can be dominated by big blue chips. But there’s a finer point to this understanding: whilst market dominance of a small niche deters competition, a small market size keeps the big boys away. It’s not necessarily a bad place to be.

Being small also improves the potential for higher levels of growth: “Elephants don’t gallop”, as famous small cap investor Jim Slater says. This is simple mathematics. It’s easier for a $100m business to double in size than it is for a $100bn business. Just ask Apple. With that in mind, here are two high-quality small caps that we think fit the bill.

Gentrack Group (ASX: GTK) provides software used by utilities and airports, collecting consumption data, calculating fees, producing bills, processing payments and managing debt collection. It also makes an airport operating system, delivering functions like aeronautical billing, flight information displays and baggage management.

If you’ve been through Sydney, Melbourne or Auckland Airports, you’ll have seen Gentrack’s software in action. In Australasia, the company’s software is installed in 85% of the region’s airports with more than a million passengers a year. Worldwide, however, it’s a minnow with just a 7% share.

Once installed, Gentrack’s software becomes a cash flow engine while the high cost and time required to switch providers make customers ‘sticky’. The average Gentrack customer stays over nine years.

High switching costs also deliver significant pricing power when negotiating contracts, which usually have a built-in annual fee escalation based on inflation. This, in addition to regular software upgrades, testing and various add-on service charges, means around 60% of the company's revenues are recurring.

Better yet, Gentrack doesn’t need to reinvest its earnings to grow revenues. When a customer wants a new system, it pays for it upfront. And, with software engineers its largest expense, Gentrack requires few tangible assets to operate, meaning profits are efficiently converted into free cash flow. The company operates with a healthy margin of around 20%.

Gentrack listed in June 2014 at $2.18 a share, rising as high as $2.40 in its first few months as a listed company. Then a profit warning sent its shares slumping, which we saw as an opportunity. Despite the hit to earnings, this remained a high quality company with an entrenched market niche.

In August 2015, with the share price at $1.80, we recommended Gentrack as a Buy. Since then, it has increased over 75%, provoking a downgrade to Hold. But should the price fall below $2.20 we’d love the opportunity to top up. At least for now, this opportunity may have passed. There is, however, another high quality small cap in buy territory.

GBST Holdings (ASX: GBT) is a financial software business with leading positions in the capital markets and wealth management sectors. Like Gentrack, GBST adds plenty of value to clients’ businesses, is protected by high barriers to entry and has a large proportion of recurring revenue.

Most exciting are the opportunities in its wealth management business. Australia and New Zealand are widely credited with inventing the platform market in the 1990s, with the goal of reducing costs and making life easier for investors. Initially, the software used by platform providers was built in-house but specialist providers also emerged. Their number included InfoComp, which was purchased by GBST in 2007, including the company’s Composer product.

GBST estimates that about 30% of the Australian platform market is now managed through Composer, with about 50% internally managed and the remaining 20% shared by other vendors, including Bravura Solutions and FNZ Group.

This gives GBST a dominant position but also plenty of scope for growth, given the competitive advantages of Composer compared to in-house software. These include much-reduced development and installation times and cost efficiencies. So attractive are these benefits that clients are prepared to pay a portion of GBST’s development spending, allowing the company to retain the intellectual property to use in future installations without fully funding it.

The UK was late to embrace the idea of platforms but is now making up for lost time. The company’s 2014 annual report notes that UK sales rose six-fold in the previous five years, but that the ‘market is still in its early stages’ with the wrap and platform market ‘expected to quadruple by 2020’. GBST, along with Bravura and FNZ, are right at the heart of a sweet spot.

So, which company will win the biggest share? Composer claims a few important advantages, including a multi-channel capability and a ‘gating’ facility, which enables the system to close off certain features to different categories of user – denying pension withdrawal options from those in the accumulation phase, for example.

This is particularly attractive to financial product providers because it enables them to offer other products to captive audiences within workplace schemes. It also makes it easier for providers to offer single platforms that address the adviser-based, workplace and direct-to-consumer markets.

GBST Composer now supports three of the top six UK investment platforms with clients including Aegon, Fidelity UK and leading SIPP provider, AJ Bell. If the UK platform market does quadruple by 2020, it will be a huge tailwind for GBST.

As with Gentrack last year, GBST is trading cheaply due to what we believe will prove to be temporary setbacks. With project delays that hit earnings, the departure of its CEO and Brexit, the 2016 financial year was one the company would rather forget, especially as the UK’s decision to leave the European Union increases the risk of further delays of software upgrades by customers.

Some of these risks mean GBST’s growth trajectory has slowed. But these risks are already baked into a lower share price. We believe there’s every chance growth will resume as customers are forced to eventually upgrade their software to remain competitive, which is why GBST is a Buy below $4.50 a share.

James Carlisle, Head of Research of Intelligent Investor owned by InvestSMART. This article contains general investment advice only (under AFSL 282288). To unlock Intelligent Investor stock research and buy recommendations, take out a 15-day free membership at http://landing.intelligentinvestor.com.au/asa.

Note: The Intelligent Investor Growth and Equity Income portfolios own shares in GBST.

Disclosure: The author owns shares in GBST.

Comments

EMAIL FROM AN ASA MEMBER:

I have just read the article from James Carlisle from Intelligent Investor in relation to:

1. GTK - Page 6 –Currently $3.35 share price with 3.38% dividend return – virtually no franking credits. James recommends the stock as a “buy” once it falls below $2.20 per share. If the share falls from $3.35 to $2.20 that would be because its profit had fallen and it is going backwards. Therefore the return based on the current dividend of 5.15% (11.33 cents/$2.20) would not happen because there would be minimal or negative profit for the share price to go from $3.35 to $2.20 or lower. Also the EPS forecasts for Yr1 and Yr2 are not shown (or do not exist) on Commsec. I cannot see why I would be interested at all in this share. Have I missed something?
2. GBT – This company has a dividend return of 4.26% grossed up. The price has been in the $4 and $5 areas in the past and is on a falling graph. The 2016 EBIT, sales etc… are falling from the highs of 2014 and 2015. James talks about temporary setbacks re Brexit etc… James bases a recovery on customers having to buy to update their software. He then amazingly says that the share is a buy at below $4.50 when it is now $3.69. So it is performing poorly now but at $4.50 the world will be set on fire as it begins to fly???!!!! This company has a current EPS growth of -38.97% and is trading on a PE of 26.88 times. I would have to wait untiI I am 91 to get my capital back… I think that he has become delusional since he bought his shares in this company.

On the other side there is a share “CSV” trading at 70 cents in the same family and is delivering 12.85% dividend return. It has an EPS projection for Yr 1 of 107% and then 15% for Yr 2. It is making profits, has a good balance sheet and is on a PE of 15% going down to 7% next year as a projection. I would be more interested in examining this share. I do note that on 17/11/16 when the reports came out the price dropped by 50 cents or so.. perhaps we have three basket cases??

All the best,