Tapping into disruption

However, our domestic stock market is concentrated around key industry segments – the major banks and insurance companies, the large resource companies, Telstra and retailers Wesfarmers and Woolworths.

A significant portion of the market’s value is incorporated in the top 20 companies and concentrated in a number of specific industry segments. As a result, this area of the market dominates the financial press and is the focus of much of the attention of the professional investment community.

There exists a long tail of listed stocks outside these household names that can bring benefits to your overall portfolio in terms of capital growth and diversification. As a general rule, the lower the market capitalisation, the less research by stockbrokers, the fewer funds that are able to invest and the less mainstream media coverage, the greater the opportunity to uncover successful businesses of the future.

Change is happening rapidly, technology is providing the catalyst for increasing competition across all facets of the economy. Many large companies are facing disruption to their business models from much smaller and more nimble competitors.

The demise of once large companies like Nokia, Kodak, Borders, Blockbuster and Blackberry are examples of businesses that failed to adapt to change. The arrival of large international companies such as Aldi, Zara, H&M, Uniqlo and the expected market entry by Amazon are further examples of increased competition facing Australian companies.

TPG Telecom, Domino’s Pizza Enterprises and Realestate.com were once small business that competed aggressively with much larger competitors and are now top 100 stocks themselves.

Along this journey, investors have been rewarded as these once emerging companies take advantage of structural change and build successful business franchises. Identifying these businesses at an early stage of development is the opportunity for microcap investors. Often, these businesses are less dependent on the health of the overall economy as they are taking market share or creating new market opportunities. These businesses can often give you far more granular sector exposure to positive investment themes.

In light of this increased competition and general benign economic growth globally, it’s worth thinking about areas where SMSF clients can seek long-term capital growth for their portfolios.

The microcap segment is one worth considering if the client has the appropriate risk tolerance and a long-term horizon. This part of the market which we define as below $250 million in market value at initial investment is often overlooked due to its size. This segment offers a very large investable universe (in excess of 1,500 companies with a market value below $250 million) that is exposed to diverse parts of the economy, both domestic and offshore.

This provides SMSF investors the combination of some of the fastest-growing and nimble businesses, in addition to a lower level of focus by the professional investment community. The opportunity to seek out undervalued business, well-positioned for the trends of the future, provides the ingredients to deliver long-term capital growth as these businesses build over time and become of greater interest to more market participants.

We like businesses that offer a solution to a problem or provide a better outcome for the consumer that can be scaled and address large market opportunities. For example, the ageing population brings with it many challenges around expenditure on healthcare and providing support for an ageing population.

People are living longer and this trend will only accelerate over the coming years. A company that is in its infancy – but offers a solution relevant to hospitals and aged-care facilities that improves the patient experience while also providing great efficiency benefits to the care provider – is therefore worth considering.  As the company increases its reference sites, there is potential for significant growth potential as the product will become a differentiation point for organisations that implement it.

The best market opportunities exist where there seems to have been no significant improvement in the product offering for some time. Companies that create innovative solutions, relevant to a large market, that address both patient experience and operating efficiency in this sector are a good opportunity for SMSFs.

The harnessing of the internet and mobile technology has disrupted many industries in a relatively short period of time. From social media, marketing and engaging with customers, the way in which we consume entertainment – such as streaming services versus the video store – to the impact on print media, free-to-air TV and CD sales, there are countless examples of major impacts to the value of businesses and industry outlook.

This remains a key area of focus as it will continue to create opportunities for microcap companies that use technology to deliver a better offering. Not every company offers a better solution to a large problem. Some are just well-managed businesses with attractive long-term growth profiles. Microcaps overall offer a diverse universe from which to build portfolios that cover a range of industry sectors and business models.

SMSF practitioners should look for emerging businesses that seek to capitalise on structural changes, changes that impact where an economy is going, not where it has been.  Small businesses run by capable and credible management with a sensible business strategy to deliver significant growth in earnings, and market value, over the medium term. It is vital to take a long-term view, aiming to identify the investments that will be the winners of a rapidly changing environment.

Investing in microcaps does carry risk as the companies tend to be at an earlier stage of development. Liquidity is an issue and performance can be volatile as a result. While it can be tempting to buy into the hype of the supposed ‘next big thing’ or a business promoted as on the cusp of a major transformation, in microcaps it pays to take a portfolio approach to reduce risk.

Joel Fleming, portfolio manager, UBS Asset Management