When we wrote our inaugural Christmas stock piece last year, our intention in future years was to share some of the lessons we’ve learned about investing each year along with a 20- year stock for your grandchild’s portfolio.

There is nothing like committing a single stock idea to paper and in public to call out the investment downgrade-gods which is what happened not long after we published last year’s gift letter. I was alive to this risk (which is heightened in small-cap investing), and experienced the emotional and financial impact alongside those that might have taken our lead.

The event, however, delivered one of the dual lessons we were keen to share: that investing is not just about success, but also about how you manage and deal with failure. And that diversification decreases the impact of individual setbacks, helps to manage the emotional impact of temporary setbacks and ultimately delivers an investor multiple opportunities to be more right than wrong.

We cannot think of a profession where even the best in the business have to tolerate high levels of failure as the price of success, but that, ironically, is the day-to-day reality that every investor faces. We invest in the face of complex and uncertain future pathways for both underlying businesses and markets. As a result, it’s not possible to know with absolute certainty that an investment is going to work out as forecasted.

Failure in individual stock decisions tends to fit into one of 3 categories. Investors can experience total loss of equity capital, a short-term set-back to an earnings growth profile and share price, or an industry or business can turn out to be not what you originally thought it would look like in the future (thesis break). The first type is very binary in terms of its outcome and often its timing (the heavy dilution event or insolvency either happens or it doesn’t). The second two can occur over time and as a result, your own investing behaviour in the face of new information really matters.

In small caps, a total loss of equity capital is a very real risk. You can invest in a very early-stage business that has big promises about what it will look like in the future, but is currently loss making and ultimately never produces real profits or generates real returns to equity holders. In these cases, your original hard-earned money can be diluted to practically nothing as the business raises money to survive. Likewise, you can invest in a more mature business that is carrying too much debt and then face a business set-back that ultimately leads to either heavy equity dilution to pay back the lenders or insolvency.

A thesis break (where the evolution of industry structure or earnings growth doesn’t play out the way you thought it would) is more common than you might think. Thesis breaks tend to happen when a series of new data points play out over time. This time period can often seem very long. Anywhere between 12 months to 2 years.

Ultimately though, the value of the business doesn’t evolve in the way you anticipate and a decision has to be made about what to do.

Finally, there’s the short-term failure to anticipate a temporary set-back to a business’s growth trajectory. This is really a set-back on the time-continuum of investing. If nothing else has changed in the business, doing nothing or buying more maybe the best course of action.

To mitigate these risks in small-cap investing, it helps to identify the most common sources of complete capital loss (like investing in very early stage businesses that haven’t proven their unit economics or heavily indebted businesses) and either avoid them altogether or heavily risk-manage position exposures to those types of businesses.

This is how and why we arrived at our investment philosophy of only investing in quality small cap companies. We all learnt the hard (and very emotionally taxing) way that 9 times out of 10, investors don’t get paid to wear the risk of total loss.

The other two types of risks are harder to avoid altogether, but there are some behavioural disciplines you can follow to help mitigate them. Firstly, diversifying your portfolio so that no one set-back causes you to lose a lot of capital or give up altogether is a big lesson we’ve learnt through time. Secondly, writing down and time-stamping your investment thesis and the milestones you expect to see over your investment time-horizon is an extremely useful discipline to follow. This helps you stay honest with yourself about why you own a stock and identify a thesis-break when it occurs (rather than stumbling into thesis drift and continuing to hold the stock for different reasons).

About a month after we’d published our 2023 Christmas gift, Nanosonics issued a profit downgrade for the 2024 financial year. Capital spending budgets in their core USA Hospital market had been under pressure and the pipeline of new machine sales and upgrades Nanosonics had thought would convert to sales during FY24 no longer would. The consumables part of the business was still growing. The share price declined, reflecting a rebasing of earnings and valuation multiples.

Given Nanosonics has a net cash balance sheet and is still self-funding its growth, it is still a quality business when viewed through our lens. So the core question for us was whether this reflected a short-term setback or a thesis break.

Where we stand today, we still see a long runway for growth for Nanosonics. The second half of FY24 saw an improvement in capital and consumables revenue and the outlook for FY25 was relatively robust. What really matters in a 20-year stock though, is the medium-term outlook for revenues and earnings. We don’t see any data points to change our original thesis; Trophon capital sales should continue, helped by a new Trophon machine launch in the next few years and new international distribution partnerships. A new disinfecting system for endoscopes is closer to final approval with the FDA and will be meeting an unmet need when it launches (expected in FY26).

Source: Longwave Capital Partners, Company Accounts

Post the downgrade we chose to do nothing immediate. We spent time reviewing the investment thesis and came to the conclusion that the business is more likely to be facing a similar issue to the one that Cochlear faced in 2004 rather than a structural change to the medium-term growth outlook. We added to the position in July 2024.

Source: Longwave Capital Partners, Company Accounts

This year I’ve chosen Imdex Limited as our Christmas stock gift. Although Imdex is a business exposed to a cyclical end-market (its customers are mining and exploration drilling companies), it supplies needed technology for successful discovery of new orebodies and has a long history of investing in R&D to grow both the average selling price of its core rental tools and also capture more share of wallet from its customers.

Imdex provide downhole sensor tools and “muds” (better thought of as lubricating fluids for drill-bits) into the global exploration drilling market.

The sensor part of their business rents out high-tech underground navigational sensors on a monthly basis to exploration drillers wherever they are in the world. Like navigation systems in an airplane or on a boat, these sensors help drillers understand where their drill bit is under the ground so that they can be confident they’re going to hit the potential metal-bearing target they’ve been hired to find and assess.

The “muds” part of their business is a lower-value consumables business, but still an essential part of the drilling solution Imdex sells. What they sell in this segment is not mud in barrels, but fluids that are a combination of oils and other viscous materials that help to keep a hole drilled into rock ‘open’ so that the drill bit can go down smoothly and the “core” can be captured in one piece (which helps geologists infer and understand what an orebody looks like under the ground).

Finally, Imdex have developed and sell a suite of cloud hosted software that can help geologists inside mining companies see information from their drilling sensors in the field on a computer desktop in real-time. This helps them see in real-time how a remote drilling program is progressing (imagine sitting in an office in Perth, but being able to see everything that happened on site during a shift in the remote Pilbara), form early views about the orebody and potentially re-direct drilling efforts as they discover new information about the orebody they’re drilling into.

Imdex have a long history of investing in research and development to produce newer and better tools that drive efficiency and insight for their customers. Over the last 5 years they’ve spent over $150m in R&D creating next generation sensors and software. The corresponding growth in tools on hire and average selling price has driven an almost doubling in revenue and over doubling in EBITDA in that time.

This has not all been driven by a cyclical increase in exploration activity. Global exploration spend is only up about 30% in that time.  This means that Imdex has been successful at growing faster than its underlying market. We see strong potential for this to continue over the next 20 years. After acquiring Devico in 2023, Imdex have a strategy in place to continue bringing new tools to market to further drive growth in their core business of tools, fluids and software. They see a pathway to almost double their share of wallet in global exploration budgets from that core from $2.10 out of every $100 spent to around $4 out of every $100 spent. In addition to this, Imdex have been developing a tool for an entirely new production drilling market. The production drilling market is less cyclical than exploration and the tool Imdex have developed (called Blast Dog) helps to drive insights into a mining production environment that can help cut costs. Imdex have been in commercial trials with several large mining companies for a few years now. Success with the Blast Dog commercialisation could see a further doubling of revenues and earnings over the long-term.

If you buy Imdex around the current price of $2.40, you’re paying a near-term PE of 24x for a business that we believe will grow earnings between 10 – 15% per annum over the medium term and has the optionality of reducing the cyclicality of its earnings growth through success with Blast Dog.  A reasonable level of balance-sheet gearing means that the growth in cashflow should come back to shareholders.

Source: Longwave Capital Partners