Small Cap Portfolio Construction: Tools vs Treasure
– David Wanis, June 2019
Small Cap portfolio construction is about balance. Building a portfolio requires an understanding of the fundamental, causal drivers of each position and how they may offset each other through time. In an over-optimised world, this means understanding the correlation of stocks or groups of stocks (sectors, industries) with each other and scaling positions to capture the diversification benefit different correlations offer. In a more robust way, it is understanding that we have a large estimation error on any forecast we make about the future, and even if we can get the end point (say three to five years out) correct, the path there remains uncertain. Stocks likely to travel a different path help diversify a portfolio.
Based upon their underlying utility to investment portfolios, two sectors within the small cap universe, which we think are uniquely diversifying are; technology and gold; tools and treasure.
The technology sector is a GICS classification that captures companies most likely to commercialise novel tools that increase productivity (of labour, capital or both). For centuries, technology has been a force multiplier on commercial efforts. Whether it was a mill, a plough, a loom, a steam engine, a microprocessor – or more recently a cloud deployed enterprise SaaS application. New technologies are fraught with risk and only a small fraction end up providing sufficient utility to enough people to become a significant commercial enterprise. Fortunately for Australian equity investors, most of that risk is borne by earlier stage investors (angel and venture) and most listed small caps are proven both from a technology and commercial perspective.
A particularly vibrant small cap technology ecosystem has emerged over the past five years. Providing investors a range of young, but proven, high quality and high growth companies to choose from. Putting valuation concerns to the side momentarily (we explored previously how difficult precision is here), the returns across the sector were by far the largest of any small cap sector over that time.
Gold is a sector which has long been a meaningful part of our small cap universe. Historically, the Australian equity market has been used to fund emerging mining companies far more than emerging technology companies – reflecting the natural advantages of Australia’s mineral wealth. Five years ago, the picture for small cap gold companies was not encouraging. The A$ gold price had declined from a recent peak of around A$1,700 in late 2012 to under A$1,400 by mid 2014. It wasn’t only the external pricing environment that was bleak; balance sheets for most small cap gold miners were loaded with debt and poor profitability was, if anything, overstated when using inconsistent management cash cost disclosure. In early 2014 the introduction of All-In Sustaining Cost (AISC) adopted across industry highlighted an even worse reality. Many companies were in the perilous position of carrying too much debt and delivering real cash losses.
If the most common investment debate about technology stocks is their sustainability and valuation, the most common debate about gold stocks is the premise of the underlying utility of the barbarous relic itself. As a store of value or a form of currency, gold doesn’t need to produce anything other than a belief among investors that others will share their belief. Gold is almost the anti-tool. An investment that delivers no productivity gains or tangible economic benefit, but one that is widely considered a viable option when most other sectors (particularly sectors like technology) are marking big losses in investor portfolios.
Five years ago, small gold stocks were difficult to use in this diversification role as the stock specific risk of failure was heightened across many names. From 2014 to 2016, companies focused on getting their true operating costs (AISC) to more sustainable levels and were fortunate enough to have a strong tail wind in the form of gold prices increasing from A$1,400 to A$1,600 over that period. Strong cash flow was used to pay down debt and many gold companies quickly got to net cash balance sheet positions. These fitter, better capitalised businesses then had the ongoing good fortune of seeing the A$ gold price continue to rise another 25% and set a record of A$2,000 / oz by June 2019 (rising US$ gold boosted by a falling AUDUSD exchange rate), driving margins, profits, cash flow and net cash even higher.
How we position tools and treasures in our small cap portfolio construction
Our investment approach is concerned with high quality companies. We do not discriminate by sector as we believe quality businesses can be found across the market. Numerous technology and gold stocks meet our quality test. Although in the not so distant past, a lack of proven, commercial technology or heavily indebted balance sheets and cash losses, would have seen these companies fail our quality assessment.
We currently hold about 10% of our portfolio in gold equities which has been a significant contributor to performance over the past three months. We hold a similar amount of the portfolio in technology stocks (not all classified under GICS technology sector). It has been an unusual period when both technology and gold have been performing well and over time, we would expect greater diversification benefits across our holdings.