Why Small-cap Stocks can Provide Some of the Best Opportunities for Investors | Brian Huerta, WCM Investment Management

During the recent Switzer Investor Strategy Day Brian Huerta, Client Portfolio Manager for the WCM International Small Cap Growth Fund (the Fund or Portfolio) presented on WCM Investment Management’s unique investment process and philosophy, the stocks Brian is seeing the greatest potential in and why small-cap stocks can provide some of the best opportunities for investors.

Presentation Transcript

Many of you are aware of our large cap growth fund. I’m here to talk about our small cap international growth fund where we see a ton of opportunities. There are just thousands of companies to choose from and the market is ripe for stock picking. Now the process and the philosophy are identical for both funds. However, there are some key differences with this particular portfolio.

For one, there’s just a wider variety of countries, companies, and also industry groups. And secondly, this fund is focused purely on small caps. Our sweet spot is 500 million to $5 billion but we go all the way up to 10 billion. And lastly, for most of the companies in the portfolio, you will have never heard of them but many of them are the most interesting and innovative companies in the world. So for today’s presentation, I’m going to first talk a little bit about our philosophy, then our process, and then leave you with a couple of stock ideas directly from the portfolio.

To get started, what do we believe in? Why do we believe in long-term investing? We think successful investing requires patience. We’re looking for those companies that can grow year over year over a long period of time, do it consistently, and also of course get the benefit of compounded returns. In this particular portfolio, our average hold period is about three years but we have certain stocks which we own for more than five years.

Secondly, we believe in concentrating the portfolio. We don’t see the point of owning our 150th best idea. So the WCM International Small Cap Growth Fund is a focused portfolio of 50 to 75 high conviction ideas.

And then thirdly, and somewhat counter-intuitively, is that we focus quite a bit on downside protection, meaning we want to do better than the benchmark during challenging markets. Now, how do we achieve that? By stock selection and portfolio construction. We’re investing in companies that are the most durable and defensible and hold up the best in challenging markets.

So now let’s talk a little bit about our process. How do we pick stocks? And there’s two big differences between ourselves and our peers. Our first is how we think about competitive advantages, and secondly, our framework for corporate culture. Now, my guess is, if we brought 10 growth managers into this presentation and asked them, describe your process. Nine out of 10 would describe it this way. You’d probably say we buy high quality companies when they’re trading well below their intrinsic value, right? The idea of buying them on the cheap seems logical, but does it work? We would argue that investing that way is going to lead you possibly into value traps. And that is you’re unknowingly invested in former growth stocks that are on their way to being a value stock. And by the way, if everyone is doing the exact same thing, how can you expect differentiated results?

Our approach is different. We’re looking at companies that are considered high quality, that are growing their competitive advantage, that are supported by strong and healthy corporate culture at fair and reasonable prices. So what does it mean to invest in a company with growing competitive advantages? Well, the simple explanation is we’re buying companies that simply get better and stronger over time. Their businesses become more defensible, they become more protected throughout time. We view competition as something that is always dynamic. It’s never static. Companies are either getting stronger or they’re getting weaker. And as an investor, you want to be on the right side of that direction or that trajectory. It might be the most important determinant whether that investment becomes successful or if it fails. Now, companies with strong competitive advantages generally benefit from a few things. It might be, they have economies of scale. It might be that they have great brand value, reputational advantages, or they might have really close customer relationships. We’re looking for those companies that are able to expand and take advantage of those competitive advantages only to get stronger. We’re looking for the companies that we think are going to be stronger not just now, but over the next five years. So the focus around competitive strategies or competitive advantages is that we’re focused on the future as opposed to the past or present.

The second element to our process is our approach of corporate culture. And this is something that we think is often overlooked or flat out, just ignored. And I’ll start first with a quick definition of what we mean by culture. Culture is a set of values that drive behaviours within an organization. And it’s what animates the business. A company with good culture is creating great habits that are done every single day and are becoming grained as a part of the day-to-day operations within an organization. They’re almost imperceptible for folks on the outside but they become very difficult for competitors to copy.

Now for the investment community, they often have a hard time thinking about culture. It’s hard to quantify, it’s hard to put a value. It doesn’t fit cleanly in an Excel spreadsheet. They question whether it’s even valid if they’re looking out at an investment for the next 12 to 18 months. But at WCM, we feel that culture is often what separates the great companies versus the merely good companies. And a company with a strong and supportive culture are the companies that are able to detect change in an industry, see new opportunities, recognize when a new competitive threat is entering the market, and maybe most importantly, make corrective actions when the business hits some headwinds.

Combining these two criteria around growing competitive advantages supported by strong cultures, we’re able to narrow our universe and select the stocks that we believe will outperform over the long term.

Now let’s spend a couple of minutes on how we build our portfolios. We take a very balanced approach and we group our stocks based on their risk and their expected growth rates. Our first bucket is defensive growth stocks and these are some of the most resilient businesses that we own. They’re steady Eddie, they continue to earn outsize returns throughout a cycle, and they also have the benefit of typically holding up quite well during market downturns. The second third of companies is our secular growth companies. And these are companies that are growing among the fastest in our universe, have the most innovative products and services, led by visionary CEOs with open-ended growth potential. And then the last third are our cyclical growth companies. And these companies tend to be the most economically sensitive that benefit from expansionary periods, periods like we’re experiencing now. But these three groups all combined form one portfolio that enabled us to have downside protection and upside participation in a variety of market environments.

I’ll spend a minute talking about a few stocks that we have in the portfolio. The first stock is called Bengo4.com which is a Japanese technology company probably best known for its cloud signed product, which is essentially an e-signature product. So think of Bengo4.com as a DocuSign of Japan. And there’s just an enormous runway for growth of this company. Less than 1% of all contracts signed are done electronically and as companies look to automate their workflows, they’re turning to companies like Bengo4.com to help them do that. Its competitive advantages stem from years of experience working with accountants and lawyers, where the product is fully ingrained into those verticals and it continues to invest in the brand to enable them to grow vertically into such areas as government. And the culture at Bengo4.com is quite different. It’s a flat organization, very merit based and it’s led by its founder CEO. It’s not saddled by some of the legacy issues from some of the bigger technology companies in Japan. And it’s shown to be quite adaptable as well.

Another idea that we’re really excited about is Royal Unibrew, which is a maker of beer and non-alcoholic beverages based in Denmark. And this is a company that has evolved from a Danish brewer into a maker of ready to drink cocktails, flavoured sodas, and energy drinks; it’s focused on the most attractive and fastest growing categories in beverages. Its competitive advantages stem from its wide scale in Eastern and Western Europe, and its focus around craft and premium drinks. They continue to invest in the brand and they’re extending into new categories. And the culture is one in which the sales people are out in the field building relationships with bar and restaurant owners and retailers, having their ear to the ground detecting any competitive shifts or shifts in consumer tastes, as well as to be on the lookout of brands that they might acquire.

So to wrap it up, we just see a lot of opportunities for us in small caps. There’s just enormous white space for us to grow. And there are just new companies that continuously are coming to the market almost weekly. By focusing on companies with growing competitive advantages, with strong and healthy corporate cultures, we feel like we’re going to be able to exploit some of the inefficiencies there are in small cap investing.

DISCLAIMER: Past performance is not a predictor of future returns. This update has been prepared for information purposes only. Any figures provided in this document are unaudited and approximate. This post does not contain investment recommendations nor provide investment advice.

You are strongly encouraged to obtain detailed professional advice and to read any relevant offer document in full before making any investment decision. This is not an offer to invest in any security or financial product.

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