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Five years ago fundies were avoiding small caps due to many Australian failures overseas. Today the market can’t get enough of them despite COVID-19 uncertainty.
Today the market can’t get enough of them despite COVID-19 uncertainty.
Anew breed of Australian companies is pursuing rapid international expansion as investors re-rate small-cap stocks with global potential. Not even COVID-19 or a higher Australian dollar, which favours domestic-focused companies, is derailing their plans.
One small-cap company after another wants to resume its global growth push when pandemic restrictions ease.
“Almost half of the companies we own now have a global focus,” says Richard Ivers, portfolio manager of the top-performing Prime Value Emerging Opportunities Fund. “We’re seeing more small caps expanding overseas earlier in their lifecyle. And more companies (IPOs) coming to market with established offshore operations. They are global from day one.”
This turnaround is remarkable. Five years ago, fund managers mostly avoided small caps that announced bold overseas growth plans, such was the number of Australian failures overseas. The phrase “transformational offshore acquisition” was code for shareholder wealth destruction.
Today, the market can’t get enough of small caps with offshore potential. And not only in information technology, biotechnology or other sectors inherently global. Even small retailers, insurance and building-materials companies are taking on overseas markets.
“There’s a lot more demand for Australian small caps that are successfully expanding overseas,” says Ivers. They’re targeting a much larger addressable market and have a longer runway for growth. That comes with risk, but those that get it right can do very well.”
AfterPay shows the potential. The buy now, pay later star has strong traction in the US and is poised to become a global platform in its market. Now a top-20 stock, AfterPay shares soared this month after its US rival, Affirm, doubled on its Nasdaq debut.
Therein lies the promise and potential pain. Australian companies that succeed overseas inevitably benefit from comparisons to offshore firms with higher valuations. Those that stay behind can suffer as more capital is reallocated to companies with international appeal.
Wisetech Global, Appen, Altium, Xero and other tech leaders reinforce the gains from Australian-listed companies that crack international markets.
Glennon Capital’s Michael Glennon says his firm’s attitude towards small-cap companies that expand overseas has changed. “We used to be adamant we wouldn’t invest in Australian companies that moved offshore through big acquisitions. Often they didn’t understand market nuances, underestimated the competition and lost a huge amount of money.
“Now a number of small caps in our portfolio have global operations and are doing well. The world has become a lot more globalised and that’s reflected in the growing number of Australian companies, across industry, that are taking on global markets. Business digitisation and a new generation of globally-savvy managers is also driving offshore growth strategies.”
Care is needed with this trend. Adam Simpson, a portfolio manager at Smallco and a former top-rated small-cap equities analyst, says the market is prepared to back offshore expansion. The Smallco Broadcap Fund was the top-performing Australian share fund over a decade to December 2019, according to Mercer.
“Growth has been harder to find, so the market is more willing to allocate capital to small caps that want to expand overseas,” says Simpson. “For now, there’s greater tolerance of start-up losses overseas to achieve that growth down the track but that could change quickly.”
Simpson’s colleague, Craig Miller, says Smallco has been a long-term investor in Wisetech, IDP Education, Webjet and Corporate Travel Management – stocks with global operations. Among smaller stocks with offshore revenue, Smallco rates Audinate Group, a maker of audio-visual networking technologies.
Smallco invested in the recent float of Nuix, a provider of investigative analytics and intelligence software, but is wary of current IPO valuations. “We haven’t found many IPOs of late that are attractively priced,” says Miller. “We have a cautious stance on the local sharemarket and are trimming some exposures with a view to buying back in when valuations improve.”
Steve Black, co-manager of the Pengana Emerging Companies fund, another top performer in its category over a decade, is also wary of overseas expansion trends. “The market is giving companies the benefit of the doubt and risk is taking more of a back seat. Five years ago, there was far more market scepticism when Australian companies expanded offshore.
“A spate of small Australian companies went overseas, failed and burnt investors. Today, it’s all about growth. Companies are under pressure to find new sources of growth, justify a rising share price and maintain the market’s interest. Boards think international expansion is the answer to drive earnings higher.”
COVID-19 has been a curse and blessing for small caps with international ambition. The pandemic has weighed on Australian companies with international assets.
But in some ways, COVID-19 has bought more time for small caps that have pursued international growth in the past few years in terms of proving their strategy.
“Offshore acquisitions never fail in the first year,“ says Black. “It’s usually year two or three when the music stops and the market reacts. Investors will probably show more leniency than usual for companies that have stumbled overseas because of COVID-19 lockdowns. That won’t last forever. This trend will end in tears in the next few years when some of these international acquisitions and organic expansions fail.”
Black says the performance of star Australian companies overseas can seduce investors. “AfterPay’s success has lifted the valuations of other buy now, pay later providers that want to grow internationally. That has the hallmark of a classic investor bubble that will inevitably destroy capital.”
Black says it’s wrong to assume Australia is too small for fast-growing companies. “It’s a cop out to say small caps have to expand overseas because they will outgrow this market. Some companies can have years of self-funded, lower-risk growth in this market. They don’t need to raise capital so don’t get the hype that comes with fund raisings for international expansion.”
Lifestyle Communities, a small cap that provides independent-living properties for older Australians, shows the benefits of a domestic focus, says Black. “Lifestyle Communities is steadily rolling out its model in Victoria and performing strongly. It’s never left its home state, yet has years of growth ahead. The risk profile is far lower because it is repeating the same strategy over and over.”
Microequities Asset Management CEO Carlos Gil is another sceptic of the benefits of international expansion. “I’m not convinced more microcap companies are expanding overseas today compared to 10 years ago. Anecdotally it feels like that, but even a lot of tech companies, particularly those that sell business-enterprise software, are mostly Australia-focused.”
Hindsight is another consideration with small-cap expansion plans. “In the past, we’ve seen many Australian businesses blow up billions of investors’ money [through failed offshore expansion strategies],” says Nathan Bell, portfolio manager at The Intelligent Investor.
“They made debt-fuelled acquisitions in unfamiliar markets due to a combination of greed, hubris, stupidity and pressure from boards and shareholders to find new growth avenues once they’d exhausted all growth possibilities at home.
“Yet we also have numerous companies that now dominate their industries at home and abroad by steadily improving their products and distribution over long periods of time. The key behind being successful overseas is patiently investing in great products that competitors can’t imitate – over decades and under different CEOs.”
Generalisations are always dangerous in small-cap investing. As always, treat each small-cap company on its merits. And beware hype about international-expansion strategies or valuation references to other companies that are succeeding overseas.
Talk of multi-billion-dollar international markets is good fodder for company marketing presentations and pitches from investor promoters. But for every AfterPay, Wisetech, CSL, Cochlear or Macquarie Group, many more companies fail overseas.
Most of all, focus on earnings. The February reporting season will show how small caps with international operations are faring in pandemic-ravaged markets, and their outlook. A relatively stronger Australian economy and our rising dollar works against small caps with offshore earnings and favours those operating only in this market.
Click here to read the article on the Australian Financial Review
Tony Featherstone – Finance writer
Updated Jan 24, 2021 – 9.48am, first published at Jan 23, 2021 – 12.00am
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