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BALANCING RISK AND OPPORTUNITY WHEN INVESTING IN THE NEXT BIG THING Joel Fleming, Portfolio Manager, UBS Asset Management Vanessa:

Well welcome, Blair. Another masterclass…

Blair:

Yes.

Vanessa:

…for you today. I’m looking forward to this one. So we’re here at Spaces, which is a co-working space in Surry Hills, and this is an appropriate place for you to meet Joel. Joel is a microcap investor, which means he’s looking for the next big idea and this is a place where the next big idea might be brewing as we speak.

Blair:

Oh, right.

Vanessa:

Joel, it’s worthwhile you telling Blair what it is you do.

Joel:

Okay. Microcaps represent the smallest listed stocks on the stock exchange. So, on the ASX you’ve got thousands of listed companies from some of the big household names: Commonwealth Bank, Telstra, Woolworths, those names we would all be familiar with and a lot of investors are well exposed to this area. Outside of that, there’s a really long tail of businesses doing really interesting things.

Blair:

Yeah.

Joel:

We focus on this long tail of small businesses that are doing things today which means they can become much bigger businesses in the future.

Blair:

Are you working off potential or is there kind of like a formula. How do you kind of do it?

Joel:

We’ve been investing in small caps since 2004, at UBS, and that’s been a pretty interesting time in history. If you think about the GFC, the mining boom, fiscal stimulus, all the things that have happened, it’s been a pretty interesting time for the share market. We use an investment process to help us identify those really good companies 1

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that have a lot of potential, the right combination of great strategy and are well positioned for where the world’s going, as opposed to where the world’s been. Blair:

Yeah.

Joel:

And great management, that’s absolutely key. Because with a small business there’s not layers of bureaucracy. You’re really relying on the people to take that idea and turn that into something that is robust and sustainable.

Blair:

It kind of feels, and this is just absorbing this, is it a pretty risky venture?

Vanessa:

When you say small business, you have to be a certain size to list on the exchange. They’re not like million-dollar companies, right?

Joel:

At UBS we define a microcap as a business that has a market value below $250 million.

Blair:

Okay.

Vanessa:

So it’s not the local.

Blair:

So the sandwich shop on the corner hasn’t got it, right.

Vanessa:

Give us some examples, Joel. Like what sort of companies are you looking at? Because there is risk involved, there’s risk in every investment.

Joel:

It’s probably best to look back in history. If you think about where you go to look for properties, realestate.com and Domain are the businesses that you go to these days.

Blair:

Yeah.

Joel:

It wasn’t that long ago that you would open the classifieds on the Saturday paper where you would find your next house for rent.

Vanessa:

That’s how we bought our first house.

Blair:

I’m just thinking about that, yeah.

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Joel:

And yet with structural change and the arrival of the internet, technology has enabled businesses like realestate.com to come up with a much better value proposition. There’s more photos that you can see, there’s more information. Far more dynamic. That’s an example of what was once a microcap which is now a true top 100 company. The returns that that’s generated for investors over time have been phenomenal. The world’s changing rapidly. In the space of a decade so much has changed.

Vanessa:

Are you looking for those companies like realestate.com that are micro but are going to be big?

Joel:

Absolutely.

Vanessa:

Like are you always looking for them, you know, their goal is to be a top 100 company?

Joel:

Well not every company has that potential.

Vanessa:

Yeah.

Joel:

If you think about where it can grow to in time, not everything is going to be something that increases in value, 10, 20 times. That’s why you have a portfolio because you will get some, right? But you’ll also get some wrong.

Blair:

So you built your portfolio with these types of companies?

Joel:

Absolutely.

Vanessa:

And how many in that portfolio, how many companies do you pick?

Joel:

Between 45 and 55.

Vanessa:

So a lot.

Blair:

Yeah.

Vanessa:

And do you know them all?

Joel:

Absolutely. Unless we’ve made significant research effort and that’s all about understanding what the company’s doing today, what the strategy is, and looking past the market’s generally short-term time 3

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horizon. And thinking “in three and five years is this going to be a much bigger business than it is today?” Vanessa:

So three to five?

Joel:

Yeah, yeah.

Vanessa:

That is a relatively short timeframe.

Joel:

But then there are great examples of businesses that were once microcaps, Domino’s Pizza sold pizzas when it listed, it sells pizzas today. It just delivers them by drone, uses technology to allow you to order and all of these kind of things, which has seen that rapidly increase in value. This is a household name, yet it sat there in the microcap space and has, you know, delivered a phenomenal return. So, we build a portfolio which is diversified, because that’s important. You are taking on more risk in an environment where a business is starting from a low base.

Vanessa:

Going back to the beginning with them, why would they list on the exchange in the first place. There’s a lot of work in being listed.

Joel:

Yeah, there’s a lot of compliance. They do it for a couple of reasons: access to capital, to be able to continue to grow the business.

Blair:

Yeah, yeah. Yeah, okay.

Joel:

Sometimes to grow at the speed that the management want to. They can’t support themselves because they’re growing so quickly, continuing to reinvest. But if we had another couple of million dollars we could go out and hire a team of developers, and really push this story forward. So, one of the things that we always look for is the idea has to be sustainable. You meet people who think they have the cure for cancer, the greatest mining deposit. We’re looking for real businesses that have a sensible strategy. They’ve got a big long-term dream of where they’re trying to get to but they understand those small steps that are required to get there along the way. You need to be able to continue to invest so your business can scale, so when you’ve won that first customer you’re able to provide that same level of support when you’ve got 10 and 20 and 50 customers…

Blair:

Yeah, right. 4

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Vanessa:

So are you going out to management and asking those questions and checking out the staff? I mean do you get to know them that well?

Joel:

Absolutely. It’s one of the great things about this job. You get to meet so many different people who are really out there having a go, and saying, “look, there’s an unmet need out there, there is an opportunity for me to take some market share, there’s an unhappy customer that I think I can address,” often from a blank sheet of paper, and really trying to create something of value, and that’s really exciting. We spend a lot of time with the company management, getting to understand them. One of the great things about microcaps is it’s a really niche area. And it’s niche because you can’t run large pools of money from this space. It’s very capacity constrained. And I think over time people have stayed away because you don’t have the level of broker research. There is a big wide group of companies to choose from and to do it properly you have to have a lot of resources out there. So we think a lot about the industry and where it’s going. We spend a lot of time speaking to the customers and suppliers, and building a picture. Because if I’m running a business and I’m listed on the stock exchange and I own a reasonable portion of the company I’m probably incentivised to tell you it’s a great idea and you should buy my shares.

Vanessa:

Got you, yeah.

Joel:

It’s about using our UBS investment process, our experience and all the resources that we have.

Blair:

If you got in on a realestate.com and they’re now that high, you wouldn’t really step away from them would you or is that based on the numbers and targets you have to hit?

Joel:

It becomes a great problem to have, but if you find something small and you go on this journey and it continues to perform in the way that it does, the investors in the fund should continue to benefit from that, if we think it’s one of our best 50 ideas. But as a stock gets bigger, it attracts more attention from other fund managers.

Blair:

Right.

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Joel:

We’re looking for things that are, you know, off the beaten path in a sense. That not everyone has gone and looked at and talked to and understood, and that creates the opportunity for someone who focuses in on that area. As these companies get bigger, the opportunity for us to find something to take its place.

Vanessa:

If you’re calling and saying “hey, I’m going to come and visit you” and they know, “this is an important one, UBS is going to look at us and they may buy”, how much of these companies can you own? I mean could you be a majority shareholder in them?

Joel:

No, you could never be a majority shareholder. You don’t want too much of your portfolio on one particular stock, because that creates risk issues, liquidity issues, and no matter your level of confidence in these small businesses you should never have all your eggs in one basket.

Vanessa:

Do you have a rule, like you never own more than 30 per cent, 20 per cent?

Joel:

No single position is greater than 5 per cent of the portfolio’s value.

Vanessa:

Right, okay. That’s interesting.

Joel:

That allows you to both continue to really take advantage of the opportunities in the microcap space, but not be beholden to only 10 per cent of every company you invest in.

Blair:

Yeah, right.

Joel:

And requiring, you know, someone to come along and say: “I’d like to buy it off you” as opposed to be able to move it in the market.

Vanessa:

So really what this fund is doing is kind of helping the next generation of businesses get up there?

Joel:

Well that’s why it’s really exciting again about microcaps. We may invest further funds, they may raise money and that’s to go and employ people. That is both helping the share price grow and the funds benefit. But for them to actually go about growing their business, that’s a benefit for everybody.

Vanessa:

Blair’s in this situation where his wife’s about to have a second baby, he is passionate about acting, and been very successful at it, 6

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and now he’s at a stage where, you know, the work is seasonal. You don’t get constant gigs. So, you know, we’ve been looking at funds where he can get an income from them to smooth out sort of daily and monthly, yearly cash flow needs. This is more a fund that is a longer-term investment I’m suspecting for Blair. Joel:

Definitely. This product is all about long-term capital growth. So there will be volatility and of course depending on your risk appetite and things like that, the unit price of the fund will move around, but in time we’re very confident that we’re looking at an opportunity set that not everyone is looking at. In an environment where, because things are changing so quickly and technology’s enabling it, someone with a small business to get up and running very quickly can go and rent server space off Amazon web services. They don’t have to go and invest $50,000 buying computer equipment, and literally can start their business and get going, and scale very, very quickly. So in a rapidly changing world, there’s a whole heap of stocks to choose from that cover the full spectrum of the Australian economy. People forget that in the top 100, you know, the biggest companies in Australia, it’s really concentrated, that means it’s ripe for disruption in our view. There’s a lot of profit that sits there.

Vanessa:

Yeah, with tech…

Blair:

Yeah.

Vanessa:

I mean you’ve seen what Airbnb and Uber have done.

Joel:

Absolutely. It’s amazing but 20 years ago Google and Facebook did not exist.

Vanessa:

Yeah, that’s mind-blowing, isn’t it?

Joel:

They are now two of the world’s largest companies and the level of people that use their services on a daily basis is phenomenal but in such a short period of time. We think in terms of a place to go out and find some long-term capital growth driven by businesses that are small today and are hopefully going to be the next generation of great Australian companies. In this environment of low interest rates, difficult top line growth for the economy generally, small businesses who are able to grow more quickly are certainly going to stand out. And you have that added benefit that, if you pick the right businesses as they get bigger, they become more interesting to other people. 7

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Vanessa:

Are these only in Australia, Joel?

Blair:

Yeah, I was going to ask that.

Joel:

We can invest in New Zealand too, so there’s an investable universe of over 1,000 companies.

Vanessa:

Okay, so…

Joel:

…so it’s huge.

Blair:

So just out of interest, like you said if you had 5 per cent of that company, do you have any say in how that company therefore navigates its way to that next level?

Joel:

Yeah, you can offer opinions.

Blair:

Kind of like a dad.

Joel:

Yeah, yeah, exactly.

Vanessa:

What’s interesting about what you’re doing is that you’re really looking for that next generation, it could be the Steve Jobs or the Jeff Bezos or the next generation of entrepreneur.

Joel:

This is a true retail product for retail investors, people that are looking for some long-term capital growth. This is about lots of small investors pooling their money and vehicles like this give you that ability to get exposure to 40 or 50 stocks where if you try and do this by yourself it’s very difficult to do the research, but to make those investments. Microcaps - some people treat them a bit like a casino. They get a tip at a barbeque and it’s like a tip at the races.

Vanessa:

Or like the cab driver tip, yeah.

Joel:

And they go out there and they put all their money in something and, you know, maybe it works out, maybe it doesn’t. This is taking a professional approach, a long-term approach, about backing, you know, the next generation of company that’s going to grow its profits, generate revenues and become a much more important part of the landscape. Often a business appears to have come together in a very short period of time, but the old saying, you know, “an overnight success a decade in the making” is very, very true. 8

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There’s no point approaching an investment when everything’s going well and you know, the information is coming through in terms of the recorded numbers. Because everyone can see that. Vanessa:

Mmm.

Joel:

It’s about building that investment case and saying this is the right team, with the right strategy and this business in a couple of years’ time because the industry is moving into their favour, because they’re making those investments today, that they’re not going to be generating $10 million profit. It’s going to be $20 million profit. Growing your business, being able to scale it, there’s lots of things to think about when you actually put your investor’s money to work and say, “look this is one of the best ideas I have, and I’m confident that this can be a really good return for the fund.”

Vanessa:

There’s a word comes to mind and that word is patience, Joel. It feels like the future’s a long time away, right and you’ll sort out what happens but making some decisions now around understanding and putting something into investments like these, and having patience, letting the fund perform, might be an interesting way for Blair to approach…

Joel:

We always make the point when we see investors, we take a longterm view with the companies we’re investing in. But if you believe in the opportunity and you believe in the way that UBS goes about things, we think in the long term that this untapped area of the market just offers so much potential and we think the fastest growing companies are going to come from these smaller companies.

Vanessa:

This has been a very interesting masterclass Joel. Thank you, thanks heaps actually for spending the time with us because this is an area, you know, that I don’t think many people understand, or even see as an opportunity.

Blair:

Yeah, yeah.

Vanessa:

Looking at it from a perspective of an actor where, you know, one movie, one show could be the next big thing, I mean you guys are looking for gains constantly from a number of companies, it’s not just one next big thing, it’s looking at 50 of them.

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Blair:

Yeah, yeah, and there are parallels; an overnight success a decade in the making and that’s, you know, from my point of view too, my career did start as an overnight success, but I’ve been working at it and working at it, to keep on keeping on. Having grown up through the dot.com boom, to see the kind of work that they’re doing in those younger companies, you feel a little bit more inclined to investigate it more. It seems a little bit more exciting than the big traditional kind of companies. It’s all about learning and it’s been great. Thank you very much.

Vanessa:

Yeah. Thanks Joel.

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