Small-cap investing: Limiting risk at the riskier end of the market

By Joshua Peach – Morningstar – original article

Ed Prendergast, co-fund manager at the gold-rated Pengana Emerging Companies Fund, explains how to limit risk in the often-volatile small-cap space.

In many people’s minds small cap investing goes hand in hand with an increased risk appetite. A high risk-high reward approach.

But some funds make it their objective to examine the smaller end of the market with a measured, value-focused approach which looks to limit risk in an admittedly riskier end of the market.

As part of our new series into the small cap space, we sat down with Ed Prendergast, co-fund manager at Pengana Emerging Companies Fund, to discuss how the fund’s strategy has navigated risk among small-caps for almost two decades.

Fund ‘among the best small-cap investors in the market’

Pengana Emerging Companies Fund is one of just a handful of small-cap Australian funds to hold a coveted ‘Gold’ analyst rating from Morningstar.

The fund’s run by founders Ed Prendergast and Steven Black, with no analysts on hand beside themselves to decide what equities are bought and sold.

But according to Morningstar analyst, Justin Walsh, who commented on the fund alongside its upgrade to a Morningstar Gold analyst rating last year, the fund’s small long-standing team is a major component of its strength.

“We consider the duo among the best small-cap investors in the market,” Walsh says.

“The portfolio has long held a growth tilt relative to the S&P/ASX Small Ordinaries Index as the two aren’t afraid to hold on to their winners.”

Limiting risk in small caps

In terms of strategy, Walsh says Pengana’s Emerging Companies Fund stands out among ASX smaller-cap investment vehicles due to its relative simplicity and consistency.

While those may not appear the most exciting adjectives to some, that is exactly the kind of approach the fund set out to champion back in 2004, says Prendergast.

“We’ve never changed anything from how we set out to do what we do from the start, the only thing that’s changed is the market,” he says.

“Our central mindset is to be patient, get to know the companies—especially the management as they’re really the key behind any business. We look for steady growth—without too much reliance on a strong economy—and well managed businesses that don’t require a lot of capital.”

This approach necessitates a smaller number of companies to choose from, with the fund entirely eschewing the resources sector, as well as other key growth sectors.

“We just don’t do biotech or tech stocks unless they’re making money on a predictable basis,” he says.

“They’ve got to be making money and we need to understand why they can keep making money and growing.”

When asked if he is ever concerned the fund’s stringent approach to risk in the small-cap market is limiting its opportunity for growth, Prendergast points to his 30-year experience in finance.

“When Steve [Black] was running a fund in the year before the ‘tech wreck’ he looked like he was in the slow lane and was under extreme pressure.”

“People were saying, ‘Come on mate, these things are doubling every week, just get involved, you’re looking too closely, you’re too conservative.’”

“But when the ‘tech wreck’ happened and there was two years of a flat market, his fund was up 70% over those two years.”

Likewise, Prendergast recounts when the company’s prudent approach caused them to exit stocks too early.

“We sold WiseTech (WTC) thinking we were smart when it doubled to $12 and it went to $60, and then we sold Afterpay (SQ2) at $16 and it went to 160 bucks. So that’s a classic case, when a hot market can make investors like us look too conservative, however this discipline is often rewarded when sense prevails,” he says.

Prendergast notes that the fund’s strategy means they’re well-prepared for when the market eventually turns more bearish.

He calls these downturns “bushfires” and says that–while painful–they help to weed out the speculators in their sector who aren’t “investing with discipline”.

It’s during these periods, that the fund’s measured approach really pays off.

“But then in calendar 2021 after COVID when you had that sort of bushfire effect again, we outperformed by 20%. That was driven by strong performance in quite boring, low risk stocks which had been irrationally sold down in the turmoil.”

Low capital expenditure and pricing power were also noted by Prendergast as key metrics in the fund’s considerations. He points to a previous holding in REA Group (REA) as an example of a company with strong revenue and little overhead.

For similar reasons, the fund continues to hold substantial positions in the finance sectors, particularly insurers.

“We’ve got big holdings in Austbrokers [AUB Group (AUB)], Steadfast (SDF) and PSC Insurance (PSI). Their businesses have been tested through a GFC and a pandemic and there’s no economic sensitivity in the sector at all.”

Looking for value in today’s small-cap market

Prendergast highlights two stocks he believes meet the fund’s strict risk-adverse approach and could still provide value for investors in today’s market: Propel Funerals (PFP) and Lifestyle Communities (LIC).

Lifestyle Communities (LIC) builds, owns, and operates land lease communities which provides housing options to Australians over 50, while Propel Funerals (PFP) is a death care service provider operating on a smaller-scale to the larger-cap InvoCare (IVC).

While the fund has established long-hold positions in Propel and Lifestyle—bought in 2019 and 2015, respectively—Prendergast believes there’s more growth to come for both companies.

“They’re not so much undervalued, but they have the potential to grow for a very, very long period of time with stable management and in a stable industry,” he says.

Conversely, Prendergast points to the marketing company IVE Group (IGL) as an example of a “classic value play” in today’s market.

“We bought it because the stock was just way too cheap, with a very strong yield, nudging 9% fully-franked. It’s in a stable industry, not particularly dynamic, but it’s just very, very cheap in our view.”