Capital Markets: Taking a piece of the pie

Mike Taylor says the key to success is to pick up growth companies when they are trading at a discount.

Mike Taylor finds untapped gold in small and medium companies, as Bill Bennett reports

Imagine you are at a house auction. If the room is full, it's likely the bids will realise all the value in the property. On the other hand, if there are only one or two bidders, the owner will be more ready to accept a deal.

That is the principle behind Pie Funds founder Mike Taylor's approach to investment. He seeks overlooked small and medium companies with growth potential, then unlocks the value.

Taylor says; "There are about 2500 listed companies in Australia and New Zealand. Fund managers typically focus on the top 200 in Australia and, maybe, the top 50 in New Zealand. The others are not followed as closely. It means many of the small and medium listed companies are not efficiently priced.

Stockbrokers are not producing research on these companies and analysts are not watching them.

"There's no point in finding small firms that will stay small for ever. We're looking for companies that will grow. Then when one becomes large, the market takes notice and it becomes efficiently priced."

This investment philosophy has worked well for Taylor and Pie Funds. It's a boutique fund with an impressive record. Morningstar ranks Pie's Australasian Growth Fund in the top 10 globally for equity performance between 2007 to 2016. It has returned 20.2 per cent per year since it began.

Taylor says he started Pie Funds in 2007 after realising most fund managers under-performed. He says: "If you left money with one for five to 10 years you might come out with a couple of per cent more than you'd earn from a term deposit. I knew from watching overseas investors such as Warren Buffet that it is possible to achieve returns of 20 per cent a year."

He says the problem with funds is they are often set up with the aim of earning fees. Managers are told not to lose any investor funds. Yet, to generate high returns you need to take on greater risk.

The other characteristic of most funds is that they are widely diversified. It's not unusual for them to include dozens of companies, maybe as many as 100.

Pie Funds uses the concentrated portfolio approach. They include up to 15 individual stocks. He says the number means you get all the benefits of diversification. The stocks are diversified across industries and across both Australia and New Zealand. Diversification benefits diminish with higher numbers. Apart from anything else, he says it's hard for fund managers to keep a close eye on that many investments: "You can be too diversified."

Dealing with a manageable number of otherwise unwatched smaller companies means spending time doing research and due diligence. Taylor says he pays special attention to company financials and to meeting and learning about management teams. This is as much about knowing which managers to avoid as to finding the star performers to follow.

The goal is to find a business that is either growing rapidly or is about to start growing. Taylor says: "Often that means finding one in an industry with plenty of tail wind. We also look for blue sky opportunities, that is, a business that's scalable. It needs to have ambition to roll out fast expansion.

"We want to see a clean balance sheet. We don't like to see a lot of debt. Ideally a small business has no debt, we don't want to invest in something that could end up being owned by a bank."

Over the years Taylor has met 1000 company management teams. Often this means focusing on the founder or CEO. He says you need someone who has the charisma and energy needed to drive the growth. They need to be good at sales without being a spruiker. Communication skills are vital. He says eventually you're going to need someone who can sell the company's story to the wider investment community. "If the CEO is a bad presenter then no-one is going to buy the stock," he says.

Pie Funds team at the Warren Buffett investor AGM. From left Sekhar Paruchuri, Mike Taylor, Chris Wright, Brenden Hall and Herald Business Editor-at-large Liam Dann.

Leadership skills are also important. Taylor says just because someone is a CEO, it doesn't mean people will follow them. He looks carefully to watch how staff respond to the CEO.

He says a concentrated portfolio of small cap stocks is more likely to generate a higher return than one made up of large cap stocks. This is partly down to mathematics. If 10 per cent of the fund is invested in a single company that doubles in size during a year, the fund is up 10 per cent. In every year there is always one stock in any market showing stellar growth. Searching for small cap stocks with potential means there's a higher chance of capturing that winner.

At the same time, there are companies that grow quickly from $100 million to $1 billion. It's much harder to go from $1 billion to $10 billion.

Taylor says his approach gives Pie Funds access to high-growth companies: "It's a matter of experience. We look for the right kind of companies where there's future growth that has not yet been recognised by the market.".

Buying at the right time helps boost returns. Taylor says the key is to pick up growth companies when they are trading at a discount. Early this year fears of a US recession saw stock prices fall to a low, small caps fell further than most, they tend to be volatile. This was an ideal time to buy.

Small cap stocks are riskier than large cap stocks. Taylor says Pie Funds guards against the volatility of the sector by carrying a lot of cash. "You never know when the next opportunity will turn up, having money means you can seize it."

Ideally a fund would have a 100 per cent success rate. Taylor says in reality about seven out of 10 work out. Of these a few usually do well and one or two will make five times the money invested. The trouble is "When you buy the stocks, they all look the same."