This article first appeared in Outperform magazine in November 2022
"We are looking for companies that will double in value over the next decade."
To most Australian investors, small to mid-sized stocks are synonymous with subscale and speculative ventures with inadequate balance sheets or a weak market position. But for the portfolio managers of the Fidelity Global Future Leaders Fund, the global small to mid-cap sector is a different beast altogether – and more attractive than the usual blue-chip giants.
In short, they’re the equivalent of Goldilocks’ porridge: not so well loved enough to be overvalued, but well established with market leading positions. “They do come with more volatility … but the additional return you get from investing in that asset class has shown to more than compensate for that,” says Fund co-manager James Abela. Co-manager Maroun Younes adds there are “structural advantages” to pursuing such stocks, including less analyst coverage which increases the opportunity for mispricing.
While there are no hard and fast rules in defining the global small/mid cap sector, the Fund targets stocks outside the top 10 or 20 on the major bourses. From an ‘investible universe’ of 4000 stocks, Fidelity’s managers whittle down the potential selections to 100 or so, using a core ‘bottom up’ approach of assessing the company’s fundamentals.
Filters include return on capital, earnings consistency and reliability, the structure of the market and – increasingly – compliance with good environmental, social and governance (ESG) practices.
The Fund also seeks companies with structural tailwinds, either because of the industry itself or because the individual company is gaining market share. The fund currently holds 40 to 70 investee companies at any one time, ranging in market cap from $US3 billion to $US50bn ($5-80bn), with a median valuation of $US20bn. “We are not talking about concept stocks,” Younes says. “By and large we are talking about well-established businesses that in many cases have been around for 10 years or more.”
Around two-thirds of the Fund’s circa $300 million of holdings are US based, which is not deliberate but no accident either. “US companies tend to do well in their own market and then go
global,” Younes says. “They generally have higher returns on equity and returns on capital and are more investor friendly.” The Fund’s biggest investment is the New York Stock Exchange-listed
Cheniere Energy, which exports LNG to a gas-hungry world.
“The company owns the infrastructure, but it doesn’t own the gas itself, sourcing it from third party suppliers. It has access to enormous volumes of low-cost gas from the Permian basin in Western Texas,” Younes says. Another key holding is the mid-tier US insurance broker Arthur J Gallagher, which ‘owns’ its customer while not bearing the underwriting risk of an insurer. Ultimately, proof lies in performance and the small/mid sector has comfortably outshone the global large caps over the last three to four decades, as measured by annualised returns.
The Fund’s benchmark, the MSCI World Mid Cap Index NR, returned 8.74 per cent per annum between 1994 and 2021, compared with 7.96 per cent for the large caps index. The Fund itself has delivered an annual return of 10.80 per cent since it was established in September 2020, compared with the benchmark of 8.84 per cent. “We are looking for companies that will double in value over the next decade,” Maroun says. “That’s really the core of what we are looking to invest in.” He says the managers are able to tap Fidelity’s global network of hundreds of analysts, who have direct access to the senior management of prospective investments. “That makes the job easier for us located here in Australia to cover the entire world.”
