Q&A with small-caps duo Stephen Wood
and Victor Gomes
November 2017

UBS Small Companies Fund Portfolio Managers Victor Gomes and Stephen Wood have known each other since the early 90s and have taken dual responsibility for the firm's small cap and micro cap strategies since 2011. This week, they speak to Industry Moves about the investments that currently excite them and some of their favourite discoveries, share what they've learnt from each other’s approach, and name the people and advice that have influenced them most.

What are some of the companies that you’re currently investing in that are exciting to you?

Victor: We are currently very enthusiastic about mining services and engineering sector. We believe that this sector has been in a downdraft for the last 3-4 years and is recovering strongly with 3 key drivers. The first is the recovery in mining investment generally. The large miners have all cut back on mine development and exploration to cut costs over the last few years. But with prices up and the A$ behaving (ie staying down) margins have rebounded strongly. This is now translating into strong investment in a catch-up in mine development. We think that exploration drilling will soon follow. In the smaller metals segments (nickel, copper, cobalt, lithium) the rebound in investment has been even stronger. This has been driven not only by the same cutbacks as have applied to the large bulk materials, being iron ore and coal, but also by the significant increase in demand that is coming from energy storage and electric vehicles.

Demand for mining services and engineering is also being co-incidentally driven by the boom in infrastructure spending around the country and also by the rapid growth of investment in renewables. No matter where we live we can all see the massive spend going on in road and rail infrastructure. This has been needed to catch up with significant population and housing growth. In addition the scale of solar, wind and electricity network investment is accelerating. Every day we are hearing about an ever bigger solar or battery farm being installed somewhere. The same companies that are leaders in mine development, engineering and maintenance are often also leaders in urban infrastructure and renewables.

Can you tell us about your active investment approach?

Victor: We have both been around investment markets a long time, over 50 years between us. We have also known each other professionally (buy and sell side) since the early 90's. We have both seen from a different perspective the same economic and sector cycles including for example the initial tech and telecoms boom that began in the mid 90's and crashed in the early 2000's. Despite this crash the tech sector is now bigger than ever.

Our approach is a blend of this often painful experience combined with a view that the correct metrics for valuing a company are based around the application of a cash flow based model that UBS has been using in Australia for 20 years.

The key to this approach is to make sure that in addition to forecasting an individual company's revenue and margin that significant effort is made to forecast capex for growth, expenditure for plant maintenance and working capital. The importance of these latter items is often overlooked but in our opinion they are critical to investment returns and are the key to business sustainability over the long run. The post tech wreck and GFC periods very quickly exposed businesses that, after taking these items into account, were not even able to survive, let along provide returns to shareholders.

Our investment approach therefore favours companies with a quality franchise bias that can earn a good return on their invested capital and as a consequence can self-fund their organic growth needs without resorting to external sources of capital. This leads us to invest in companies with generally lower levels of debt (or often net cash).

In addition to this numeric approach we have a list of what we call our 8 Commandments for small cap investing. They are our guidelines to make sure that we do our best to invest alongside trustworthy management who place customers, employees and investors ahead of their own interests. Needless to say experience has taught us that many management teamss put themselves first, second and third.

"We don’t want to be another small cap fund with the same key 60-90 ideas as many of the other small cap managers in the market." - Stephen Wood

…and, in your opinion, what are some of the downfalls that come with a passive approach?

Victor: Passive is a key part of the current investment environment and provides investors with a service that in many ways is complementary to ours. We are investing in smaller companies that often have limited public or broker research. Hence we have to do a lot of our own homework. Passive investing tends to concentrate on larger companies where markets offer much more efficient price discovery given the greater availability of public information to drive index returns and hence passive performance.

In our space we often see passive funds driving share prices wildly up and down on small and often semi relevant pieces of news. In general we do not believe it is in anybody's interest to have the share price of any small often illiquid company determined by a large passive fund investing in an utterly value agnostic manner. Having said that, in order for us as small cap investment managers to add any value for our investors we have to outperform passive funds over a reasonable time period.

"We have both been around investment markets a long time, over 50 years between us. We have also known each other professionally (buy and sell side) since the early 90s." - Victor Gomes

What have you learnt from each other’s investment approach?

Stephen: Victor is great at non consensus ideas which are a key plank of what we do. Without them the funds' performance would not have been anywhere near as good as it has been. We don’t want to be another small cap fund with the same key 60-90 ideas as many of the other small cap managers in the market.

Victor: Stephen has a great way of cutting through much of the clutter and irrelevant noise that often surrounds an investment idea and then zeroing in on the few key issues that will determine the success or otherwise of the opportunity. Success in investing is often as dependent on determining what information is relevant as it is on having all the information required to make the decision.

What has been one of your favourite small company discoveries?

Stephen: Definitely Dominos. Ticked all the boxes on returns on capital and exceptional management who earn every cent they get paid. It has been wonderful watching this company's unrelenting drive from minnow in Australia to now the largest local player and now successful on the world stage. The vision and investment in technology has been great to great to watch. It has been very kind to our investors.

Victor: REA Group is one of my favourites. I first invested when in an earlier life an ex-BT colleague and I were managing a small Aussie broadcap equities fund. From out of the ashes of the early 2000's tech wreck we discovered that some of its survivors were prospering and even delivering on some of the promise that had driven much of the excesses of the tech bubble. I recall us going along to visit them in their modest offices in Sydney's William St in early 2003, having been cast out and ignored by the market. Back then they were trading at 27c and were still called realestate.com.au (later renamed REA Group). At the time anything with a ".com" in its name was still regarded as toxic. Despite the perceptions we were encouraged by their recent moves to achieving a positive cashflow and also the significant utility that their product now offered customers compared an old fashioned newspaper classified. We made it one of our fund's largest holdings and did very well for our investors. Roll forward eight years when I joined UBS, we again bought in at around $17 just as they were expanding their depth offer (higher priced ads). Again it became a significant contributor to our fund's strong returns. It is still one of the best business franchises in Australia.

Who has had the biggest influence on your life/career so far?

Stephen: Well putting aside my parents and wonderful wife I'd probably have to say anybody who is good for a great quote. I find I get inspiration and enjoyment from quotes from great investors, movie characters, and social leaders. You just know when you have heard a cracker.

Victor: My mum for helping instil in me a sound set of values combined with the importance of hard work, regardless of the hand you have been dealt. My family for keeping me grounded and connected with the reality that not everyone has been as lucky or as fortunate as I have been. More humility and less hubris are very important qualities for investment managers.

"More humility and less hubris are very important qualities for investment managers." - Victor Gomes

What’s a piece of advice that’s stuck with you?

Stephen: For investing any one of Warren Buffett's many memorable quotes. "A horse that can count to ten is a remarkable horse – not a remarkable mathematician." This is a memorable way of highlighting that a company with an exceptional and interesting story may still be a very poor investment.

Victor: Investing is small companies is as often a judgement about the people you are entrusting your client's money with as it is about the business. It is equally important to find a business that is run by competent, honest and aligned management as it is finding a quality business franchise.

…and what advice would you offer to an industry newcomer?

Stephen: Go and watch Trading Places, Wall Street, Enron, The Big Short etc. The reality is nothing like that but if you enjoy these movies some aspect of finance may be for you.

Victor: Many people often overestimate what can be achieved in 1 year and underestimate wheat can be done in 5 years. Be patient and stick with good companies that can compound up returns.

If you weren’t in finance, what would you like to be doing?

Stephen: I'd be racing cars...well, you asked what I'd like to be doing.

Victor: Investing in small companies is what I enjoy most but perhaps travelling the world a little more.

Stephen, what’s kept you at UBS for so long?

Stephen: I've had challenging jobs. The culture and professionalism of UBS Australia/NZ. I have tried a couple of other places over the journey but at the time, for me, neither came close.

Victor, what has been one of your career highlights so far?

Victor: Working with so many Australian industry pioneers along my career journey and learning from their investment insight and wisdom.

Originally published in Industry Moves.

Stephen Wood

Stephen Wood

Portfolio Manager

Victor Gomes

Victor Gomes

Portfolio Manager