Investment Strategy

Our process

Kinetic intentionally maintains a small selection of strategies. This allows us to focus on our investment process and deliver consistent above-average long-term returns.

Jump to: Australian Small Companies Strategy

Australian Small Companies Strategy (Small Caps)

Style

Kinetic Small Caps does not target a specific investment style. The Small Caps investment approach seeks companies undervalued on a cash flow return on investment (CFROI) methodology.

Universe

The Small Caps investment universe consists of small companies that are listed (or due to be listed) on the Australian Stock Exchange. Small companies are defined as those companies lying outside the S&P/ASX100 Index with a market capitalisation of generally greater than $25 million. This universe currently consists of more than 900 companies.

Identifying Opportunities

Liquidity, market capitalisation limits and macroeconomic overlays are applied at this initial stage to reduce the potential investable universe to a more manageable number.

Following this initial cut, the next level of the screening process is driven by preliminary analysis of key drivers and industry structure and background research of company management. More detailed investigation of sectoral trends may also be initiated to further target potential investment opportunities. Potential investment opportunities sourced from broker and/or other sources are also considered at this stage of the process.

This reduced pool of prospective companies (around 250) will then be subject to formal contact by Kinetic and a company meeting undertaken.  A large number of company visits are performed each year by Kinetic. These meetings generate a significant flow of information and investment opportunities.

These meetings will be used by Kinetic to fully understand the industry structure in which the company operates and the trend in key drivers. An assessment of the quality of management and their strategy will also be made. Catalysts for change will also be identified.

Following a company meeting and where the fundamentals warrant further analysis, Kinetic will model the company and produce a valuation. The detailed financial modelling undertaken by Kinetic allows a more complete understanding of the company’s operating performance and will often trigger follow up questions to company management. Once established, the models allow for ready quantification of a company’s progress and allow for rapid changes to expected returns in the light of new information.

This filtration process reduces the number of stocks in the total investable universe to between 100 and 120 companies. It is this lower number of stocks that are subject to the full Kinetic investment analysis and expected returns generated. It is from this pool of companies that the portfolio (30-70 stocks) is constructed.

Fundamental research

Kinetic’s primary focus is fundamental research of each company identified in the filtering phase of the process.

Management and strategy

Company interviews represent the primary source of internal research. As such the managers undertake a large number of company visits and engagements with company management. Our interrogation of company management focuses on the key criteria we use in our stock selection process. In particular, our identification of the key drivers (see below) of each stock enables us to pursue a focused line of questioning. Qualitative judgement of management and strategy are based on the following points:

  • Coherence of management team;
  • Consistency of application;
  • Track record;
  • Corporate governance; and
  • Focus on shareholder wealth creation.

Placing great emphasis on regular company contact, Kinetic tends to average three contacts per annum for each company held. In addition to one-on-one meetings, we attend quarterly, half-yearly and annual result announcements, broker presentations and organised company visits. Visits to competitors, suppliers and customers of companies also help us assess the ongoing trends in a business.

Catalysts for change

The Small Cap Team then identifies each company’s catalysts for change. These can either be positive catalysts (for example, new technology, drug development milestones, exploration success, or the awarding of significant contracts), or negative (for example, management instability, competitor activity, litigation or a change in regulation).

Valuation

Kinetic’s primary valuation tool is cash flow return on investment (CFROI). Kinetic employs CFROI analysis as it more effectively isolates how a business is performing, which is a key input to successful small companies investing. Where relevant, a supplementary discounted cash flow valuation is undertaken. The results of the valuation stage are presented in the form of 12-month expected returns (the difference between the current market price and Kinetic valuation). Companies are ranked from highest to lowest, in terms of their expected 12-month return.

Portfolio construction

The portfolio is constructed subject to Kinetic’s Small Cap Portfolio Guidelines. Stock selection is determined by the Teams bottom up research process. This information serves as a starting point to the portfolio construction process from which the team actively assesses the merits of each company in the context of the overall portfolio. Stock weights are largely a function of fundamental research, risk / return trade off, liquidity, market capitalisation, and risk management. Risk management in this stage of the process also seeks to ensure the portfolio’s stock and sector positioning is appropriately exposed to the current and expected business cycle environment.

Risk management and stock / portfolio monitoring

Kinetic employs a comprehensive approach to risk management. Risk management is applied on a stock level and operates around a simple risk / return principle. That is, we expect the portfolio to be rewarded for the proportion of risk we take in the portfolio. Macro risk management is applied to ensure the portfolio is appropriately exposed to the prevailing macroeconomic conditions.

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