Expert Investor: Claude Walker | Assessing Management & Analysing Small Caps

HOSTS Alec Renehan & Bryce Leske|19 August, 2021

Meet your hosts

  • Alec Renehan

    Alec developed an interest in investing after realising he was spending all that he was earning. Investing became his form of 'forced saving'. While his first investment, Slater and Gordon (SGH), was a resounding failure, he learnt a lot from that experience. He hopes to share those lessons amongst others through the podcast and help people realise that if he can make money investing, anyone can.
  • Bryce Leske

    Bryce has had an interest in the stock market since his parents encouraged him to save 50c a fortnight from the age of 5. Once he had saved $500 he bought his first stock - BKI - a Listed Investment Company (LIC), and since then hasn't stopped. He hopes that Equity Mates can help make investing understandable and accessible. He loves the Essendon Football Club, and lives in Sydney.

Bryce and Alec talk to a guest who’s an expert in a range of thematics that are frequently talked about in the Equity Mates community, so we’re hoping it’s going to be a really valuable conversation. The guys are joined by Claude Walker, who’s the founder of A Rich Life and writes the Ethical Equities column for this publication. Claude specialises in assessing the efficiency and health of management teams, and scouring smaller, unloved and ignored micro-caps because, as Claude himself has said: ‘the market is much less efficient at the small end.’ They take a deep dive into these questions during their conversation, and look at some of the small caps Claude himself has a close eye on at the moment.

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Bryce: [00:00:16] Welcome to another episode of Equity Mates, a podcast that follows our journey of investing, whether you're an absolute beginner or approaching Warren Buffett status, our aim is to help break down barriers from beginning to dividend. My name is Bryce and as always, I'm joined by my equity buddy Ren. How's it going? [00:00:31][15.0]

Alec: [00:00:31] I'm very good. Bryce excited for this interview because we're going to be covering two topics that are of particular interest to us and the Equity Mates community that is assessing management and small caps. And we're going to be speaking to an expert that we've long followed on Twitter and we finally got on the show. [00:00:51][19.7]

Bryce: [00:00:52] That's right, Ren. It is our absolute pleasure to welcome Claude Walker to the show. Claude, welcome. [00:00:57][5.3]

Claude: [00:00:58] Thank you so much for having me. That it's I really always wanted to be on this show, so it's great to say hello to you and also your listeners. [00:01:05][7.0]

Bryce: [00:01:06] So as you said, Ren Claude covers to thematics that are of particular interest to the Equity Mates community. So we think that this is going to be a very valuable conversation. Claude is the founder of A Rich Life and writes the ethical equity column for that publication. He specializes in assessing the efficiency and health of management teams. So maybe he's going to give us a score or you and I score around how we're managing Equity Mates and also love scouring Smolla unloved and ignored microcaps because as Claude, you said yourself, the market is much less efficient at the small end. So we're really looking forward to unpacking both of those areas today. But before we do, as always, we'll kick off with that game over you, Ren. [00:01:52][46.1]

Alec: [00:01:53] That's right, Claude. We like to start with this game just to touch on a few topics that we may not otherwise get to in the episode. We call it overrated or underrated. We'll throw out some themes or some investing, I guess. Yeah, investing themes. Let's go with that and get your thoughts on whether they're overrated or underrated. We'll start at home. The ASX 200. Overrated or underrated? [00:02:16][23.4]

Claude: [00:02:18] Overrated. That's probably the only one I caught that I don't hesitate on. I think it's definitely overrated. [00:02:23][4.8]

Alec: [00:02:24] And why is that? [00:02:25][0.9]

Claude: [00:02:26] Basically, just because it has so much weight towards mining companies and banks? I think it's a lot, maybe 40, 30 percent banks massively concentrated in terms of industry. So it's not doesn't do very well in index sense because if you have an index, you'd want to be concentrated in something you think has long term tailwinds. [00:02:44][18.7]

Bryce: [00:02:45] Speaking of long term tailwinds, overrated or underrated, the Nasdaq 100. [00:02:49][3.2]

Claude: [00:02:50] I'll go I'm going to go underrated always for the opposite reasons. But I think that there's been a real framework change with big tech companies being almost sometimes quasi monopolists and having more and more power. So the Nasdaq catches them. And I think that there's a structural shift in their favor. [00:03:08][18.4]

Alec: [00:03:09] So could I. And often controversial topic is the value of full service brokers compared to the online discount peers. So overrated or underrated full service brokers for a retail investor? [00:03:23][13.7]

Claude: [00:03:24] I think among the younger generations, myself included, it's they're probably actually underrated, but only for people that have probably more money than what I have and what most people our age would have. But they do actually have certain advantages for like they can be very knowledgeable people and have access to good deals and stuff like that. So I think they're actually probably underrated [00:03:48][24.3]

Bryce: [00:03:50] clode overrated or underrated bitcoin, [00:03:52][2.5]

Claude: [00:03:55] probably, to my mind, overrated. I, I think that the my my aha moment that it wasn't as good as some people think it is is when during the first. Well I don't know if it was the first one, but during the Bitcoin craze a few years ago, I think it might have been twenty, seventeen or something. Yeah. So doing that during that crazy you might remember, I mean I've had lots of fun with cryptocurrency, but I just think that it's massively overrated because I had bought some bitcoin basically just when Motley Fool actually decided to start writing articles about Bitcoin and I was like, oh, here we go. So I bought some shares in like a nutshell, I bought some Bitcoin. But then when I tried to sell it at the height of the of the mania, I remember one transaction was going to take hours. And in the end, because I wanted, like, instantly to get my money, I think I end up paying like forty or fifty dollars in a transaction fee. And I just thought. How is that going to work as a currency? So, yeah, but I held my dogecoin, so but I have since sold my Dogecoin, I'm not still holding it. [00:05:03][68.0]

Alec: [00:05:04] No. And then finally clawed overrated or underrated Australian residential property as an investment. [00:05:12][8.2]

Claude: [00:05:13] Yeah. This is this is a really tough one. And to my mind, I'm going to say underrated. If you're choosing somewhere that is beautiful in nature and sort of any you know, this Australia has so many stunning places to live like you would never get in most countries. And if they were in most countries, it would be like impossibly expensive. But for substantially less than an apartment in a big city, you can buy what feels like a little piece of paradise up and down the east coast of Australia and many other places. So and sometimes they sometimes the United States and Internet. So I actually think underrated, but specifically for that reason. [00:05:56][43.5]

Bryce: [00:05:57] Nice. Well, you're right, Ren an island on the property ladder here in Sydney. But, you know, it is there's plenty of opportunity. Well, I think some amazing places outside of the big cities. So one day. One day. But anyway, could we like to always start these interviews with the story of the first investment from our guests? Because there's often some pretty interesting lessons to learn from it. So are you able to share with us the story of your first investment? [00:06:24][27.3]

Claude: [00:06:26] Yes, happily so. I've told this story before, so forgive me for those that have heard it before, but it is quite embarrassing. So it does bear repeating. What happened was I had made a list of companies that I thought were know really ethical and that would lead to a better world in 2007 because I was interested in share investing, but it just felt to me like the share market was pretty hot. Also, I had no money, so I just made watch lists and I mostly stole my watch lists from the holdings of Australian Ethical Company. Now a lot of superannuation with them, but that was my original idea source. And I had this, I guess through that I had on my watch this a company called Ceramic Fuel Cells, which purported to have sort of like a dishwasher sized technology that they could put in your house and turn gas into clean electricity, which I thought was cool and interesting idea. And at the same time, I was just reading books and I'd read the little book of value investing, which seems quaint now, but it was all focused on having, like price to book ratios and buying minutes and, you know, the Benjamin Graham kind of stuff. And that was in the lead up to 2009. And I've been sort of traveling overseas in early 2009. So this we're right. The could have been crashing for like a year and a half now. And I was just thinking, oh, wait until the market sort of stops crashing and then I'll buy in. And I got home from traveling in South America in February 2009 and used my remaining money from my travel savings to invest in ceramic fuel cells because it's pay to be ratio was like, you know, extremely low. Now, what I didn't realize is that because it was about to have a massive write down of all of these market linked instruments where I had put all of its deposit cash into investments that it was going to spend on developing its dishwasher gas machine. In any event, despite me not knowing what I was doing, the stock went from I bought it at five cents and then it did a capital raising, you know, at five cents, which I doubled my five hundred dollar investment to a thousand dollars and then promptly sort of went to thirty cents over the next six weeks. So I thought I was a genius. Fast forward a few years, and obviously the technology never took off and the company went to zero eventually. [00:08:53][147.4]

Alec: [00:08:54] Oh, no, I have to say I hate to say that, but look, I think everyone every investor has a story like that where they lose a lot and they learn a lot from it. And I'm sure you did. And you really built, I guess, a career in in equities. You worked with The Motley Fool. You founded Ethical Equities. You've now the founder of A Rich Life. Over all that time, have you developed a personal investing philosophy? [00:09:23][29.5]

Claude: [00:09:24] I yeah, I'm not sure that I've ever managed to articulate it perfectly because it's always a work in progress. But I guess and I just copy this ideas of other people in books I read and stuff. But I think my favorite philosophy for investing comes from the book The Last Liberal Art, which basically talks about a latticework of frameworks. So like lots of different frameworks, you can view like market analysis and what, you know, look at a share price and make predictions about where you think it'll be in five, ten years or one year or three months or whatever it is making those predictions. But, you know, I guess within those frameworks, one of the ones that I focus a lot of energy on is, I guess, to try to judge people in some of the work I've done. I've been also very concerned with helping design algorithms that automate a lot of the parts of investing analysis that can be automated. And through that work, which I do with friends for their company, I also, for my own practice, become stronger in the belief that actually the best time to develop the best area to develop expertize is in trying to like judge people, because that's so qualitative that I think will be very hard for algorithms to replicate that to this to the same level of precision and speed as a human can. [00:10:47][83.0]

Bryce: [00:10:48] So could those so used to work for The Motley Fool, Hidden Gems? And here at Equity Mates, we admire the quality of the Motley Fool alumni. This Andrew Page on Rajkovic, a nearby Mohanty and yourself, all of which we've been lucky enough to get on the show at some point in time. What do they teach you at The Motley Fool that we should all apply to our investment analysis? [00:11:12][24.0]

Claude: [00:11:13] I think the most important thing is in the name, which is motley. It's really cool to actually have license as an analyst to try and develop your own specific style and your own specific way of going about things, because it allows people to lean into their own strengths and interests as an investor. And that is something that I think we can all take to our approach to investing where every single person has a slightly different optimum investing self based on your own nature, what you're good at, what you're interested in, in that kind of thing. And so I think that's actually the surface like that's the real spot comes from that side of things. And more specifically, a lot of those guys you mentioned, you know them like, you know, they're good friends. And we I feel like I grew up as an investor in many ways with those guys. And certainly, you know, Andrew and Matt, enormous influences in my investing style and Anjo. And on top of that, anybody is perhaps the biggest single influence on how I do us investing, which is a little bit more steps that I do it a little bit more in his style, basically, because I put less time into it. And so in a way, just copy his style and I copy a lot of his stock picks as well. [00:12:29][76.5]

Bryce: [00:12:30] No, nothing wrong with that. [00:12:31][1.1]

Alec: [00:12:34] So could you mentioned in when when talking about your personal investing philosophy that you spend a lot of time thinking about people and analyzing people. And one thing that we've noticed in, you know, what you do, what you talk about another podcast and what you talk about on Twitter is a real focus on managing management teams and trying to assess them. So for beginner investors, for Bryce and I, who are always trying to, you know, learn more, let's start General, and then get a little specific, I guess, why focus so much on people and why focus on the management teams at different businesses? [00:13:12][38.6]

Claude: [00:13:13] Yeah, so basically the the reason is because I think that you have to start from a situation where you assume a basic competence in terms of the other stuff, which is the I guess the math space stuff in terms of doing a basic valuation of a company. So the reason that I focus on management teams is because that's basically the area where I want I think that I have the best percentage chance that I can do better than other people and get a competitive advantage over them in the market because everyone. Can sort of download everyone should teach himself how to do basic valuation stuff, but generally speaking, Buffett's rule of thumb about valuation should be simple enough. You can do it with sort of crown or whatever, whatever the quote is, that is kind of right. Like, I think it's hard to get an advantage there and people can write machines that are very efficient there. So with that on on one side, basically, I just think for the average investor looking at small caps in particular, where they're maybe not that many people looking at them, having a good sense of, you know, the people and and how that can massively determine how successful the company is. And then secondly, on top of that, when people are creating value, running a company, they're also usually in a position to influence greatly how much of that value they manage to capture for themselves and also how much they share that value with the other shareholders. And ideally, therefore, very important that if you do have a team that are creating value, that then they're also sharing that with you, the sort of random retail shareholder. So I feel like it can almost have double significance when it comes to small caps. And so hence, yeah, I just think it's a fertile it's not the only thing I look at, but it's a fertile ground for like area for trying to do better than other people. [00:15:03][109.5]

Alec: [00:15:04] There's a there's a common, I guess, distinction or saying in investing and that's good, good horses or good jockeys and good horses refers to the business itself. Is the product market fit all of that stuff. And then good jockeys refers to the management team. And you know how how competent they are and you know how focused they are on shareholders and the like. And, you know, we have people like Warren Buffett saying he want he wants to find businesses. Even a fool can run because one day they will. How do you think about that distinction between good horses and good jockeys? Is it are you looking for both or is it really just trying to find the best jockeys and backing them? [00:15:45][40.9]

Claude: [00:15:46] Yes, I'm first of all, I'm definitely like, you know, everything you said. It's on point. And I definitely am looking for both. And the only thing that I guess I'm trying to lean into is that. Good is to look at the jockey and get better at understanding the jockey and also use that to understand what the jockey is telling you about the horse, because let's just say the jockey understands. The horse better than anybody. Well, you can get really good at looking at the horse and understanding the horse yourself and you should. But then another thing to think about is what is the jockey's behavior telling you about the horse? Because we're absolutely looking for, you know, good management with good businesses. But, you know, when people have a good business that they can make grow with not very much investment, which is sort of the shorthand for a good business, they act in a certain way, like they don't need to, like, promote top line growth relentlessly and try to make people not look at how much money they're losing because they're probably confident in the fact that they can make the business fund itself, for example. Yeah, that's the that's the approach that I'm taking. But yeah, looking for both a good horse and a good jockey for sure. [00:17:00][73.9]

Bryce: [00:17:01] Clode One of the things we hear time and time again is as a retail investor is to do exactly what you're saying, try and understand management. But when you are trying to assess management or the jockey, are you able to give some clear examples where you're finding information that is important to you? And what sort of data points are you looking for to make these assessments? [00:17:24][22.9]

Claude: [00:17:25] Yeah, so that's a great question. And there's a lot you can do here. But I'll give you I'll give some, like, easy starting points. For example, like the one of the first things you could do is with all the companies you're looking at is you could just look at how many shares each of the board members owned. And then just for example, look at the CEO in particular and just ask yourself, A, is it A fantasy? And B, you know, how many how much percent of the company do they own? And I guess how are they getting that? And, you know, a good rule of thumb would be that what I love to see is a founder, CEO who has basically, you know, he's gotten his shares by founding the company and starting at one hundred percent, I guess. And he's obviously. Or he or she, I should say. But they have, you know, gradually given away shares over time as the company has grown. But they've also managed to hold onto a few, which is a good sign that the company is like has good returns on investment. Very capital intensive kind of business would generally have to dilute out more and more, whereas you tend to see, you know, high return on invested capital companies the founder manages to retain more. So that would be like a good rule of thumb that you'd be looking for. And generally having more than 20 per cent of the company of a small company is generally a good time. Sometimes, you know, probably one of the sweetest setups that you do say so to founders as in MNF group and primitiveness, where each has around 20 percent and together they kind of control the company. These are kind of patterns that you see that often bode well. Of course, that's just the start. [00:19:07][101.9]

Alec: [00:19:08] So called one one thing that we often hear about when we read or listen to people talking about assessing management is looking at their incentives. And I think for a lot of beginner investors that that's some that can be somewhat confusing. Like, first of all, what are you looking for, an incentive structures? And then where are you looking to get that information? How do you think about assessing management incentives and where are you going to get that information? [00:19:34][26.3]

Claude: [00:19:36] Yeah, well, that's actually such a beautiful way of generalizing the search for. Truth, I guess, and one of the first places that you've got to look is in the annual report and try to understand as much as you can about remuneration, or basically you're asking the question like how are they getting money from the company and what's the split so you can do? And this is the kind of analysis where you can actually, like, automate sort of some aspects of this. But generally you want to ask yourself, OK, is this inside or is this board member they making most of money through their fees or their salary, or are they making the most of money through the dividends they're getting paid from the company? And then also oftentimes they'll be performance pay and sometimes you can. Sometimes the annual report will have information about what the key performance indicators KPIs that the management has to achieve in order to get paid more money, basically. And that is a key area to look. And I would definitely encourage people to try and find that out. You can ask management, you can look in the investor relations, you can look in the annual report. If you can't find in the annual report and you just email investor relations that often tell you where that information is. But be aware that sometimes with some companies you really don't get good information and that can be a bad sign as it is. And you can ask about that information and I'll just sort of decide not to tell you. And that can often be a sign that that they are poorly remunerated. Like, for example, the performance is way too easy to achieve or. Can be sort of easily achieved, but that's the but only at the detriment of the company. So a good old old school example of this is a company that's long since gone from the ASX called Forge Group. And this was off the back of the two thousand and eleven kind of mining boom. There was a lot of mining service companies that had done had, you know, got bumper profits taken on debt and sort of started taking each other over, I guess, and their profits had gone up and up. Mining Services has a lot of leverage in that business model. So when demand goes up, they can make big profits and they were incentivized to grow earnings per share, which basically an easy way to do that is just take on debt, because if you take on debt, then you don't add to your per share. But you can use that debt to buy earnings of another business so they can increase earnings per share by just taking on debt to buy another company. And so they did that. And, you know, ultimately what happened is those earnings proved ephemeral and they lasted long enough for the earnings per share targets to be met in the short term, which triggers the performance pay. But then in the end, those earnings did not sustain and the company was left with a whole lot of debt. It couldn't service and I think it went bankrupt. But either way, it's not trading on the ASX anymore. [00:22:33][176.8]

Bryce: [00:22:34] So Claudia mentioned that, you know, you want to see founders who are CEOs who are keeping the shares. So I guess a two part question, you know, how important is management keeping skin in the game as they grow? Would you be worried if they're selling down their positions? [00:22:52][18.1]

Claude: [00:22:53] It depends on the context, but it's definitely a sensible thing to look at. So I think the selling, buying and selling behavior gives you an idea about the kind of trajectory they are imagining for their company or at least for their involvement with the company. So if the company lists and they sold out a bit in listing and then the share price doubles from there and then they sell out even more and then. It's just sort of like all you're saying is them exiting, then it probably they you seeing it as like towards the end of the arc of the business. If, on the other hand, you know, they they control the company and they and they hold onto it for, you know, five times gain and then they just sell a little bit and then they hold onto it for another five times gain after that. And then they sell a bit more and they hold onto it and they keep on selling it, but only after they've had big gains and they're still only selling a little bit of their overall holding like, say, going down from twenty six percent to twenty five percent or something like that. I wouldn't worry about that. And oftentimes you even see. The company will actually broadcast intentions, so like there's a little company that I own shares in called MacGraw Education Center Centers and it's run by St. McGraw, Kit, Kit McCrossin. And when Kit McGraw, who's obviously older and retired, wanted to sell shares, they preannounced it to the market and saying, you know basically what, he's going to sell this many shares for whatever reason, just because he wants the money, because he's older now, I guess I don't know why, but they preannounced it, you know, and and then so the market knows what to expect and you have that bit of information and that, you know, I would never hold against someone for doing that. And in fact, they're showing their respect for shareholders, a lot of people, by even saying what their intentions are ahead of time. So that would be an example of where selling down by the founder would not worry me at all. [00:24:48][115.2]

Alec: [00:24:48] So, Claude, we've touched on a key, a few key, I guess, sources of information to assess management. We can see how they're compensated and their incentive structure in their annual reports. We can see how many shares they hold in, you know, ASX announcements and annual reports. We can look to ASX announcements to see how they're communicating in terms of things like selling down shares. One one other area of information on management that we've been paying a lot of attention to recently are the statements that management make, particularly in earnings calls. Um, how how much stock do you put in? You know, how they're engaging with shareholders and how they're answering questions on earnings calls? And are there any, like, particular things that you're looking out for, either red flags or positive signs in how management is actually communicating on on these calls? [00:25:49][60.3]

Claude: [00:25:50] Yeah, great question. Yes, sir. Absolutely. Both on calls, on webinars and even in the written documents of on the earnings reports are, you know, absolute treasure trove of information about people. It's just them communicating to you so you can judge a great deal about that. And that's why, you know, the earnings season is so busy. There's a there's a range of kind of different tests you can do on. Let's just take earnings calls on. You know, one thing, just a basic thing you can think about is who are they taking questions for? What do they take? Is it always just like the house broker or the friendly broker that they're taking a question for? It's almost better? Or are they taking random questions from the crowd, essentially, some of which might be like hot or skeptical? I just the question, just the fact of whether they're willing to open up to those kind of questions in public is in itself meaningful. But then second from that, you can test that yourself. If you've got a genuinely good question that also might probe something a bit negative, like find the most negative criticism or whatever, and ask about that. You can learn something about the company just by emailing them and asking them the question. And if it's a good question, you'd hope that someone would give you a decent answer and. But do they do that or do they just waffle you? Often they don't want to talk about the negatives and that kind of thing. So, you know, there's been there's been times where a company presentation can work so hard to minimize the negative. You know, there might be some kind of chot crime where they have a chart that kind of has a weird axis that makes things look better than they are or whatever it may be. If you get the sense as part of all that communication that they're like trying to bury the negatives and just make you look at the flashy positives of adjusted a bit or something like that, that in itself can be like just tip you off that they're a bit promotional and to tread a bit more cautiously or something. [00:27:47][117.2]

Bryce: [00:27:48] So, Claude, we're going to talk about small and microcaps, as we said, an area that you spend a lot of time in and get your perspective on some of the key factors when conducting your analysis. But before we do, which is going to take a very quick break to you from our sponsors. So small caps, very exciting space for a lot of the Equity Mates community cloyed, and you spend a lot of time in that space. So again, let's start general wise, small caps attractive for you. [00:28:16][27.8]

Claude: [00:28:16] The reason small caps are attractive to me is because you can get if you have a smaller amount of money, that is an advantage in small caps basically. And that is a self-sustaining thing like. But you can still have that advantage up until maybe you have 10 Dollars million or something like that. So it's definitely a great place to focus before I have ten million dollars, which I definitely don't yet. [00:28:40][23.4]

Bryce: [00:28:41] Yeah. Yeah. Can you elaborate on that, though, for for people who are trying to understand why that actually makes a difference? [00:28:50][9.1]

Claude: [00:28:50] Yeah, for sure. So essentially the way it works is that for a for many small companies, especially if they're the ones that we've just been talking about, where management own half of them or whatever, that might be one hundred million dollar companies, but management owns 50 million dollars worth of those shares. And if there are a few other big shareholders, the actual number of shares that are trading in circulation in the market, in the open market for that company, it might be one hundred and something billion dollar company, but it might take days to just accumulate one hundred thousand dollars worth of shares without, like, meaningfully pushing out the share price. So for a fund, for example, that has one hundred million dollars under management, it might take them 10 days of normal volume to build a one percent position in this stock. And so if they were to go so far as to try to build a two percent position or three percent position, it might be just months worth of work and they end up moving the share price. And then they also stuck in there. They couldn't easily get out if they did all that. And also, that's just a feeling among the fans where, like, just they can't do that. There's no point. They can't even get a three percent position. If they try for three months, it's just not going to happen. Now, I would sort of say, well, usually when there's a will, there's a way have to wait for a moment until there's a little bit of a sell down. But for that reason, they don't look at those. They do not look at those companies really or consider buying them. So that takes out a huge source of capital and money that is not going to be competing with you to buy these companies. When a good one comes along, like let's just say you've identified a good one. It pays a little dividend, it's profitable. It has a cool business strategy. It has software. That's it. In a reasonably sticky, resilient part of the tech stack. So like, oh, this looks pretty good. Yeah, it's got a few problems, but also just hates the people that have money, the funds, and all of a sudden they're not even going to consider buying it. The idea is you I would try to buy that company now in the hope because that in the future it will be a bigger company and maybe there'll be a little bit more liquidity and then some more people like, oh, you know, when this was trading at 10 cents per share and was one hundred million dollar company, it really was too small for us. And we couldn't accumulate shares. But now there's been you know, they did a capital raising maybe to do an acquisition. And also the founders sold down a little bit of shares and now it's a 200 billion dollar company with its share price at 18 cents because it's had a bit of dilution and maybe we could actually accumulate some shares. And then as it gets bigger and bigger, more and more people can actually start buying into that. And looking back, because, you know, the market price might have been 20 times earnings when it was tiny, then it goes up to 40 times earnings because now there's so many more people as potential buyers. But, you know, maybe that if it's a really good company, then maybe there's not so many good sellers constantly. So the market finds that equilibrium where like maybe the guys that bought it to pay 20 before and now they'll sell it, pay 40 because that that's their style. But or maybe you're holding on if it's a good company in the ideal world and the Holy Grail, what you're looking for at the end of that is if it gets put into the ASX 200 now, companies sometimes ruin this opportunity by doing a big capital raising just before they get into the ASX 200, which allows all the index huggers to kind of get set and ruins this sort of liquidity squeeze that happens. But in the best case scenario, which, you know, I think you've seen this recently with one of my shareholdings, Objective Corp, get started, put into some sort of, well, small cap index or something like that. And as they go into these indices, then the ETFs that track those indices, they have to buy the shares. And if they if the register remains fairly tight, then you have been is the cherry on top, which is essentially forced automated buying of the stock just because it's got bigger, like now, in order to have got bigger, it must have done some things well, presumably actually grow. And so that's not, you know, completely a fact and an easy fact. But if a company can get bigger without having to dilute massively, then you get these huge blow outs when they enter the index. And that's a great time to consider taking some profit or just hold on. Either way, it's I generally wouldn't be buying at that time, put it that way. But it's still a lot of fun if you've got set at a much lower level. [00:33:10][259.8]

Alec: [00:33:11] So could we a lot of the Equity Mates community sort of see the attraction of small caps. You know, everyone is chasing that 10 bagger or a 100 bagger and some of those market dynamics that you were just touching on there around forced buying from indexes as these companies grow makes them very attractive. But they're also they're also the riskier end of the market. So let's start with the negatives and then we'll move on to the positives. So what are some of the key watch outs you're looking for when analyzing small caps? And I guess for a lot of the Equity Mates community that are used to analyzing larger companies, how is analyzing the smaller end of the market different to the big end? [00:33:53][41.8]

Claude: [00:33:54] Well, I think that the biggest difference is for the big end of the market, you could almost just go through every company and you wouldn't be wasting your time to analyze them. But for the small end of the market, if you want to be effective in a sustainable way, you just need to cut out massive swathes just on uninvestable swill. Basically, that's the first step in small cap area. [00:34:15][21.2]

Alec: [00:34:16] I mean, in terms of in terms of determining what's uninvestable, uninvestable swill and what might have potential, what are some of those things that you're looking for? [00:34:25][8.6]

Claude: [00:34:25] Yeah, for sure. Well, like the first step would be I would just knock out every single mining explorer or biotech, not saying they're all bad, but you just need to make some calls to get yourself into a safe. A little playground at. Where you can have a better strike, right, so I'd take out all mining companies or biotech companies, all companies that don't have revenue and I mean serious revenue, like I would say, definitely at least a million dollars a year, but probably more like for at least five million dollars a year. So that takes out the biotech and the mining anyway, basically. And the more established the company is in terms of also having, say, profits of free cash flow. Generally speaking, the less risk, there's an awful lot of companies that say they're going to one day be profitable. But really the economics mean that it seems extremely unlikely and they can trade based on the hopes and dreams for a long time as well. So I think that what you're essentially trying to do to make it a safer place to play is take away all of the stuff that's on hopes and dreams and stories and that kind of thing. So, for example, I take away risky sectors like to do with debt and lending and stuff like that. Most retail shareholders don't have the requisite skills to actually understand the balance sheets of those financial companies and the risks on them. So that leaves you with hopefully, you know, back in the day I would even just scan. I wouldn't even want profit. But perhaps with some companies that have good business models, you would be willing to say that you don't need to see profit yet. That would be the first sort of step. And then, yeah, you can do other things beyond that to continue to look, you know, basically make sure that you're in the right area. I think something that I invest a fair bit in is companies that I guess are turnarounds where I'm expecting something to return to or become growing when it wasn't previously growing. But I would actually avoid that for most people. I think that that's that's the that's the riskiest area I play. I think that you can minimize your risk further by basically demanding evidence of growth and the more metrics you're getting that growth on, in my view, probably the closer you are to actually finding like a genuine growing small business. And you could almost do this quantitatively, you know, if you just went through and always made sure you were looking at businesses that were growing on at least three metrics out of revenue, a bit profit dividends. And, you know, perhaps you could make up another metric as well. And then you also look for insider ownership, not too much, not exorbitant salaries. Generally, a low salary with a high insider ownership suggests alignment. You know, you're starting to get to the you're starting to narrow down the sort of pool that you're fishing in. So the fact where the odds are actually in your favor, the more of these kind of stuff, you lay over it. So beyond that, that's when the point you could just go through that list of companies and try to understand every single one. And and that's when you might want to start engaging with the story of a stock. Right. I'm not saying a story of a stock is irrelevant. It's always relevant. But if you're buying a company that has no revenue or know nothing and it's just raising cash and telling you a story about what it's going to do, like you're just going to be riding the waves of sentiment and stock promotion, which you have no control over and very difficult to predict and also may not be controlled in a way that's designed to give a favorable outcome to you. [00:38:03][217.7]

Bryce: [00:38:04] Hmm. Pretty fascinating that quote. So before we move on to chat about some of the some perhaps some examples that you're looking at, the kind of fits what you've just spoken about, so you're looking to exclude, you know, lack of proper minimal revenue, mining explorers, biotech's, you know, avoiding the debt and lending space, but then looking for companies with a bit of a turnaround story, perhaps some revenue growth, a bit of growth, and I guess a business model that you can back. Just briefly, though, are you able to outline like what is the length of time it takes for you to research from the initial idea through to sort of first investment? Just to give our audience a sense of what it takes to do this sort of level of research? [00:38:49][45.6]

Claude: [00:38:50] Yeah, right. So, well, I'll take there's a bit of a range in the answers. So on the on the very low end on just because of my own personality. One of the things I do sometimes do is if I don't know a company very well, perhaps it's a recent IPO, perhaps for whatever reason I haven't spent the time looking at it. One common one for me is that if I buy a stock and then sell a stock and then it goes up, I get psychological pain looking at it. So then so then I won't look at it again for ages, even if it's actually quite an interesting company that I should be monitoring, whether or not I own it, I should still be monitoring it in search of that opportunity as part of building my knowledge base so that I have an advantage over other people. I should be following it, but I don't because of that. Psychological pain, sometimes what I do if I say enough is enough, I'm going to actually force myself to buy a little bit more of this company, even that its more elevated price, even though I probably think it's too expensive and I don't like looking at it and thinking about it anymore just to try and unwind my psychological tangle. So that would be you would think of that as a research position. And so with the research position, you know, I sometimes it's just more of a psychological thing where I'm like, I want to look at this stuff again. I'm focusing my attention onto this company because the objective analysis, people I've spoken to, I've changed my view. I just need to refocus. So I would say that actually buying a research position in a sock, which is basically saying a promise to yourself, you're going to follow it and dove into it. Then once you've done the work and caught up on that stock, sometimes I'll sell it and that's fine. And I do that. But I'm not saying that's the best thing for everyone else to do, but that's just the trick that works for me. And that would be the low end of how much work I would do. But then on the high end of your question, in terms of like the companies that I have large positions in and that I've perhaps taken a while to build that, looking at the companies that are my top three holdings, one of them I've followed for almost 10 years, pretty much now. Another one would be probably on and off for six or seven. And then and then the third one is not so long. Then the fourth one again, we're looking at almost 10 years. So for me, really, where retail investors build an advantage is if you find the good ones. And then so there's a lot of stocks that I've just followed for five or 10 years now. And that does there's never too much like basically that is going to help you, even if you don't own it for most of that time, you're going to understand the history. Where is it in its evolution? Who are all the people that have been involved? And just by contextually knowing the story of the company, you are able in my opinion, that is how you get your advantage. You're better able to contextualize and understand new information and understand how meaningful it is if you know that story better. So it's really old fashioned. That's why you do it in small caps is because if you are the guy that knows the story, there might be like five people in that position. So there's no limit to the amount of time I would spend trying to follow and understand a company. And the only reason that I'm saying five, 10 years now is because basically I was saying I started investing in 2009 and I didn't really come across any good companies until a few years after that. And that's where we are. So in another 10 years, I hope I'll be saying I've followed stocks for 20 years. [00:42:19][208.5]

Alec: [00:42:19] So I would love to hear a couple of examples of small caps that are taking some of the boxes for you at the moment. But before you answer, I just want to stress and I guess emphasize a key thread that's coming through in in this conversation, which is, you know, these stocks. You try and know those stocks better than anyone. You try and know them as well as the CEO and the board and the people that work for the company. So in answering this question, it is obviously not buy, hold or sell advice. It's you know, it's I guess to help people build a watch list to start researching stocks so they can know them as well as you know them. But it would be great to hear a couple of small caps that are taking some of the boxes for you at the moment. [00:43:03][44.0]

Claude: [00:43:04] Cool. Yeah. Yeah, definitely as well, thanks to that bringing that forward. But also it's worth remembering that inherently small companies have bigger risk and more volatile. And I am personally comfortable with saying my shareholdings go down forty five percent as a general rule. You know, I would hope that by 50 percent I thought automatically thinking, oh, what if I got wrong? But then I do get things wrong as well. Right? So that's something to keep in mind and that's just something that I've become used to. I take high risk and high quality volatility in my portfolio, but sometimes that leads to sickening drawdowns. And I can remember when I was starting out, like I would feel physically anxious, like when I gave a recommendation and then it was down like fifteen percent. This is when I was at Motley Fool. I had to like, go up and go for a run every morning just to like, get past the sick feeling in my stomach that I made a mistake. So, yeah, basically I'm inured to like massive drawdowns now. So that's something to keep in mind in terms of the companies that I talk about. With that said, I think probably my favorite or the one that I like most like right now as a small cap stock is energy one, which I have a reasonable size position, which is unfortunately now not so cheap as it was previously. So I think that I would expect that there will be a time when the share price will come down and be more available at a more attractive level. But it has. One hundred and seventy dollars dollar market cap and operates in the industry of making software that allows participants in wholesale energy markets to manage their risks, opportunities and obligations. What it does is it provides the software that some energy generators in Australia would use to, you know, run their businesses in many ways. But it's the part of the software that's specific to their specific energy trading businesses. So that's generally like that's that's an interesting part of the software to provide to someone because it's essentially sticky. They it's not very easy for them to go away from that area. And it's also in nature. So it's plausible that a small Australian company could actually be the leader in a nation. If you have some massive enterprise software suite, then you'd be you wouldn't really expect to find some small ASX company doing great there because that's going to be dominated by some massive US company. So it makes sense that it's a niche there. And, you know, essentially they've had good market share in Australia for years. They have paid dividends, being profitable, generally grown over over the long term. I mean, I've watched them for at least five years or more and they have high insider ownership. Now, what we've seen more recently is that they executed fairly well on some acquisitions of European and European companies that are sort of in a similar space. And so whereas they had 50 percent market share in Australia, they only have around five percent market share in Europe. So that's now they hope, you know, an area where they'll be that'll be the next sort of center of growth, I imagine. And then I guess the longer term plan would be to try to do the same thing in the US as well. So there's a reasonable growth thesis there. It's it's on a fairly high multiple of earnings. But, you know, as you may have noticed, when we get to larger software companies, you often can see people more just valuing them on revenue rather than earnings or at least valuing them recurring revenue. And these guys do have a fairly high level of recurring revenue. And I'd say that, you know, they're trading at a cheaper multiple based on recurring revenue than many large software companies. So, you know, I would hope that this is a company that will be able to deliver organic growth. It will be able to deliver a bit of acquisitive growth. That will mean it keeps getting larger. And then that whole ecosystem of funds management will start looking at it more closely. And, you know, at that point, you know, I would I would hope that it's only going to be good things for the share price. [00:47:15][251.0]

Alec: [00:47:16] Fascinating company closed. Not one that I've heard of, but definitely one that I'll add to my list of stocks to research. So I appreciate you sharing that name with us. Now we are reaching the end of our time. So first of all, I want to say a massive thank you for joining us today and sharing your knowledge. We do have a final three questions. But before then, if people want to find out more about you or follow your work, where should they be going? [00:47:45][29.6]

Claude: [00:47:47] Yeah, basically, you can read some of my writing for free just at a rich life dot com today and write about it or all manner of things, some education stuff, if if that's what you're more interested in and some stuff just reporting on companies and obviously gearing up for our busy period at the moment as companies report towards the end of August. [00:48:10][22.4]

Alec: [00:48:11] Nice one. And I think if you are on Twitter, Covid is a good follow on Twitter as well. Some some interesting stuff shed there. So going for the quote on Twitter as well. But we will get into these final three questions, coord. And the first one is, do you have any books that you consider must read. [00:48:29][17.8]

Claude: [00:48:30] I have to say, I would definitely recommend any investor peruse the last liberal art, which is that's a more advanced book, I guess, for investors. But I definitely think even if you didn't read the whole thing just to get an idea of or even just read the first chapter, you know, just get an idea of that basis is interesting. And then, you know, I generally think that the little book of this and a little bit of that little book of that in investing is a pretty good place to start. However, my favorite in that series would be the little book that still beats the market. It's it's super simplistic, but I think it's just a great way to understand, you know, how price and business quality interacts and how you can think about that in a basic way. [00:49:16][45.1]

Alec: [00:49:17] Yeah, that Joel Greenblat book is is a Crocco definitely second that recommendation. So the second question, Claude, is in 60 seconds or less, what's the best company you've ever come across? [00:49:31][14.3]

Claude: [00:49:32] Iranian quality. [00:49:33][0.3]

Alec: [00:49:34] Yeah. Yeah, quality. [00:49:35][0.8]

Claude: [00:49:36] I think that the best company that I've ever come across is a project of a friend of mine who is automating share quarterly report analysis and basically creating algorithms that can also then feed into templates that create like well-written, informative and helpful articles to people that can also be published almost instantly because it's all automated. So it can be faster and more accurate. And I think it's just going to be really helpful. And yeah, for all the businesses that I've had had a real look at this, that's that's probably the best one that I just think it has massive potential. [00:50:14][38.5]

Alec: [00:50:15] I feel like you'd be doing your friend a disservice if you didn't say the name of the business so people could check it out. [00:50:19][4.6]

Claude: [00:50:20] That's about stockstory, actually. Stock Yeah, and that's still in the early stages of development. But I'm just excited about what they're doing there. [00:50:28][7.4]

Alec: [00:50:28] And then final question, Claude, if you think back to your younger self analyzing companies in 2007, 2008 and then watching that first investment go to zero. What advice would you have for your younger self? [00:50:43][14.9]

Claude: [00:50:44] I think the advice would be to invest, invest more in software companies. Essentially, when I was first starting out, I didn't invest massively in software companies. But then, you know, most of the most successful companies that I was looking at or did own at that time turned out to be software companies. So that would be my advice. [00:51:05][20.8]

Bryce: [00:51:06] Nice one cloud. Well, as we said at the top, we wanted to touch on what is a very, I guess, enjoyable and sought after topic here at Equity Mates in those small caps and also the focus on management. And I think it's been a very valuable conversation. I've thoroughly enjoyed it. And the insight you've provided, I think, is certainly going to help a lot of the members in our community navigate the small end of the market. So very much appreciate your time. And we look forward to having you. [00:51:33][27.6]

Claude: [00:51:34] I love that. Thank you for having me. It's been fun. [00:51:34][0.0]


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