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Why market noise highlights the importance of identifying high-quality businesses

By Rhea Nath
4 minute read

While fund managers grapple with the perennial question of how to navigate the unpredictable terrain of financial markets, Blackwattle’s co-founder and CIO shared his philosophy on where to get started.

Acknowledging that it’s impossible to accurately forecast equity markets, commodity prices or rates, Blackwattle Investment Partners’ Michael Skinner believes the focus should remain on identifying high-quality businesses capable of sustained growth over the long term.

Appearing on the Relative Return podcast, Skinner observed that the starting point in an uncertain investment environment “should always be business quality”.

“I personally think it’s impossible to forecast equity markets, commodity prices, rates, the future. No one has repeatedly and accurately done that, so our starting point is always on business quality,” he told InvestorDaily.

“We’re looking at businesses that are growing, that are maintaining and expanding margins, increasing price, generating free cash flow over time, and generating a high return on equity or high return on invested capital.”

According to Skinner, the firm’s focus on quality has meant looking for businesses “that are going to be stronger in five- and 10-years’ time than they are today”.

Among the top holdings of the Blackwattle Small Cap Quality Fund, which provides exposure to Australian smaller companies emerging as industry leaders, are travel agency Flight Centre, olive oil manufacturer Cobram Estate, and location-sharing app Life360, the latter of which was among the key contributors to performance as at 31 March 2024. The fund outperformed the ASX Small Ordinaries Accumulation index by 1.8 per cent last month.

Meanwhile, the Blackwattle Large Cap Quality Fund, which outperformed the S&P/ASX 200 Total Return benchmark by 0.67 per cent, has ResMed, Carsales, and retail conglomerate Premier Investments among its top holdings.

However, Skinner acknowledged that apart from business quality, the firm’s other considerations include macroeconomic and risk overlays to all its portfolios and investments.

“We do have to have an opinion on these things, but they don’t base their formation of our portfolios,” he explained.

Moreover, he forecasts that the themes of sticky inflation and potential rate cuts will continue to play out throughout the year, based on the current market conditions.

The upcoming US election, he added, is also being closely monitored by managers.

“Elections, particularly US elections, are typically very good for equity markets, so we’re weighing up those two dynamics and our teams are finding great pockets of opportunity across ASX.”

The promise of small caps

Fund managers have been forecasting a renaissance for small caps in 2024, highlighting a more favourable macroeconomic environment for the asset class as a monetary easing cycle looks to unfold.

Speaking to InvestorDaily, Skinner agreed that small caps are beginning to look promising.

“We think the market is relatively fairly priced as a whole, but there are some really good pockets of opportunities in specific sectors and also in small caps, which remain undervalued, in our opinion, versus larger cap companies.”

He added: “We’re finding opportunities across the whole of the ASX, but you do have to be quite selective in where you deploy capital.”

Last month, Datt Capital CIO, Emanuel Datt, also shared his conviction about the promise of small caps, particularly Australian small caps.

While US small caps offer possibly greater depth and diversity, Australian small caps present distinct advantages for investors seeking value and growth, he said.

“The inefficiencies and relative under-coverage of the Australian market create fertile ground for identifying overlooked gems and undervalued assets,” Datt observed.

The Australian small cap market remains under-researched, which in turn can present unique opportunities for astute investors to uncover undervalued assets and generate outsized returns.

“The Australian market is considerably cheaper than the US market on a relative basis,” Datt said. “Valuation differentials between the two markets are quite apparent, with Australian equities trading at more attractive multiples compared to their US counterparts.

“This affordability could appeal to investors seeking exposure to high-growth companies at more accessible entry points.”