Investment Philosophy

Having a clear business strategy is critical for a company to achieve its long term goals. Without it, there will be no financial returns for investors.

So what is strategy?

Simply put, strategy is a high level plan to achieve long term goals whilst trying to navigate through conditions of uncertainty. At Canary Capital, we spend a great deal of time with the management teams of companies we invest in. We gain an understanding of what their goals are and the strategies they intend to employ to achieve them. Then we spend a considerable amount of time assessing whether we believe these are the right strategies to deliver the ultimate goal for our investors; a satisfactory return on investment.

The most critical element for any micro cap investment is that your money is being managed by the right people. Warren Buffett famously quipped that “you should invest in a business even a fool can run, because someday a fool will”. This is likely a sensible approach to take when investing in securities of companies that are well established in their respective markets and have significant barriers to entry. However investors in micro cap companies simply cannot afford to adopt this philosophy when they are deciding on their investment portfolio. The reasons for this are two-fold.

Firstly, small companies have limited funds and trained personnel to execute their strategy. Often these companies will have a ‘first mover advantage’ and therefore usually only a narrow window of opportunity for them to capture a large portion of their addressable market before their competition catches up. The room for management error is incredibly small and even the slightest mishap can lead to potential disaster for investors.

Secondly, a more hazardous possibility is investing in a company which is run by “lifestyle directors”. These are directors of companies who have developed a reputation for not taking shareholder responsibility seriously. They may receive exorbitant salaries and receive consultancy fees from other vehicles. Furthermore, they usually lack alignment with shareholders (due to a low equity holding, a low number of options or a lack of performance shares). As a result, they are not concerned with the performance of the business they are running, let alone delivering a return on investment for shareholders. It must be noted however, that even alignment with shareholders does not necessarily guarantee management performance.

Because of these issues, we do thorough due diligence and investigation on the management behind any company to ensure they are the right team for the job and are able to execute on their strategy. This includes an assessment of their past track record to ensure they have the relevant qualifications, incentive and ambition to make the company a success. We also have multiple conversations with a company over a long period of time, getting a sense of what the culture of the management is like before we decide to support them.

At Canary Capital we believe in backing Australian companies that have a global mindset. This is beneficial for investors as companies that can address a global need have a significantly larger opportunity for growth compared to those that can only meet a domestic need. Many Australian companies have and will continue to be on the forefront of new drug discoveries, new medical devices, new technologies and new innovations which will continue to shape the world as we know it. By investing in unique and novel technologies that can meet a global need, the potential return for investors can be exponential.

If a company has a scalable business model, it means it is able to significantly grow revenues without a significant amount of additional capital investment or operating expenditure. By combining a global reach with a scalable business model, the company is able to roll out its product and capture a significant portion of the global market while only deploying a minimal amount of capital. This ensures operating margins are high and the return on equity for shareholders is also high. In addition, investments that are seen to be high growth and have a global reach are generally rewarded with higher earnings multiples compared to those that have lower growth and/or a domestic reach.

Therefore, even if a high growth global focused company generates a small amount of revenue, the market could reward it with a significantly higher multiple and hence a larger market capitalisation than otherwise possible. With a larger than normal market capitalisation, the company can access the equity market for additional funds to accelerate their growth without being heavily dilutive to existing shareholders.

A company’s unique IP or other barriers to entry into a marketplace help to create a path to longevity and financial success. Being first to market can also provide a significant long term advantage for a company to achieve long term prosperity. When investing, we look for companies which either own their own intellectual property or have a significant first mover advantage over potential competitors.

Technology is fast moving and changes can render a company’s core value proposition worthless overnight unless it is truly unique and protected under a patent. Some companies choose to retain all or part of their intellectual property in house because of the risk of counterfeiting or copying – we call this “In House IP”. Doing this can serve to extend the longevity of a company’s total IP portfolio thereby generating further long term returns for shareholders. We take a positive view of companies which protect their future income stream by adopting a strategy of utilising traditional patent protection as well as retaining some internal “In House IP”.

Even if a company ticks 4 of the above boxes, it all becomes irrelevant if the price an investor pays is too high. The lower the entry price relative to the company’s true value, the greater the upside in the event of the company succeeding and the lower the downside in the event of the company failing. The opposite also holds true, if the price paid is too high relative to its valuation then investors are exposed to greater risk on the downside in the event the company does not succeed and will receive less reward if it does. It goes without saying therefore that, all things being equal, it is better for investors to select companies with the former attribute rather than the latter.

This concept is commonly referred to as investing in stocks with favourable ‘risk-reward ratios’. In value investing circles, this is also referred to as ‘investing with a margin of safety’, the margin of safety being the difference between the price paid and the investors assessment of the fair value of the company. The greater the margin of safety, the more favourable the ‘risk-reward’ ratio is. There are no hard and fast rules when it comes to determining what the right risk-reward ratio (or margin of safety) is. It will largely depend on the nature of the company’s activities and the industry that it is operating in. For Canary to do this, markets have to be less than fully efficient, otherwise it would be impossible to invest with a margin of safety (because all stocks would always be trading at fair value and reflect all known information by all market participants).

Canary Capital believes markets are semi-efficient and therefore the potential for mispriced securities do exist. There are several factors that determine mispricing and therefore the potential attractiveness (or unattractiveness) of publicly listed securities. Firstly, the market may simply be unaware of the opportunity, due to a lack of investor relations and marketing activities by the company. The market may also view a certain sector, commodity or particular company in an overly and irrationally optimistic or pessimistic light.

Other factors of mispricing may be due to the size of the company. Generally, the smaller a company is the less likely it will be receiving research coverage from analysts at established broking firms. Furthermore, smaller companies may also lack liquidity in their shares which means it is more difficult for institutional investors to take a meaningful position in the company relative to their funds under management.

In consideration of everything listed above, the team at Canary Capital have spent many years developing the skills necessary to identify investments that are being overlooked and therefore mispriced by the market. Because Canary specialises in micro cap companies, the sheer number of potential opportunities (and potential pitfalls) that exist are greater than for those who specialise in investing in larger companies.

By being vigilant with due diligence and ensuring a good entry price, Canary Capital strives to ensure the best possible risk/reward characteristics for the investments it recommends to its client base.