Despite this, any seasoned (and objective) investor will tell you there have been many times when their investment in an emerging company was not as fruitful as expected. At extreme points, investors may have accrued significant “paper losses” with a subsequent view of “will I ever get back my initial investment, let alone make a reasonable profit?”. 

In NAOS’s opinion, the last two to three-year period has been one where doubt and self-reflection have come into play, and in a big way, for emerging companies. 

With the February reporting season just gone, NAOS had the chance to gain an insightful and timely view into the health of many emerging companies. In NAOS’ opinion, several of these companies could have the potential to become much larger and successful businesses, regardless of their current share price. 
 

Case Study

[Editor’s Note: Do not read the following case study as a recommendation to buy securities in Reece Limited. The case study is for education purposes only. Do further research of your own or talk to a licensed financial adviser before acting on information in this case study. NAOS Asset Management does not hold shares in Reece Limited].

One of the most notable examples of a business that started its life as an emerging company and now finds itself in the ASX-100 is Reece Limited (ASX: REH). The business listed in 1954 and over that time it has produced a total shareholder return of 16.84% per annum. However, as the chart below shows, this return did not eventuate in a linear fashion.

The chart below measures Reece’s share price range during a particular financial year, compared to the price as at 1 July in that year.

At first glance, the average trading range is +/-25%, however there are some periods such as 1986, 1987, 2002, 2007 and 2021, where the share price climbed 75% higher compared to the price at the start of the financial year. This is ignoring some large falls, for example in 1988 and 2022.

So, if an investor purely reacted to a short-term drawdown in the REH share price and sold out of their investment, the forfeited long-term returns would have been significant. This shows that even successful companies sometimes experience significant volatility over time.
 

Chart 1: Reece share price range during financial years

Source - FactSet

Identifying emerging companies

NAOS seeks to apply a long-term strategy and considers the share-price volatility and the long-term returns that emerging companies can produce. In the context of its activities, NAOS has regard to a number of principles it considers significant:

• Keep it Simple – The simplest business models may be more complex than many investors appreciate. Therefore, NAOS attempts to focus its research on not only the business but also its customers, suppliers, peers and the broader industry to ensure we understand the drivers of risk and opportunities. 
  
  
• Alignment & People – Emerging companies are sometimes driven by a few key people within the organisation. Therefore, it’s imperative that the decisions they make have the long-term interests of the business at heart even if to the detriment of short-term profits. There is no better way (but by no means the only way) to ensure this than with a significant investment in ordinary shares alongside all shareholders. 
  
  
• Cash is King – When investing in emerging companies, things rarely go exactly the way you anticipate, so it is important for a company to have the internal financial resources, via cash holdings, unused debt facilities and/or internally generated cash flow. This flexibility can often mean a permanent capital loss event is averted for investors if challenging conditions arise. 
  
  
• Industry Tailwinds – A well-known investor once told NAOS, “it’s easier to grow your revenue when the industry is growing as a whole”. In hindsight this may be obvious but the allure of investing in “cheap” businesses, operating in industries with poor prospects, may be too tempting for some and can often lead to poor results. Investing in businesses with industry tailwinds may assist in achieving sustainable growth. 
  
  
• History of Capital Allocation – Most investors are often forward thinking and so are many company management teams, but often a part of the answer we are looking for lies in the historical performance of a business. Spend some time looking at basic historical data around capital management such as “How has the number of shares on issue changed over time?” and “Have the dividends been consistent over time?”– this can potentially provide you with more confidence in future projections.

Risks

Investing in any asset class carries varying degrees of risk but when investing in emerging companies there are certain risks that need to be understood, not only to ensure the chance of any permanent capital loss event is reduced but also to minimise any reactive decisions driven by emotion. These risk factors include:

• Illiquidity of Shares – The shares of many emerging businesses are often illiquid and may only trade in volumes of less than $50,000 per day. This can mean share price volatility is significant in times of distress or euphoria. 
  
  
• Earnings Volatility – As the law of small numbers states, it’s easier to grow off a smaller base than it is off a large one. So, at results time, be prepared for large percentage swings, both positive and negative. 
  
  
• Key Person Risk – The unexpected can occur, no matter what people’s best intentions are. Scenarios where the leaders of emerging companies are required to step away and/or are replaced can lead to a subsequent period of instability and uncertainty.
  
  
• Valuations – The great economist John Maynard Keynes once said: “markets can remain irrational longer than you can remain solvent.”  This is particularly relevant for emerging companies, which in times of strong business performance can stay “cheap” for a significant period of time. 
  
  

It Pays to Be Patient

NAOS views patience as one of the great factors for successful investing in emerging companies. NAOS has the view that compounding returns are powerful but the ability of the market to understand the strategic value of a business may take years to be fully realised, even after much hard work from management teams.