Small caps, smart returns

By Jessica Bruno | October 21, 2016 | Last updated on October 21, 2016
9 min read

When it comes to companies, small doesn’t mean risky, says Virginia Au, vice-president and portfolio manager at Trimark Investments in Toronto.

“I’ve been a small-cap queen,” says Au, who has been looking at companies with market caps under $5 billion since she was an analyst at Pembroke Asset Management 13 years ago.

There are more than 45,000 publicly traded small-cap companies worldwide, so there’s plenty to choose from, says Au. There are just 2,000 firms with larger capitalizations, and that relatively small pool is teeming with analysts. She says large companies like Apple have more than 50 people tracking performance on the sell side alone.

“Given that situation, it’s very hard to do better and out-think the next guy,” she says. Small caps often have fewer than 10 analysts, giving investors a better chance of spotting price inefficiencies.

A small company doesn’t necessarily mean a rickety start-up—that’s a common misconception, says Au. Instead, her portfolio has 25 to 35 companies with sustainable competitive advantages, reasonable valuations and scalability.

Global Payments, a credit card transaction processor, and Cubic, a transit payment processor and defence company, both fit the bill, she says. They’re also examples of how small companies can have big impacts—millions of people use these companies’ services every day without realizing it.


Global Payments (NYSE: GPN)

Incorporated in 2001, this payment processing company is used in 29 countries across North America, Europe, Asia-Pacific and Brazil. It processes transactions for American Express, Discover Card, MasterCard, Visa, Interac, and non-traditional payment methods, including Apple Pay.

Au ranks Global Payments as one of the largest payment providers in the world. In 2015, it processed 7.2 billion transactions worth US$425 billion. Though the bulk of that business comes from retail customers, it’s also used by casinos, healthcare companies, utilities and not-for-profits.

Say you buy something for $100 with a credit card, explains Au. The store pays 2% plus a fixed fee of about 20 cents to have the transaction processed. Actual fees can vary widely, depending on the size of the merchant, its bargaining power, and the cards it accepts. Part of that cut goes to the card company and part to Global Payments. “For the fee, Global Payments works on behalf of the retailer to do real-time payment authorization,” she explains. That means checking a customer’s card is valid and making sure the merchant is paid.

Putting it through her process

In 2013, Global Payments was recovering from a data breach a year earlier, and Canada was tightening credit card rules. The company’s stock price was down and Au saw an opportunity.

She flew to Atlanta to hear management’s long-term strategy. She also met with their competitors, as well as with credit card providers, so she could understand the industry from every player’s perspective. Global Payments was hardly the first company to have a data breach, Au reasoned, with most firms bouncing back in two to three years. She holds stocks for an average of four years (giving companies time to work through most of a typical seven-year business cycle), so there was plenty of time for the company to recover.

Au looks at companies’ growth margins before investing. While they vary across sectors, she says firms with proprietary technologies usually have higher growth. In this case, Global Payments’ competitive advantages are its data network and position as middleman between retailers and financial companies.

“Retailers are reluctant to switch their payment systems,” explains Au. Imagine walking into a store and not being able to buy something because the credit card system isn’t working. “You’d leave and either go buy it on Amazon or [at] the retailer down the street.”

The expense of setting up a processing network and getting security approval from card companies is another deterrent to competitors. Since Global Payments’ network is already established, it can grow simply by handling more payments. Au purchased in August 2013 at US$24.

Turning point

Mobile payment methods, such as Apple Pay, were in their infancies in 2013. That caused Au some worry when she initially invested in Global Payments. Three years later, Global Payments now handles such companies’ transactions.

Global Payments will also benefit from inflation and long-term economic growth, she says. With more people buying more things at higher prices, the firm will reap more (and more lucrative) transaction fees. But it’s vulnerable to slowdowns. The energy rut has affected its Canadian business, but revenues are steady. U.S. growth made up for that: total North American revenues were up 8.8%, to nearly US$2 billion in 2015.

Post-purchase performance

Global revenues increased 8.6% in 2015, to US$2.77 billion, up from US$2.55 billion the year before. Though 71% of revenue came from North America, the company has been growing in Europe and Asia.

“That’s where the next leg of growth will be,” Au says. Industry reports find that countries like China, Indonesia and India, where nearly 100% of transactions were conducted with cash in 2010, are now adopting mobile and credit card payments. Global Payments is already in 13 Asia-Pacific countries and territories, and it’s one of the top processors in most of them. It’s also partnered with UnionPay, China’s only domestic bank card company, and it’s helping mobile payment systems like Android Pay expand into the region.

Though Au sees potential in Global Payments, she’s mindful that the company’s stock price has more than doubled since she bought. She sold some of her stake last year when it was trading in the high US$60s to low US$70s. The stock was worth US$78.98 at press time.

“I like to buy things on sale,” she says. “When they become full price or even more than full price, I start to sell.”


Cubic (NYSE: CUB)

Cubic is the parent company of Cubic Transportation Systems and Cubic Global Defence. About 60% of its revenue comes from the defence business, which provides combat training systems, surveillance, intelligence and special operations equipment to the U.S. and 35 allied countries.

Accounting for 40% of Cubic’s revenue in 2015, the transportation business provides automated payments for public transit. It processes more than 24 billion payments a year and works with more than 450 operators, serving 38 million people a day.

Riders in London, New York, San Francisco, Vancouver and Sydney, Australia, pay via Cubic systems. Founded in California in 1951, Cubic now operates in more than 60 countries. In 2015, it had sales of more than US$1.4 billion.

Putting it through her process

In 2012, U.S. political brinksmanship and the threat of defence spending cuts took a toll on defence stocks, says Au. With about 70% of Cubic’s revenue at the time coming from the sector, it was vulnerable.

But Au was really interested in Cubic’s transportation business. “It’s actually a much bigger business than it looked,” she says. Though it was only 30% of revenue, it was half of Cubic’s profit, and the company had several competitive advantages, fitting Au’s criteria.

Transit systems everywhere have been updating from a variety of older payment methods—such as magnetic passes or tokens—to ones that allow riders to simply tap their credit cards and go.

Company stats

Global Payments

Ticker: NYSE: GPN

HQ: Atlanta, Georgia

What: Mobile, in-person and online payment processing

Buy: US$24 (August 2013)

Average price since purchase: US$46.11

Low: US$23.81 (Aug. 12, 2013)

High: US$79.23 (July 26, 2016)

Current price: US$78.98 (Oct. 6, 2016)


Ticker: NYSE: CUB

HQ: San Diego, California

What: Transit infrastructure and defense company.

Buy price: US$47 (July 2012)

Average price since purchase: US$47.12

Low: US$30.80 (Feb. 9, 2016)

High: US$56.55 (Nov. 27, 2013)

Current price: US$47.12 (Oct. 6, 2016)

Cubic has operated for 65 years, which is an advantage in an industry that rewards well-established firms. Bureaucrats awarding contracts often turn to these companies, rather than smaller ones, for peace of mind, she says.

“These are 12- to 15-year contracts. You don’t want to go with someone who might go bankrupt tomorrow,” she explains.

In a typical contract, Cubic is responsible for building and implementing a payment system across a transit line, which Au says can take three or four years. The rest of the term is for maintenance and operations. This phase is most lucrative for the payment company, as expenses are low.

In the cities using its systems, Cubic has an incumbent’s advantage to bidding on upgrades, notes Au. That’s because of its specialized software for calculating and tracking fares. Take a system like London’s Oyster card—charging a rider is more than a matter of charging a ticket to her account. The subway system has nine zones that cost riders more the further they’re traveling. The system also tracks journeys per day and week, so riders are only charged up to a capped amount. The expense and inconvenience of starting from scratch every time a transit authority wants to update its system gives the existing provider an advantage.

When Au was considering investing in Cubic, she met with Transport for London (TfL) to learn about the agency’s experience working with the company. Before awarding the Oyster card contract to Cubic, she says TfL put out a global call for proposals, so it had an extensive understanding of the payments industry and Cubic’s competitors.

“It was a great way to talk to a large customer and understand what the environment is like,” Au says.

Turning point

When Au purchased Cubic in 2012, she expected any decline in defence business would be made up in transit growth. In 2011, Cubic had won a 12-year, US$454- million (later US$520-million) contract to update Chicago’s transit systems. She also thought the company would soon win new business in New York City.

“Given that this is a miss, you can tell it didn’t work out,” says Au.

In Chicago, the project involved changing three transit lines—downtown trains, buses and regional rail—to one payment system. Riders would be able to pay at the turnstile by tapping a credit, debit or transit card. Cubic would also develop and manage an app that would let riders pay for passes and activate tickets on their mobile devices, someday letting them tap their phones to ride.

In 2013, implementation was beset by glitches, poor service and a major outage, causing months-long delays. Chicago wouldn’t pay until Cubic met service standards. So, for years, Cubic was working for free. (It met standards in early 2014.)

Cubic also had to reimburse the CTA roughly US$1.2 million after malfunctions with its Ventra payment app in the fall of 2013 forced the CTA to give away nearly one million free rides.

Despite the problems, “the Chicago contract is lucrative,” says Au.

In New York, which has nearly 500 stations and more than 5,000 surface vehicles, transit operators have been toying with contactless payments for over a decade. After two pilot programs that went nowhere, a push by New York Governor Andrew Cuomo in late 2015 put the program back on the table.

Still, Cubic and other payment operators had to wait as politics delayed requests for bids until the spring of 2016. The contract is worth US$450 million, according to 2015 estimates.

Post-purchase performance

At US$46.42 as of October 6, “it’s below my buy price at the moment,” acknowledges Au. She still owns her stake, and the stock must hit the mid-US$50s or there must be a fundamental change in the company’s prospects, before she sells.

In 2015, Cubic fell 2.3% short of its sales target, and also missed its earnings per share and return on invested capital targets.

Au met Cubic’s management in San Diego again to discuss Chicago, and they explained the implementation issues were resolved. She now predicts company fortunes will improve in 2017 and 2018.

In the defence sector, the company has also bought a number of smaller competitors and expects they’ll start contributing to earnings in 2017.

The company is also cutting costs by 2% to 2.5% by 2018. In transportation, the company wants to get into tolls and parking. It says it’s already expanding in Melbourne and New York.

Au is also optimistic about Cubic’s prospects in New York. As operator of the city’s MetroCard system, it has an incumbent’s advantage.

But it faces competition: a rival has already installed mobile payment systems on the city’s regional routes. Bids were due in the summer, and the Metropolitan Transit Authority is expected to announce the winner later this year.

Au is secure in her investment decisions because she knows the companies she selects have strong inherent value.

“No matter what happens to oil prices, the truth is the transit system will need to be upgraded,” she points out. And in Global Payments’ case, “payments won’t all of a sudden go back to personal cheques.”

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Jessica Bruno is a Toronto-based financial writer.

Jessica Bruno