In part one of this note to young investors, I set out the reasons why I think young investors should steer clear of index funds and instead invest in high-quality, growing companies. So, the question is: how to find and invest in these companies?

Well, one obvious way is to invest in these companies directly. In Part 1 of this note, I mentioned ARB, Cochlear, CSL, Promedicus and Reece. I have no reason to believe these companies will remain anything other than the high-quality growth businesses they hitherto have been over the next 10 to 20 years. 

Investigating and investing in direct shares, however, does require some skill and study. I wrote a book called Value.able to help investors short cut the process, and while tens of thousands of investors have successfully applied the lessons taught, the fact is your time may be better spent focusing on and building your career or other side hustles.

If that’s the case, a vast array of actively managed funds invest in high-quality growth companies, especially in Australia. These are the actively managed funds you have been told are inferior to index funds. Of course, some people who say that are restricted from recommending any direct securities or actively managed funds, and are forced to promote index alternatives under general financial advice requirements.

Why small companies should be appealing

In Australia, it is worth noting most active small company managers beat their index. So those arguments you have heard about index funds doing better are simply wrong when it comes to Australian active small company managed funds. 

If you are a young investor, small companies should be especially appealing. Not only are you rolling your own investment snowball down a long slope, but the companies you are investing in are also on their own accumulation journey. Remember, big companies once started small. And, as a young investor you have the time – or the runway – to let those small companies grow.

Let’s look at one example of a high-quality small company listed in Australia.

Alliance Aviation Services

Alliance Aviation Services (ASX:AQZ) is an aviation infrastructure company, providing airlines with aircraft sales and leasing services as well as being a fly in, fly out (FIFO) air charter operator and air charter services provider for the tourism, corporate, sporting, entertainment and media, educational and government sectors.

In effect the company buys planes really cheap and then leases them out, along with the crew, under a ‘wet’ lease arrangement, to larger airline customers, helping them operate more efficiently financially and operationally.

When we talk about quality, we are often referring to the presence of competitive advantage. One of Alliance’s competitive advantages is its lowest unit capital cost. Another is the productivity of its staff being non-unionised and therefore flexible.

When the company purchased its first tranche of planes, it doubled its fleet capacity by aircraft volume and tripled its available flight hours. It then proceeded to sell out that capacity. Its second purchase added another fifty per cent to capacity, ensuring profit and cash flow growth for several years as it sells that capacity.

Importantly, management has a strong record of creating value, and generating returns on invested capital of circa 30 per cent. Finally, Qantas owns almost 20 per cent of the company and has bid $4.75 to take it over. The takeover proposal however is now under review by the ACCC, which explains why the share price is so much lower than the Qantas bid price.

Alliance Aviation Services is just one example. If I look at the top holdings of successful small company funds in Australia at the end of February, I find companies including Lovisa, Hub24, Johns Lyng, Hansen Technologies, Capitol Health, Ardent leisure, oOh! Media and Peoplein.

Is investing directly in shares for you?

If, while you were reading the above description of Alliance Aviation, your thoughts turned elsewhere, it probably means investing directly in shares, even in high-quality companies, is not for you.

And even if it appealed to you, remembering investing directly requires some skill and study, it would be unwise and imprudent to rush out and buy these companies simply because they are listed here. The fund managers who owned the companies at the time of their reports may have already sold, or may sell their holdings at any moment if, for example, the price of the shares change, the valuation of the company changes, the fund manager determines the outlook for the company has deteriorated, or a superior opportunity is presented. It is virtually impossible to follow the buying and selling of other experienced investors without any lag. It would therefore be impossible to match their returns. It may simply make more sense to invest with the manager directly, leaving them to make the decisions about what to buy, sell and own. 

For most people, successfully investing in direct shares is better left to professionals. We’ve demonstrated, however, the great fit small company funds might have with young investors.

Small companies are growing, while young investors have plenty of time to allow those small companies to become highly successful larger companies. The longer runway also provides room to navigate volatility, and being able to not only ride-out market sell-offs but to be able to take advantage of them by investing more during those episodes is a sure source of better returns – especially if you add to an investment with a small cap fund manager who is successfully investing in quality growth companies.

Finally, spare a thought for the systems and frameworks that have delivered a message of investing only in index funds. These may look cheap and convenient but in the long run they could be very expensive indeed.

This article follows PART 1: A NOTE TO YOUNG INVESTORS: WHY YOU SHOULD RETHINK INVESTING IN INDEX FUNDS  

The Montgomery Funds own shares in Cochlear, CSL and Promedicus, Alliance Aviation Services, Lovisa, Hub24, Johns Lyng, Hansen Technologies and Capitol Health. This article was prepared on 13 April 2023 with the information we have today, and our views may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.