20 stocks primed for the ASX small cap resurgence

Not so long ago, small-cap stocks were in hot demand. Inflation was tamed, rate rises were done and the “risk on” brigade was planning a parade. Except it didn’t happen.

From a big picture perspective, the RBA hiked rates yesterday and there's strong speculation of another one or two hikes.

In the US, the Fed has stayed pat on rates in its last two meetings but there remains a case for more hikes ahead, despite Jerome Powell’s softer language recently.

In that vein, small-cap stocks have been shunted to the back burner again – after a brief sentimental resurgence a couple of months ago. (Even our resident SEO guru here at Livewire says the term “small cap investing” ranks nowhere in Google search terms.)

But that’s one of the very reasons why now is the best time to consider smaller companies, according to a handful of fund managers who fronted financial advisers at a recent Sydney breakfast event.

Kicking off the session were Longwave CIO and portfolio manager David Wanis and Melinda White, who run a diversified portfolio of around 150 companies. Their chat opened with an assessment of “Why active small why active small-cap managers do so well and why we think they'll continue to do well.”

Why stocks are like sea turtles

Wanis cited an unusual analogy – sea turtles hatching eggs on a beach – to describe how his team thinks about small caps versus large-caps.

Why sea turtles? Because those younger companies are like the hatchlings, who start life as “an egg on top of the sand” before “racing down the beach trying to fend off the seagulls, get through the water and try to survive.”

Longwave doesn’t buy the hatchlings but focuses on finding companies that have survived that “existential risk” of their lifecycle and have reached the high-growth phase.

Small-cap lifecycle sweet spot

Longwave's Melinda White reiterates the “wild ride” for small-cap investors given the heightened volatility they experience.

“You generate a 2% return over the long term relative to the benchmark and obviously high conviction managers who are in the room today with us, there are some very good ones who can generate better than this, but at various points in time you've done no better than the index and it has been a very wild ride,” she says.

The Longwave fund holds 115 companies. “And we know that a lot of people in the market believe that you can't outperform the index if you hold a more diversified portfolio, they believe that you need to be concentrated,” White says.

But she points to a seven-year study comparing the performance of concentrated and diversified small-cap managers

A wild ride to small-cap alpha

“The thing that really stands out is in the most concentrated bucket, just how much capital the worst performing manager lost for their investors, 63% versus 13.5% for the most diversified bucket,” White says.

“So, we conclude that the skill of your manager matters a lot more than how concentrated.”

Skill matters more than stock numbers

Anatomy of a drawdown

For White, the length of the current period of small-cap underperformance versus the large-cap market segment is one of the most interesting phenomena currently.

“It has gone longer now than either the GFC or the tech wreck. So, we’re 24 months in and a lot of people are surprised at just how long it’s been,” White says.

“We cannot tell you when the market is going…but we are seeing a lot of preconditions for market liquidity in small cap really withdrawn and we're seeing a lot of high-quality small cap stocks on sale today.”

Stock mentions

Nanosonic (ASX: NAN) – “This business has been selling to its global market for a decade and it's generated 27% compound revenue growth in that period and it's a classic razor and razor blade business model”.

“This business used to trade on an EV to sales multiple or 10 to 15 times. It's currently trading on an EV to sales multiple five times. It's only 25% penetrated in its global market. So, it has a long runway rate of growth, and it represents really good value today.”

From the travel sector, a handful of ASX names currently in the portfolio include:

• Corporate Travel Management (ASX: CTD)
• Webjet (ASX: WEB)
• Flight Centre (ASX: FLT)
• Auckland Airport (ASX: AIA)

Wanis also named:

• Silk Logistics Holdings (ASX: SLH), an ASX-listed company that provides door-to-door services to some well-known Australian brands
• Karoon Energy (ASX: KAR), an oil producer with operations in Brazil
• Perseus Mining (ASX: PRU), a West African gold miner
• Super Retail Group (ASX: SUL), the owner of Supercheap Auto, rebel, BCF and Macpac retail brands
• Beach Energy (ASX: BPT) an Adelaide-headquartered producer of natural gas that supplies around 12% of gas on the Australia’s eastern seaboard.

Three strong small-cap tailwinds

Firetrail Investments’ Matthew Fist, Eleanor Swanson and Chris Robinson provided their view, from the perspective of their high-conviction approach.

Robinson believes small caps are cheap currently and is excited by what he regards as three additional tailwinds emerging:

1. Private equity activity among corporates, taking advantage of low company prices.
2. Early signs that the IPO pipeline is starting to build.
3. Institutional investors showing “clear intent to allocate to small caps,” most notably the Future fund announced its first-ever allocation to small caps.

On the first of these points, Firetrail has benefited from the activity surrounding the likes of Azure Minerals (ASX: AZS) and Silk Laser (ASX: SLA).

One of the session’s standout comments came from Eleanor Swanson and Chris Robinson, alluding to the comparison of managers who pursue distinct style biases, versus their own “style-agnostic” approach that spans Value, Growth and Quality.

“There are some fantastic managers…but if you spoke with a value manager like Allan Gray in around August 2021, they would've been frustrated with seven years of value underperformance,” Swanson said.

Some of the stocks named by the team include:

• Furniture retailer Nick Scali (ASX: NCK)
• Homewares retailer Beacon Lighting (ASX: BLX)

“But where we see some of the best money-making ideas, the potential for 100% plus returns are in two of the lesser researched, more inefficient parts of the market,” Robinson said.

Under the portfolio management of Swanson, other names from the Firetrail Small Companies Fund include:

Telix Pharmaceuticals (ASX: TLX)– The global, commercial-stage biopharmaceutical company doubled its return for the fund, said Swanson.

Regis (ASX: REG), a top 10 aged care provider in Australia, also ranks among Firetrail five largest positions. “We continue to see material upside in the aged care sector and the reason is that the supply-demand backdrop is incredibly compelling,” Swanson said.

Managed Fund

Firetrail Australian Small Companies Fund

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Hyperion: “Hope is not an investment strategy”

Hyperion Small Growth Companies Fund’s Jolon Knight helped explain why his fund has returned an eye-watering 1,400% in total returns – or 255% above the benchmark – since it opened in 2002.

His ideal-world metrics for companies include:

• Return on equity of around 15% or greater over five years.
• Sales growth of 6% or greater over five years in EBIT interest coverage on the EBIT line or four times or greater.

“Our small company's portfolio completely smashes those metrics. We aim for return on equity of over 30% and sales growth of over 20%,” Knight said.

He also emphasised 80% of the portfolio is net cash, and those with debt have interest coverage of “more than 30 times interest coverage on the EBIT line".

“Hope is not an investment strategy. We want robust businesses are patient before we invest in them, to make sure these companies really are that ultra-quality we're looking for.”

Some companies:

REA Group (ASX: REA) – Describes it as a “phenomenal business, the real estate listings portal has been a holding since the early 2000s.

Managed Fund

Hyperion Small Growth Companies Fund

Australian Shares

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Finally: Spheria Asset Management

Spheria Asset Management Marcus Burns spoke about opportunities across the team’s Australian Micro Cap, Australian Smaller Companies and Global Opportunities funds.

“The opportunity is appearing because of the massive dispersion we’ve seen, particularly in smalls,” Burns said.

Burns emphasised cash flow is a core focus for his team, which has an average holding period of between three and four years.

Dan Peters, Spheria’s head of research, pointed to their strong preference for businesses with low or no debt.

“I was a real estate analyst during the GFC, so I understand better than most what it looks like, but it all goes wrong with too much debt on your balance sheet,” he says.

Another reason for this condition, from the perspective of company management: “When things get tough, obviously you can survive, you don't get stopped out by your banks, but it also means that you might have an opportunity to buy out some of your distressed competitors when they themselves have a little bit too much debt.”

A few company examples Burns and Peters name are:

Maxiparts (ASX: MXI) A provider of truck and trailer parts, described as a micro-cap business that is “very poorly covered” by analysts.

Supply Network (ASX: SNL) A long-term holding of Spheria, Burns describes it as an “exciting company” that supplies aftermarket truck parts.

Harvey Norman (ASX: HVN) Despite the raised eyebrows he sometimes sees when buying consumer discretionary at this point in the market cycle, Peters emphasises HVN is “very good at what they do. They've been around for a long time, highly incentivised and engaged management. They've seen a lot of cycles, and they generate fantastic free cash flow through the cycle.”

BML, a Japanese stock that is the second-largest provider of blood testing within its market.

Managed Fund

Spheria Australian Smaller Companies Fund

Australian Shares

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