3 overcrowded small caps (and a viable alternative)

This episode was taped on Tuesday 3 September 2024. 

The ASX Small Ordinaries Index has 192 constituents. But whether all 192—or indeed many of them—are quality companies could make for a very robust debate. Abroad, the MSCI World Index has more than 4,000 small-cap constituents. Again, not all may pass the standard filters for quality investors, but at least the pool from which to pick potential investments is larger and more varied.

All this is a long way of saying that when there are few good options available in your home market, these companies will naturally be a lot more expensive. 

Case in point - How many times have you heard someone say Pro Medicus (ASX: PME) is just way too expensive? Or that Wisetech Global (ASX: WTC) shares are out of reach? Or that the horse bolted on NextDC (ASX: NXT)? 

All of these companies are well and truly discovered - and as a result - very expensive. That reality alone would be enough to deter plenty of investors from investing in the small end.

But others like Marcus Burns, Co-Founder and Portfolio Manager at Spheria Asset Management, see things differently. Burns believes this quandary provides a good impetus to look overseas for companies making similar waves but available for a more attractive price and risk-reward proposition.

"The universe is so much bigger [overseas]. As a result, you get so much more opportunities to invest in interesting companies," Burns said. 

So much so that Burns believes that long-term investors would be better served by investing in global small-caps than Australian small-caps. Of course, the start of rate cuts in lands abroad helps, too. 

In this edition of The Pitch, Burns makes the case for small caps, compares local companies to our overseas rivals, and discusses where he sees overcrowding in today's market. He'll also talk about a US-listed firm that could be a cheaper alternative to WiseTech - Sapiens International (NASDAQ: SPNS). 

Edited Transcript

Small caps have struggled in the last two years but over the long term, are one of the better-performing asset classes. What does this come down to?

What are your key observations in the current market, when comparing ASX smalls to global smalls?

Burns: It's a good question and we get asked that quite a lot - Why would you look globally versus domestically? I think the answer is, as you said in your introduction, that the universe is so much bigger. There are 4,000 stocks, so it's 20 times the size of [the] Australian market. As a result, you get so many more opportunities to invest in interesting companies and names.

We tend to be a little bit overcrowded here as well. High quality names here get bid up to the moon in Australia. Globally, there are many more outlets for those high-quality names. More people are looking at them and so the valuations are much more appealing globally. So we can find excellent quality names internationally, that are in many cases, a fraction of the multiple of an Australian equivalent, with the same forecast growth rates looking forward. 

Are global small caps more appealing given the interest rate-cutting cycle has started overseas?

Burns: That's the million-dollar question! I think there is a short-term and there's a long-term angle here. I think if you asked what the best long-term opportunity set is, I would definitely say international because it's just such a big universe. In the immediate term, you've had rates being cut in the UK and Europe, Canada, Switzerland, and New Zealand. The US is yet to cut rates and Australia is yet to cut rates as well. But you have to remember that two-thirds of that global index is actually in the US. They haven't cut rates yet, although realistically, we're probably a month and a half or two months away from the first cut there. 

I guess that does put a rocket into small caps. So yeah, I think probably in the short term, you might get a bit of a kick from those rate cuts globally. But I'll say long term, I think the opportunity set is so big that if you have a good process and discipline, I think the opportunities internationally are probably better than in Australia. 

Where are you seeing overcrowding in ASX smalls and can it be avoided if investors are willing to look offshore?

Burns: To answer the first part of the question, I think we are seeing overcrowding in Australia. We see that quite often in small caps in Australia, not just overcrowding, but bubbles forming where there is momentum around, say, AI stocks right now. Even though rates are rising, it's been the growth names and those associated with AI that have been bid up aggressively. Names like NextDC (ASX: NXT) in small-cap land. Often these are great businesses, but they're well and truly discovered here. Internationally, the escape valve of that massive market opportunity set means that the stocks aren't as highly valued. And so yes, we would argue that long term, there are good opportunities internationally, and because there is overcrowding in certain names in Australia, there are also areas that correspondingly get left behind. 

We're seeing opportunities in areas like the property sector, for example, more cyclical areas like media, and some of the retail names that are being left behind by this rally that we think are interesting currently. 

One example of a stock we own in our fund globally is called Sapiens International (NASDAQ: SPNS). 

It's a company that sells software to the insurance market. So it does a lot of ERP and marketing software for insurance companies, and it's got a double-digit growth rate, and it's trading on a multiple that is probably a quarter of what WiseTech is trading on. It has a good balance sheet, great return on capital, good margins, and all the things Australian investors love. Yet, the valuation is probably sitting around about 22-23x vs WiseTech which is on over 100x. There are many examples like that internationally that we find through our screens that I think people could find if they're willing to put the work in. 

Access to great businesses with strong fundamentals

Marcus's fund focuses on small cap businesses that generate predictable free cash flows at an appropriate multiple for the forecast growth profile. Learn more by visiting Spheria's website, or fund profile below. 

Managed Fund

Spheria Australian Smaller Companies Fund

Australian Shares

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