3 undervalued micro caps and the secret to finding them

Smaller companies and micro caps can continue to perform well in a challenging environment, including one as fraught with risk as we face now, says Karen Towle, the portfolio manager of the Tribeca Special Opportunities Fund. 

Robust economic conditions, which are stimulating the inflationary environment that we now face, actually bodes well for companies that have the opportunity to grow market share or grow into new business streams, she says, such as micro-cap stocks. 

But finding these gems within the small end of the market, particularly undervalued ones, isn't exactly easy. So in this video, Towle shares her secret to finding value within the micro-cap market, as well as how she recommends retail investors, like you, can find winners too. 

Plus, Towle also names three stocks that she believes have been undervalued by the market, including one that she has recently been propping up her position in during the recent sell-off, a stock that can help you rest easy at night, and a reader favourite with huge opportunities ahead of it. 

Note: This video was shot on Tuesday 1st of February, 2022. You can watch the video or read an edited transcript below.

Edited transcript

Why is it easier to find value in the micro-cap end of the market?

Karen Towle: The largest stocks, the ASX 100 and ASX 200, are incredibly well covered by analysts, and the buy-side community as well. So there's a lot of eyeballs on those companies and therefore valuations tend to kind of adjust to reasonable values much more quickly. At the micro-cap end of the market, often there might be one analyst looking at it or maybe no one. And there are thousands of companies that you can have a look at and thousands of opportunities. So it is just possible in the micro-cap end of the market to find undiscovered gems, and they're growing fast and they're at a reasonable value.

Are there any strategies or tools you use to find value in the micro-cap market?

My strategy is just to talk to a lot of people, to be very open-minded as well about who I'm talking to, not to get sucked in by a good presentation, but to actually listen to what someone's saying and to think about where the opportunities are and is that realistic. So I ask a lot of questions, I push back on people as well, just to test them and to test their confidence and commitment to what they're talking about. And I try to be very open-minded as well.

I'll give you an example. So there's a company that I've looked at whose managing director is quite young and has a lot of tattoos. And if I was quite close-minded, I would've gone, "Well, I don't want to invest with someone like that," being an older person. But it's been one of the best investments I've made. So I think you just have to constantly challenge what looks good and be very open-minded because, with things like batteries and lithium, it's a whole new sector. And I think we have to be open-minded to the opportunity.

Retail investors don’t have the same access to company management. How can they uncover gems within the micro-cap market?

I think it is a lot more difficult for retail investors to find those opportunities. But in saying that, I think just look around and see the sorts of companies that you're constantly interacting with, and maybe just look at your everyday life to see, "Oh, wow." I game so, therefore, Playside Studios (ASX: PLY) - maybe it produced the game that you like to play, and investigate it that way. But definitely, I think as a professional investor, having access to management gives us a massive advantage. 

How will micro caps perform in a rising rate, inflationary environment?

My view is that a lot of smaller companies can absolutely continue to do well, even in a more challenging environment. I personally don't think the environment is challenged. I think consumers have got a lot of money behind them. A lot of people have locked in interest rates. So I'm very positive about the outlook for the economy and the next 12 months. Interest rates are going to go up. But nevertheless, I think economic conditions are going to still be pretty robust. And so smaller companies where they've got lots of opportunities to grow market share or grow into new businesses and new areas can continue to do really well.

What can investors do to protect their portfolios in this environment?

In terms of protecting your portfolio in markets that are going down, really, cash is pretty much the only safe place to be. So we tend to keep quite a lot of money in cash. At the moment, it's about 30% of the portfolio that's in cash. That gives us quite a few opportunities as well because it means that when the market falls, then we've got cash there to take advantage of opportunities. And I was in the market last week, buying some things that had fallen quite a bit that I thought now look quite good value. So I think the ability to move your cash around, to sell things quickly, if you feel that things aren't going the right way is important. And also just think about it over the long term as well, not a three month or six week cycle. 

Take us through three micro caps that you believe are undervalued by the market?

I added to my position in Pureprofile (ASX: PPL) last week, and that's a business that provides market insights to companies. They operate in Australia, in the UK and in Asia. In Australia, their biggest customer is Flybuys, and they've been growing really quickly in the UK. And that's where I think their opportunity really is. They've just landed a big contract in Asia. So the Asian market is now open to them and the blue sky for them is moving into the US market. So plenty of growth ahead of them, and trading at quite a low multiple as well. 

The other stocks I like are Coventry Group (ASX: CYG) and Frontier Digital Ventures (ASX: FDV). Coventry is a really solid, well-run business that I think you can own through the cycle and sleep really easily at night. It provides industrial hardware to the manufacturing and mining industries in Australia. I think at the moment with a lot of companies bringing manufacturing back into Australia and trying to avoid China, it's in a really good position. Management turned the business around a couple of years ago. And the business is in great shape now. And I think they're in a really good position to actually start to consolidate the industry as well. So there are plenty of acquisition opportunities for them as well. 

Frontier Digital is a business that we've owned for a number of years now and continue to see fantastic opportunities ahead for them. They invest in emerging markets into online businesses. So mainly like a mini carsales.com.au or realestate.com.au of the South American market or the Pakistan market. So Shaun Di Gregorio, the managing director, started working at REA when REA was just starting to take off in the Australian market many years ago. He has real experience in understanding fledgling online businesses, and he's taken that experience and he's put it into emerging markets, as I said, in South America and the Middle East and Asia. So there are tonnes of opportunities there. He only takes a number one or number two business, and then he just adds his expertise. And he's seeing extremely fast rates of growth in the businesses as they benefit from that expertise. So those markets have all suffered a little bit from COVID, but are coming out of COVID as well. So they're a reopening story to a certain extent, but more than that, I just think that the opportunity for those markets to grow and mature is huge, and it'll be a very big company at one stage.

You can stay up to date with all of Karen's high conviction ideas by following her profile here.

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