6 unique microcaps under the radar (for now)

Like many popular terms in finance, there’s no strict definition for a microcap. Some define it as sub-$250m market cap, some sub-$100m, while others still define it by a stock’s exclusion from an index, such as the ASX 300 Index.

However you define it, microcaps offer the potential for huge gains, but also huge losses, and even the total destruction of capital – as investors in AxsessToday, BlueSky Alternative Investments, and RCR Tomlinson have all discovered in recent times. But while losses can be painful, a single big winner like A2Milk or Afterpay (both of which were microcaps in the not too distant past) can make up for many mistakes.

In today’s Collection, we asked five managers with a particular interest in microcaps for a unique idea that they think could not exist among larger stocks. Their responses are as diverse as the microcap space itself, ranging from a conservative, 130-year old company, to a $11m turnaround story that’s positioning for growth.

Responses come from Nick Guidera, Eley Griffiths Group; Shane Fitzgerald, Monash Investors; Oscar Oberg, Wilson Asset Management; Scott Williams, Fiftyone Capital; and Harley Grosser, Capital H Management.

Not your typical microcap

Nick Guidera, Eley Griffiths 

A 130-year-old, Melbourne based financial services company that is synonymous with corporate governance, entrusted with bestowing the wishes of many and often ‘wins’ customers as they leave this world is not your typical speculative microcap. But for us Equity Trustees (“EQT”) is a company that fits the mold of a micro-cap opportunity that looks attractive today, in a terrific industry structure with high recurring revenue streams and a clear path to global growth.

We acknowledge the business of testamentary and charitable trusts may lack the sizzle of investment platforms (i.e. HUB & Netwealth) but having a differentiated core skill set in the structuring of trusts and ultimate trusteeship, to ensure estates are planned and the intention of trusts adhered to, is a very lucrative business.

Source: Equity Trustees 2018 Annual Report

The recent Royal Commission into Banking, Superannuation & Financial services has shone the light on the ineffectiveness of some in-house trustees. Conflicts have emerged and ultimately the corporate affiliated with the fund is unwilling to the take the risk of non-compliance. EQT is very well equipped to take advantage of this opportunity with very few companies in a position to ensure a Super Fund is meeting the obligations set out in the trust structure.

Concurrently, corporate trustee services are critical for the effective administration of unit trusts the world over. Having a key market share position in Australia providing Responsible Entity services to leading fund managers and an emerging opportunity to provide similar services for global fund managers is a key growth leg of this story. With ~$80 trillion USD in the global funds management market, launching a capital-light office in Europe to take advantage of the quest for prolific retail distribution will ensure EQT is well positioned.

Water matters

Shane Fitzgerald, Monash Investors Limited 

In 2018, Cape Town was set to become the first developed city to run out of water. The city staved off “Day Zero” (the day on which all taps run dry) by only weeks when rain finally arrived. The city’s desalination projects are still years away from completion. Cape Town is by no means unique. From Murray-Darling Basin issues and East Coast Australian droughts to California’s dustbowl and Chennai in India (see below), water scarcity and contamination is a global and growing challenge. This also makes it a market opportunity.

Much like Cape Town, many countries are inadequately prepared for these emerging crises. Coupled with diminishing supply and rising demand, water shortages affect 2.7 bn people, today. It is estimated that water demand for food production and manufacturing will increase 60% and 400% by 2050, respectively. Overall global water consumption is forecast to double by 2050. McKinsey estimates a global water supply shortfall of 40% by 2030, a mere 10 years away.

Source: McKinsey On Sustainability & Resource Productivity 2012

So why are these cities getting caught out to dry?

Constructing traditional desalination / water treatment facilities is capital intensive, complex and slow to deploy. Centralised water treatment plants tend to be landlocked with aging infrastructure that cannot be expanded easily, and upgrades are costly. However, there is a viable alternative. Global Water Intelligence estimates by 2021 USD$22bn per annum will be spent on decentralised solutions, which are cost efficient, quick to deploy and scalable. As investors, how can we participate in such significant tailwinds?

Fluence Corporation (ASX:FLC) is a leading global provider of decentralised water treatment and waste-water management solutions. It is a pure play on the water thematic and winner of Global Decentralised Water & Wastewater Treatment Company of the Year by Frost & Sullivan in 2018. Fluence has a market capitalisation of A$200m, generated US$100m in revenue in FY18 with a US$200m order-book and operates in 70 countries across the Americas, Africa, Middle East and China.

Source: Fluence 2019 AGM Presentation

So why do we like it?

Fluence uses its patent-protected membrane aerated biofilm reactor (“MABR”) to tap into a significant total addressable market through a full suite of water treatment solutions from waste-water treatment to desalination that caters for diverse customer requirements and situations. Incumbent water treatment technology is over 100 years old and ripe for disruption. Fluence’s solutions have 90% lower energy consumption and 60-70% lower operating costs than competing technologies. Fluence has an experienced management team skillfully executing its product roll out, achieving 74% YoY organic revenue growth (December FY18).

Even with modest assumptions, Fluence’s revenue and earnings potential is sizeable. In particular, China’s has allocated US$15 bn to treat rural water sources, an opportunity Fluence is leveraging with current partnership agreements.

The balance sheet is strong with US$40.8m net cash (December FY18) and management is guiding to be EBITDA positive by 4Q 2019 which we see as a key change in its risk profile and a potential signal to the market for a re-rating.

Lastly, with over US$4 bn of flows into ESG-orientated funds during the first quarter of 2019, we anticipate a strong investor appetite for Fluence once it achieves de-risking milestones (e.g. EBITDA-positive).

Why is this flying under the radar?

Like most microcaps, we followed Fluence before any analyst coverage and it remains largely undiscovered or insufficiently understood. Fluence’s operations are global and complex requiring extensive research to understand and value. In addition, there remains a fair amount of execution risk and its growth may be volatile.

In general, microcaps can require substantial research and patience before significant returns are earned. I suggest watching for Fluence’s EBITDA-positive achievement, additional broker coverage and continued strong revenue growth.

The beneficiary of a seismic shift

Oscar Oberg, Wilson Asset Management 

A stock that we like over the next three years is a homeware and furniture online retailer, Temple and Webster (ASX:TPW). We believe the seismic shift from offline retail to online retail will gather momentum, which bodes well for pure online players. The potential is for TPW to replicate the success that Wayfair has had in the US in Australia over time. Wayfair is the leader in the space in the US and currently has a market capitalization of USD15 billion, sales of USD7 billion and last year still grew its revenue by more than 40%.

We believe TPW will continue to gain market share in their categories by outperforming their brick and mortar peers in the online channels and this will underpin the growth of their business.

A new paradigm in osteoarthritis treatment

Without a doubt Paradigm (PAR) is still the best microcap opportunity we can identify. The risk/return profile for the company from this level now they are fully funded with successful Phase 2b trial results in osteoarthritis is being completely missed by the market. This is a company we have done extensive research on and published to our investors as well as on Livewire.

The company has numerous upcoming catalysts including the treatment of Ex-NFL players in the US, which should significantly boost the profile of the business to US based pharma investors. Submissions for their IND to the FDA on two different trials (OA & MPS) and the potential for near term revenue from TGA provisional approvals in Australia that would result in treatment becoming available prior to passing the phase 3 trials.

Probably the biggest catalyst though would be any potential pharma deal which we think could compare against the novel (but failed compound) Anti-NGF drug deal sizes that were in the $1b-$2b range. It should be an exciting 6 to 12 months for the company.

Two sub-$100m stocks

Harley Grosser, Capital H Management

I’ll give you two. One that I’ve written about on Livewire is 5GN. This is a telco and data centre play.

I like the business model of owning acquiring select parts of the telco infrastructure, cross selling services to the existing client base, selectively deploying CAPEX to improve service delivery (and reduce OPEX), and extracting synergies by running services over your own network or hosted in your own data centres.

The strategy works well as a microcap because 1) it can be built from the ground up as a public company, so you can get on board early and 2) the model scales and returns on capital can be sustained or improved as the company grows and makes larger acquisitions (there is a limit of course, but we are not there yet).

We bought into 5GN when it was around a $20m market cap and today it is close to $100m. I think, with ongoing execution, that they are just getting started.

Fresh, tasty, and organic

One I haven’t disclosed, and this is a probably a bit divisive among microcap investors, is Oliver’s Real Foods (OLI). If you want a primer on the background here, you should check out this blog by ‘10FootInvestor’.

The opportunity exists as a microcap because the stock has been crushed as a larger fund exited and it was at one point trading as if it is likely to go bankrupt.

We bought it because I viewed bankruptcy as quite unlikely (but not impossible) with upside if they simply survived.

The founder has returned to the business after a tussle with the previous board. You can take a view as to who was right or wrong there, but ultimately, I think if anyone can turn this business around it is probably the founder.

My thesis is simply that the business will be able to achieve breakeven this quarter, which is seasonally slow, and then they will be well positioned to grow as they enter the peak Spring and Summer periods when families get out and travel.

It is a turnaround though, so keep in mind that the risks are higher.