9 ASX small caps these fundies are backing today

To hear a small caps investor tell it, the recipe for creating the next great bull market is very simple. Earnings growth just needs to remain solid and rate cuts need to begin. 

That last part, especially, is what Oscar Oberg, Lead Portfolio Manager of WAM Capital (ASX: WAM), WAM Microcap (ASX: WMI), WAM Research (ASX: WAX) and WAM Active (ASX: WAA), told a packed audience at the recent Morgan Stanley Australia Summit in Sydney. 

"We just need rate cuts to start and we need that money that is sitting in large-cap companies. We all sit here, seeing a great business like CBA, it probably looks a bit overvalued versus history just a little bit. But we need that money to come back into small caps and we won't see that until rate cuts start," Oberg said.

Needless to say, it's been a rough trot for small-cap investors for most of the last three years. You can thank a rapidly changing macro environment and the fastest interest rate hiking cycle in 40 years for that.

"The frustrating thing in small caps is that you get a good idea, and it might upgrade [earnings], and then the macro changes and it falls lower than what it was when you first bought it. You're left scratching your head and pulling your hair out." 

But now that the gap between large cap and small cap performance is narrowing and the earnings quality is improving, investor interest in the small end of the market is soaring. With that in mind, Oberg was joined by two of his industry compatriots, Eleanor Swanson, Portfolio Manager for the Firetrail Australian Small Companies Fund, and Michael Higgins, Portfolio Manager of the Milford Dynamic Funds at Milford Asset Management for a conversation around the stocks they are most closely eyeing. The conversation was moderated by Will MacDiarmid of Morgan Stanley.

3 high conviction picks

The bulk of the session involved each manager bringing along their highest conviction pick. 

Oberg's Pick: Austin Engineering (ASX: ANG)

Trading on an 8x P/E ratio, the Perth-based firm designs and manufactures customised off-highway truck bodies, buckets, water tanks, tyre handlers and other ancillary products for the global mining industry. Austin Engineering also offers off-site repair and maintenance services. Its products are located across five continents and its CEO is former Austal CEO David Singleton.

Despite its cyclicality, Oberg argued, "From our perspective, we don't see it trading to a market multiple like it used to, back in 2012, but we think it could maybe go to like 10 or maybe even 12x earnings, which would be great."

"The catalyst right now is two out of their three divisions, North America and South America, have been doing incredibly well over the last two or three years," he added. 

With business lagging in Australia due to higher operational costs, Singleton moved most of its Asia Pacific business to Indonesia. It's this move that has Oberg very excited.

"Once that facility gets going, it will earn the highest margins in the group," he said. "As it stands today, they've got a profit guidance in the market of $30-33 million for this year. We see a pathway for that to get close to $60 million over the next couple of years," he added while noting "the share price can double".

It's worth noting that fellow panellist Eleanor Swanson is also backing Austin Engineering, with Swanson's fund buying in three or four months ago.

Swanson's Pick: Integral Diagnostics (ASX: IDX)

This pick is all about the ageing population and market share opportunities. The company is a provider of medical imaging services across Australia and New Zealand.

"It is very much exposed to some structural growth tailwinds in terms of an ageing population. A growing incidence of chronic disease means you need more scans," she said.

"You've also got medical professionals trying to shift more to proactive care, so getting them to diagnose it earlier also helps. And then finally, you've got this kind of mixed shift and you've got people moving to MRI/CT, it's higher accuracy but it's also more expensive. So they're getting tailwinds in terms of price mix and volumes there," Swanson added. 

The top three imaging companies in Australia occupy 35% of the market share while the top three pathology companies occupy 95% of the market share, suggesting there is a long runway for consolidation and corporate activity.

"There are definitely opportunities for listed consolidation ... you can play it any way but we think IDX is the most interesting just because it's probably the highest quality," Swanson said.

But it's not all smooth sailing. For a period, the balance sheet of Integral Diagnostics was disliked by the market. In early November, the company's share price fell by 27% off the back of a sour trading update including a 600 basis point fall in EBITDA margins. 

But now that costs are looking a little more under control, Swanson said there is reason to believe the company will be able to pay down its debt and start growing again.

It's worth noting that Oberg's preferred pick in that space is Capitol Health (ASX: CAJ) while Higgins prefers the likes of Neuren Pharmaceutical (ASX: NEU).

Higgins' Pick: Viva Energy (ASX: VEA)

Few companies can lay claim to being an industry where the upside is theoretically unlimited but the downside is, in theory, capped by government support. But Australian energy refiners Viva Energy (and its main rival Ampol (ASX: ALD)) are two of them.

"Refining is about 20-25% of its business. Historically, refining [has been] an ultra-volatile space. [It's] capital intensive and no doubt a low multiple business," Higgins said. "The dynamic that we're gonna get flooded with new refineries, particularly in countries like Australia is low so that's a demand dynamic that's quite positive," he argued.

So low is that multiple in fact that Higgins and his team think the refining business is worth just a 2x earnings multiple. 

But of course, that's not Viva's only foray. It also has a convenience business (Coles Express) and just made a bigger move into that space by acquiring OTR (previously called On the Run and an icon of South Australia). 

"We think there's a really good opportunity for Viva management over the next couple of years to execute and transition a lot of those Coles Express sites that are in great locations but are pretty tired into far better convenience offerings," Higgins added.

Both fellow panellists also own stakes in VEA but Swanson trimmed her position in the stock recently. It's also worth noting Higgins said that his fund is not opposed to owning both VEA and ALD at the same time.

Some bonus picks

To close out the session, MacDiarmid asked the panellists to share their views on some hot sectors such as tech, uranium, and retail. 

Within tech, Higgins offered CAR Group (ASX: CAR) and Life360 (ASX: 360) with a particular emphasis on the latter:

"We still really like that opportunity of bringing more advertising into their non-paying customer base. And we still think it's under-appreciated by the market in terms of that future opportunity," he said. 

In uranium, Higgins' preferred play is Nexgen Energy (ASX: NXG) while Swanson offered this on that hot trade:

"We think the demand side should continue to grow strongly while the supply side is pretty constrained, which is why we're seeing uranium price run pretty hard over the last 12 months. And it does take three or four years to bring a mine online," she said.

Finally, Swanson and Oberg both offered their takes on retail. Swanson offered Premier Investments (ASX: PMV) as a preferred (and arguably, contrarian) trade heading into the August reporting season while Oberg simply had this to say:

"If you want to be bullish on small caps, you need to be bullish on the consumer," he said.

Livewire is a guest at the Morgan Stanley Australia Summit.

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