A deeply undervalued high-quality small cap

The small cap index is essentially a proxy for the market's appetite for growth, and a broad willingness to accept the risk associated with it. November saw the start of a rotation from small cap stocks into large caps triggered by a number of macro global events that created uncertainty and put a dent in investors’ willingness to take risk.  These included the British High Courts intervention in Brexit, increased global terror activity, OPEC’s decision to cut production, the US elections, and the heightened sense of uncertainty and insecurity which all saw investors transition to ‘safer’ investments.

Our sense is that the pendulum of investor group-think has reached the point of maximum pessimism. A period of mean reversion and rotation back to small caps simply requires average economic growth and a little stability.

At present, the ASX top 20 is looking rather expensive. Investors however, are prepared to pay up for what they perceive as a safe option. We expect to see small caps back in favour in the coming six to twelve months.

Four key filters we use when assessing companies 

A lot of pain and suffering can be avoided at all market cap levels with just a few considerations – most of which are magnified when dealing at the smaller end of the market.

1) Ensure that the balance sheet of the company is strong: Companies with strong balance sheets can survive short-term volatility and will still be there when the market turns around.

2) Ensure that Management is engaged, and preferably have a remuneration plan closely aligned with a performing business (and share price). Human nature dictates that people can always be relied upon to act in their own self-interest. We want a management who share our interests.

3) Ensure that the price paid is attractive enough to ensure that mild disappointment won’t overly negatively affect intrinsic value.  Too often investors allow their emotions to make decisions for them and end up investing in the current fad at any price.  If a share price has risen substantially without a parallel improvement in earnings, avoid.

4) We seek businesses that have a diversification of product, and customer base. Too often, a share will soar on the back of a single promising product, or the promise of a large new customer relationship. Companies with all their eggs in one basket tend to go hungry when they trip and fall.

One high-quality  small cap that passed our filters

A small company that our fund likes is Litigation Capital Management Limited (ASX:LCA).  LCA is a funder of litigation cases.  The business finds its niche in being able to recognise funding opportunities in a space not serviced by the larger litigation funder IMF Bentham. The business passes each of the tests we’ve mentioned above.

1. LCA has a proven business. Having run privately for 19 years the company recently listed with no debt and a robust flow of new business.

2. Management of LCA each have a substantial interest in LCA shares. The management stand to profit considerably more from performing well and creating shareholder value than they do from directors’ fees.

3. Having recently floated, LCA is one of the few IPO’s in recent times that listed at below market multiples. On re-confirmed prospectus guidelines, the company is currently on a PE of just 6.3 times, with a ROE of 22%. When a growth company with a return on equity over 20% is trading on below market multiples, we think it’s worth consideration.

4. LCA’s business model ensures that they seek many smaller cases rather than taking on the risk of large cases. While diversification of business ensures that they are not heavily reliant on a single case, it also ensures that their cash flows are consistent and easier to anticipate. We much prefer this business model to that of the bigger funders who generate lumpy earnings.

Given Litigation Capital’s strong balance sheet, competent and committed management, attractive valuation, and relatively low-risk business model, we at the Collins St Value Fund is happy to be invested in what we think is a deeply undervalued, well run, high-quality business.