How this investor finds high-quality Aussie microcaps

Emphasising quality companies is how micro-cap-focused investor Robert Gregory, founder and portfolio manager of Glenmore Asset Management, navigates this more volatile part of the Australian market.

We’ve seen the S&P/ASX Emerging Companies Index gain a little over 18% in the last six months, as higher valuations in larger companies have seen investor interest move up the risk curve. But returns in this part of the market also tend to be lumpier, as shown in the following chart.

That said, the Glenmore Australian Equities Fund doesn’t focus on indices. A long-only, growth-focused fund, it is benchmark-agnostic, targeting strong absolute returns over the medium- to long-term.

In the latest wire in my series profiling ASX microcap investors, Gregory outlines how he identifies opportunities and discusses a few stock examples. These include an aviation services company – his most successful stock pick since launching the fund – and an under-the-radar financial services company on track to deliver earnings growth of more than 10% annually for the next few years.

How do you find the best micro-cap opportunities?

There is no single way we identify cheap micro-cap stocks. New ideas can come from management meetings, attending conferences, results presentations, reading financial newspapers, and talking to industry contacts.

The most important factor is this: The company must be what we deem to be a “quality company”.

That means it has a product or service that has a demonstrated ability to add value for customers and generate consistent profits.

We use several screens to find undervalued microcaps, such as:

• Companies with a track record of consistent EPS growth,
• Founder-led businesses,
• Culture of successful capital allocation,
• Prospects for strong organic revenue growth, and
• Large addressable markets or scope for the company to take market share off competitors.

What are the red flags that signal “avoid” to you?

Red flags include:

• Weak cash flow generation, such that the company cannot self-fund its growth plans. We don’t like owning companies that require periodic equity raises as part of normal operations.
• Companies with a product or service with no clear differentiation versus competitors.
• Poor or dishonest disclosure to shareholders.
• Management teams that are overly promotional.
• Excessive M&A, which often reflects a lack of focus on organic growth.

How do you use your smaller size (in terms of FUM) as an advantage?

The fund’s smaller AUM size is helpful for investing in micro-cap stocks, allowing us to build a position in a stock much more easily than a fund with a large AUM. This can be particularly the case on the ASX with a founder-led business where there is very small free float and hence poor liquidity.

Another positive of a fund with a smaller AUM is that there is a much wider range of stocks on the ASX that can be considered investable.

For larger small-cap funds, it is likely some high-quality (but illiquid) stocks are simply “too hard” in terms of liquidity for the fund to consider investing in.

What has been your most successful microcap stock pick?

Alliance Aviation Services (ASX: AQZ) has been the fund’s best microcap stock investment.

A provider of contract and ad hoc charter aviation services to Australia’s mining, energy, and government sectors, AQZ commenced operations in 2002. It later listed on the ASX, in December 2011, at $1.60 per share.

The company also provides wet-leasing services [where one airline provides an aircraft, complete crew, maintenance, and insurance to another airline] for Qantas and Virgin Australia.

A key strength of AQZ is its “on-time performance”, which is materially better than its competitors - a very important performance metric for both mining/energy customers and Qantas and Virgin in wet leasing. This has led to a strong track record on customer retention.

The senior management team has been very stable, with current managing director Scott McMillan having held the position since 2002.

We first invested in AQZ back in June 2017 at prices around 90 cents (versus the current stock price of around $3.00).

At the time of our initial investment, AQZ was trading on very cheap valuation metrics, with a 12-month forward PE multiple of 6-7 times. Profit growth since then has been very impressive, with earnings per share (EPS) growing from around 15 cents per share (CPS) in FY18 to around 25 CPS in FY23.

We still view AQZ as attractively priced, trading on an FY24 PE multiple of around 9 times. For those interested, we wrote an article on Livewire on AQZ on 25 August 2020.

What is one ASX micro-cap company you believe investors have missed, but which has the potential to re-rate higher from here?

Fiducian Group (ASX: FID) is a microcap that we believe is well-positioned to outperform. FID is an integrated financial services company with three divisions: Financial Planning, Platform Administration, and Funds Management.

FID commenced operations in 1996, when it was founded by Indy Singh, who is still the executive chairman. Singh owns around 11 million FID shares, so is very aligned with shareholders.

CFO Rahul Guha has been with FID since 2012.

Of the three divisions, the two that generate the bulk of FID’s profits are Funds Management and Platform Administration. A key part of FID’s success has been its “Manage the Manager product”, which is a multi-manager product that combines various leading fund managers into a product that delivers excellent returns but at below-average risk (that is, more consistent returns with lower volatility than investing in a single fund).

In its recent 1H24 result, revenue increased +10% to $39 million, while NPAT rose +17% to $8.2 million. Net inflows were $121 million, with almost all of this invested in FID’s platform and multi-manager funds.

The business model is highly scalable, and we believe FID can continue to deliver EPS growth of more than 10% per annum over the next few years, with adverse equity market conditions the main risk to this being achieved.

What do you think?

Do you hold any of these companies or have other Aussie micro-caps on your watchlist? Let us know in the comments section below.

Enjoy this wire? Hit the ‘like’ button to let us know. Stay up to date with my current content by clicking "Follow" below to be notified when new wires are published. You can read other wires in this series via the following links: 

• A 10-bagger battery metals play (and how this fundie found it)
• Bizarre: The $11m microcap sitting on a $21m cash pile
• The best ASX micro-caps you’ve likely never heard of