How to identify successful microcaps and where to find them

Everyone dreams of picking that small company that will one day be one of Australia’s largest and most profitable companies, but investing in microcaps can also be risky and volatile.

After all, these are the companies that are most likely to struggle in market downturns with their higher debt loads, smaller balance sheets and, more often than not, small customer bases. But it’s still possible to find quality in microcaps – if you do your research and focus on a few key characteristics.

“There’s absolutely no shortage of opportunity. There’s always something happening that is really exciting and capturing attention. We always look to put that hype to one side and ask ourselves, "well, what’s going to make this business successful?" 

Often, it’s the people driving the plan, a plan that's credible and hopefully exposed to an area of the market that’s growing or where they’re taking market share,” says Joel Fleming, head of microcaps for Yarra Capital Management and Portfolio Manager of the UBS Microcap Fund.

Fleming also believes adequate diversification is crucial when investing in small caps – don’t go all-in on a single theme.

In this episode of Expert Insights, Fleming shares how to identify successful microcaps and manage volatility. He also talks to the sectors he likes right now and explains why his portfolio is underweight commodities – but he still sees promise in specific areas of this sector.

Edited transcript:

What characteristics do you look for in companies for the UBS Microcap Fund?

At its core, we want it to be a really well-managed business. People you can trust that have a credible plan.

In microcaps, we can all get carried away. There’s absolutely no shortage of opportunity. There’s always something happening that is really exciting and capturing attention. We want to bring it back down and say, well, what’s going to make this business successful? Often, it’s the people driving the plan, that plan being credible and hopefully exposed to an area of the market that’s growing or they’re taking market share.

Consumers are changing how we do things. People are interacting differently with businesses and what’s important to them. It’s about finding those businesses that can really tap into that and take full advantage. That requires patience. We understand that these things often take longer and cost more, but when successful, microcap companies can really deliver some outstanding returns over very significant time periods.

Microcaps are notoriously volatile. How do you manage this in the portfolio?

The starting point is having a diversified portfolio of between 40 and 55 stocks to help reduce that volatility. A spread by sectors is also important. You don’t want to bet all-in on a single theme. That’s really important. And we have stocks at really different stages of their life cycle. We have stocks where we are high conviction, we think they’re catalyst-rich, they’re really starting to hit their straps and nearing those inflexion points in terms of being relevant to the broader market. Or their earnings are really starting to take off. Then we have other stocks where they’re perhaps 12-18 months away from reaching that and others which are a three-year view. There’s a nice time horizon through the portfolio. There’s also a valuation spread through the portfolio.

We want to find growing businesses, but we want businesses that are trading on value-like multiples today because the market doesn’t yet recognise their longer-term potential.

We think a lot about risk management. It’s really easy to say, what’s the upside? How big could this be? How quickly can it grow? That’s really important of course, but what’s the downside? What could go wrong? How much funding do they need? Do they need to win that big contract? And if they don’t, what happens at that point?

All of those things are important for risk management – factoring appropriate position sizing for the risk that you’re taking and running a diversified portfolio of microcaps helps reduce that volatility over time.

What triggers would lead you to sell a position and why?

Most often it’s one of two things.

Usually, something’s changed from when you bought the stock, where you thought the business was going, how it was going to develop and build those sustainable foundations to go on to be a high-quality growing business. Where we think there’s been an issue with that thesis and their ability to get there, it’s important to recognise that we’ve got it wrong and that we need to move on.

The other one is valuation.

Sometimes we’ve captured a lot of value for our underlying investors and we see better opportunities elsewhere. Or we think that the market is overpaying for a business at that particular point in its lifecycle and it’s time for us to move on to another more attractive opportunity.

The UBS Microcap Fund has overweight active positions in capital goods and software and services. Can you discuss why?

In large caps, if you’re overweight the banks, you’ve got the four big banks and they’re exposed to the same thematics. In microcaps, what makes up capital goods is a varying amount of different businesses. The underlying driver is not the same in terms of those end exposures, capital growth and capital goods.

When we look at infrastructure spend on decarbonisation, looking at the grid and the work required there, there is so much work required to be done. There are a number of niche players in these industries that are really good at what they do.

One of the interesting things post-COVID was that smaller companies tended to have much slower supply chain normalisation, and their ability to attract skilled workers into their businesses was more difficult than larger companies. That’s starting to normalise at a time where they’ve got lots of work in hand and they’re able to productively deal with it, drive margin improvements and really scale their businesses.

We think there’s some really positive long-term drivers. A lot of these companies are on the cusp of that inflexion point where they become more relevant and where their underlying earnings will be stronger than what the market forecasts.

Software services are another interesting one. There’s still value in building annualised recurring revenue, offering a product that makes it more efficient, more productive for an organisation to more effectively use data.

If you’re a small business that offers a really great product that can make an industry more productive, then that has real merit for investors. We’ve seen a number of examples of stocks where we believe the product is great, they’re at that point where they’re getting market acceptance of that product, and we’d expect the take-up rate to be quite strong from this point forward.

The Fund is underweight materials. What are your concerns about this sector and where should investors be looking?

Australia has been driven by its commodities. It’s been a really important part of the country’s success and we think that will remain in place.

When global growth is under pressure, commodity prices must come under pressure and that’s been the case over the last few months.

When we look at opportunities in the longer term, we are big believers in ‘we need more lithium, we need more copper, we need more nickel.’ Those things are very clear. But at this stage in the cycle, we’re focused on trying to find the right balance between an ore body that is economic, and a management team that can actually bring that into production and generate cashflow. It’s more challenging in this environment to find such examples, but longer term we’re very positive about the opportunities that will emerge.

Discover microcap potential

Joel Fleming is the Portfolio Manager for the UBS Microcap Fund , a fund which has been managed by Yarra Capital Management since August 2014. The Fund aims to deliver superior returns and long-term capital growth by investing in undervalued, high quality micro-sized companies in their early stages of rapid growth.