How to invest in microcaps: Blessed be the loss-makers?

Some people don’t find the price-to-earnings ratio very useful in gauging the “investability” of companies. And this rings particularly true if you’re looking at the microcaps portion of your (hopefully, diverse) portfolio.

So, how do you find Australian microcaps? In the following feature, I speak to two fund managers and another industry insider who all specialise in the space. The fundies are:

• Dean Fergie, CFA, director of Cyan Investment Management
• Luke Winchester, portfolio manager and co-founder, Merewether Capital.

As established previously, the definition of a microcap is quite fluid. But we’re talking here about ASX-listed companies with a market cap of somewhere around $100 million (or less) but no more than about $300 million.

“They all have the P (share price), but often they don’t have the E (earnings),” says Dean Fergie, founder and portfolio manager of Cyan Investment Management, noting one of the key problems of using PEs to gauge microcap valuations.

“A lot of the companies in my portfolio don’t yet have earnings, so first and foremost, we look at the revenue they’re producing.”

Reading the tea leaves

All non-profitable, ASX-listed companies are required by the financial services watchdog, the Australian Securities and Investments Commission, to regularly lodge an Appendix 4C document.

“Required four times a year, it’s very transparent and management can’t fudge the figures. The quarterly cash flow statements here are very specific,” says Fergie.

“Many earnings numbers can be fudged. For example, you see “underlying earnings” mentioned frequently in half-yearly results, which I think aren’t very useful.”

In a nutshell, Fergie and his team like to “look at the revenue and then subtract the costs.”

The quarterly cash flow statements are far more fruitful in gauging business performance than the half-yearly reporting seasons employed by large-cap stocks. This is because of the volatility in the microcaps space. 

"Because they’re small and nimble, microcap companies can turn on a dime. Bids might come through the door; directors reshuffle; and innumerable other events occur more regularly (and faster) for microcaps than mid- and large-cap companies. The more rapid-fire movements, and their effect on company cash flows, are captured in these 4Cs very effectively," says Fergie.

EBITDA, EBITDAS – or EBITdon’t?

You can’t avoid this one, though when weighing microcaps you need to give the numbers a more extensive “read-through”, explains Fergie.

“It’s ‘earnings-before…’ many other things (and the list is growing all the time, often taking on S, C to become a real alphabet soup). You’ve just got to be careful about how EBITDA is calculated and analysed,” Fergie says.

“I get a bit concerned if the operating cash flows don’t’ reconcile with the EBITDA, because something odd may be occurring sometimes.”

He cites a catchy mantra to sum it up, in which Fergie firmly believes: “Revenue is vanity, profit is sanity and cash flow is reality.”

“We sometimes see businesses that are driving top-line sales that are also spending the same amount on marketing. If you’re spending $100 to get $90 of revenue, that doesn’t work for long,” says Fergie.

Merewether's microcap maths

The art and science lie in judging whether microcaps are either over-earning or under-earning, says Merewether Capital co-founder Luke Winchester.

Again, PE is useful only as a very secondary sanity check. “You have to put more context around the PE," Winchester. He’s adamant you must look at what the earnings are doing.

“A classic example is in the retail sector. Post-COVID, it’s clear to me that retail companies are over-earning. Stores had very little discounting over the last 18 months and consumer expenditure was unusually concentrated on retail because they couldn’t buy flights or pay for leisure activities,” Winchester says.

So, that’s an example of spotting over-earners. What’s an under-earning company look like?

“If an early stage or growing business is tipping a big chunk of its revenue into development or expansion initiatives, it’s probably under-earning,” Winchester says.

And price-to-sales? In crude terms, he describes this metric as one that has been “bastardised” by companies that are yet to (and may never) turn a profit.

“Price-to-sales has been co-opted by many loss-making businesses and I think that’s dangerous,” Winchester says.

Blessed be the loss-makers?

While we’re talking about investor education, he highlights the role volatility plays in markets – something that is very clearly a force to be reckoned with in microcaps.

Do you avoid unprofitable microcaps? “No, but be careful,” says Winchester.

“We get taught that risk and volatility are the same things, but they really aren’t.

When you invest in a loss-making business you assume that capital will always be available. But it obviously won’t be.”

Citing the clarion calls many made as liquidity dried up when COVID (then known simply as 'coronavirus') first popped up, he notes the panic - financially speaking - has so far been largely unwarranted. But as inflation begins to tick up and interest rates gradually climb again, that cash can be taken off the table very fast.

What to avoid

Avoidance of pre-profit companies isn’t the message either of these fundies are peddling. But the need for an almost over-abundance of caution is their core message.

Winchester steers a wide berth around companies in the EV metals and clean-tech spheres: “To me, they feel like the themes that come up every couple of years, and they’re crowded as a result.”

He is also no fan of the junior resources stocks and miners that clutter the microcap corners of the ASX. And he’s equally cautious on pre-profit tech firms.

These are the stocks you’re looking for

Dean Fergie’s fund, Cyan C3G, holds about 25 companies at any given time. And currently, it's also holding fire on a couple of pre-IPO names he expects to hit the boards in early 2022.

But first, what’s his track record of picking micros? He first bought Alcidion (ASX: ALC), a locally-listed healthcare company that connects AI and other “smart” technology with medical organisations, in 2019. Early in that year, ALC stock was worth just 4 cents but hit nosebleed levels of 30 cents in the second half of 2019. Though he exited a while ago, Fergie rode a smart race, the company opened today’s session at 32 cents.

Fergie also (quietly) mentions Afterpay and Bellamys (ASX: BAL) among other early wins for Cyan Investment Management.

What’s his 'next Afterpay', you ask? To his credit, Fergie embraced the question and fired back with RAIZ Invest (ASX: RZI) – the name behind the retail-investing-platform-formerly-known-as-ACORNS.

But for companies he already owns, Australian video game developer Playside (ASX: PLI) is one he’s very bullish on. In the same breath, he also mentions Animoka Brands, which was in the same industry but has since de-listed.

And though the term “the next Afterpay” is bandied about (sorry), another one with potential here is Touchventures (ASX: TVL). Having just been listed at the end of September, its largest shareholder is Afterpay, and Touchventures wants to own a stake in up to 10 unlisted companies in the retail innovation, consumer, finance and data segments. The magic words uttered here by Fergie, in connection with the above-named stock, are “ridiculously undervalued”. You can read more about it here:

Mark Tobin cites a couple of picks, too – even though he’s doesn’t run a commercial book of stocks over at Coffee Microcaps. He likes SDI Limited (ASX: SDI), a family-run Melbourne business that has carved out a lucrative (and global) niche in dental medical devices.

And in the resources space, Tobin likes EnergyOne (ASX: EOL). An energy-trading software company, around half the electricity traded in Australia runs on EOL’s platform. In the words of Tobin, management has “executed flawlessly”.

Other microcaps he rates highly include:

• Software-as-a-service company MSL Solutions (ASX: MSL)
• Gourmet cookery brand Maggie Beer Holdings (ASX: MBH)

Given he’s not a fundie himself (not these days, anyway) Tobin freely reels off a few microcap-focused fundies he also rates highly:

• Altor Capital, the money here run by portfolio manager David McNamee
• Savill Capital, which invests in ASX and NZX-listed companies (excluding resources), headed up by Jonathan Collett.
• OC Funds Management and the head of investments Robert Frost, who runs money at the long-running microcaps shop.
• Among more recognisable names, Perennial Partners also gets a mention for its Microcap Opportunities fund.

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