How to uncover the next small-cap champions

It's fair to say there is something truly exhilarating about investing in a winning small-cap. And over the past 12 months, the ASX has produced a considerable few. 

Battery material producers like Pilbara Minerals (ASX: PLS) and Chalice Mining (ASX: CHN) completely shot the lights out, while cancer therapy companies Imugene (ASX: IMU) and Race Oncology (ASX: RAC) similarly impressed. Meantime, the S&P/ASX Small Ordinaries has lifted 27.3% over the past year, and 12% in 2021 alone.

In our latest Buy Hold Sell thematic, Perpetual's Nathan Hughes and Australian Ethical's Mike Murray join Livewire's Ally Selby as they sift the local small-cap sector and open their stock selection playbooks.

Nathan points to decarbonisation plays like copper as a sector that has him excited, as well as some of the more mature retailers as an area of opportunity. However, it's healthcare and tech that really revs Mike's engine. 

If that's not enough, our fundies also provide you with some helpful tips on sorting the duds from the darlings within the small-cap arena, including the red flags they believe you should watch out for. Plus, they also name two companies each that are capable of becoming the champions of the ASX over the years to come. 

Note: This episode was filmed on Wednesday 15th September 2021. You can watch or read an edited transcript below.

Edited Transcript 

Ally Selby: Hello, and welcome to this thematic discussion of Buy Hold Sell. I'm your host Ally Selby, and today we'll be taking a deep dive into the world of small-cap champions. There have been a few notable success stories over the past decade: Afterpay, Fortescue Metals Group and Dominoes come to mind, but how do you uncover the next market darlings? To figure that out, I'm joined by Nathan Hughes from Perpetual and Mike Murray from Australian Ethical.

First up, what are two must-have characteristics when identifying the next small-cap champion? Nathan, I might start on you.

Nathan Hughes: The first thing we look for, Ally is a long growth runway, and it's not about having an enormous potential market or a lot of excitement around it, it's about being in an industry that's growing and looking for a sustainable runway for continued growth. And that may be through new products, the rollout of an existing store footprint, new verticals, or even sensible bolt-on M&As. The other thing we look for is attractive returns on capital. Companies that can deploy capital well and generate really high rates of return can really accelerate their growth and become quite exciting investments.

Ally Selby: Mike, over to you. What are two must-have characteristics when identifying small-cap winners? And how do you identify the darlings from the duds?

Mike Murray: One of the first things we look for is companies with a degree of intellectual property. And we definitely do care about companies that have a big runway of growth too, so we're very focused on the total addressable market. That often means we're looking for a company that has an established position in some Australian technology that they can take global. Areas like healthcare and technology are often places where companies can scale globally – they’re often happy hunting grounds for us.

In terms of sorting the darlings from the duds, that's a tricky question. There are a lot of duds that are masquerading as darlings and vice versa. For us, a lot of it comes back to relationships. It could be a five or even a 10-year process on some rare occasions where we've followed companies before we've made an investment and all the stars have aligned. The other thing I'd point to is looking for companies with a high degree of recurring earnings, and we definitely steer away from financial engineering.

Ally Selby: Mike, staying on you. What is one red flag that you think investors should look out for when investing in this arena?

Mike Murray: In small-cap investing, a lot of it is about finding companies that are going to scale well, and there's certainly no shortage of companies coming to the market with roll-up strategies in different industries. It's just the nature of the beast that some of those industries scale better than others. We tend to find that product-style businesses with that degree of intellectual property are quite scalable, particularly if they've got a global market.

As a counter-example, if we're looking at a company that's more personal, services-oriented, you might find that one plus one doesn't equal two. An example that springs to mind is aged care. The domestic industry is probably quite resilient, but it's very labour intensive and I'm not sure that you get a lot of synergy by putting businesses together in that industry.

Ally Selby: Nathan, same question to you. What's the one red flag you look out for when investing in small caps?

Nathan Hughes: We're always wary of investing in, or looking at, companies that are heavily reliant on capital markets to fund their growth. I think there's a couple of issues there. One potentially points to the fact that the business model doesn't work. We like companies that generate cash flow, that can grow using their own internal cashflows, but also that are beholden to risk sentiment and equity markets. In the event that sentiment changes, you can find that funding runs out pretty quickly for these sorts of companies.

Ally Selby: Nathan, another question for you. How do you filter for companies that deliver value to all their stakeholders?

Nathan Hughes: This really comes down to understanding the business that you're looking at and really understanding how they make money. What is the nature of the product that they're offering to customers? Does it add value? Is it a product that genuinely delights and excites customers? Or is it something that's reliant on apathy or customer inertia?

I don't think it's as easy as a screen. It comes with understanding businesses and the supply chains, their labour and how everything works in an ecosystem. You can't look at companies in isolation, you've got to understand how the whole value chain comes together. It really comes from a deep understanding of companies, rather than a simple screen.

There are some industries that are easy to exclude, such as predatory lending or unregulated lending, where we think that is cause for concern. Again, it’s about a deep understanding of the company you're looking at.

Ally Selby: Mike, I know that Australian Ethical has quite a complex filtering system. How do you guys filter for companies that provide value for all their stakeholders?

Mike Murray: As an ethical fund manager, that's all that we do. We're not interested in companies that don't meet our ethical filters. We are happy to say that we screen, and we screen quite extensively. The test for us is that, if a company doesn't have a starting positive impact across all its stakeholder groups, including customers, it generally will be screened out. Clearly, the balance of positives and negatives comes into play - and the absence of negatives too. 

Ally Selby: Mike, I asked you to bring along two game-changing themes that you are currently investing in, in mid-caps and small caps. What have you brought for us today?

Mike Murray: That’s a tricky question because we are not thematic investors per se. Everything must stand on its own two feet as a bottom-up stock opportunity. But the intersection between healthcare and technology is an area we are very interested in. Governments around the world are struggling with healthcare costs, which tend to rise above the cost of inflation or the rate of inflation each year. And we see great potential in the use of technology to help manage those costs.

The challenge, of course, comes with finding healthcare technology companies at an appropriate price because it's certainly a part of the market that people are excited about. We spend a lot of time looking for new and emerging companies in that space that maybe haven't been recognised yet.

Ally Selby: Over to you, Nathan. What are two themes that you're currently investing in within small and mid-caps?

Nathan Hughes: Much like Mike, we are not necessarily thematic investors at Perpetual, we're bottom-up investors and each stock must make it in the portfolio on its merits. But again, something that we're mindful of is the energy transition and decarbonisation. And somewhat counterintuitively, that is very heavily reliant on base metals, which we think is an enduring theme.

The challenge for the world, in terms of decarbonizing, is enormous and is something that's going to run for a long time. Base metals are an interesting way to play that, so we've got a couple of copper stocks in the portfolio.

The second theme, while perhaps not as big, is the shift in consumer spending to online from physical stores, which has accelerated very quickly over the last 18 months. Part of that was necessitated by COVID and being at home. But we think the winners coming out of it are perhaps not the pure plays, which again, might surprise. We actually think it's created a real opportunity for good retailers using their existing distribution networks, their existing footprint, and those that have been investing in developing a really good online capability. We think that is a trend that will leave them really well placed to win market share and keep that market share over the next five to 10 years.

Ally Selby: Nathan, how sustainable are those themes? It often feels like when you hear about a winning small-cap, it's often too late. How do investors know they're not getting in at the top?

Nathan Hughes: The theme around electrification and the energy transition is quite long-dated. The size of the challenge is quite big for the world, and it's something that we're going to need to be working on for quite some time. Likewise, the supply cycle in commodities and particular base metals is quite long. There are long lead times, and there hasn't been any supply growth really of note for quite some time. So we think that theme has some significant legs.

And regarding changing consumer habits and retail, we've seen a further acceleration in the last 18 months. And while I think the theme, perhaps won't be as long data as the prior theme that I've just touched on. I think the shifts that you'll see in the marketplace will be permanent. While that shift may have already been accelerated and largely played out, I think you'll see enduring gains for the winners.

Ally Selby: Mike, over to you. Valuations in healthcare and tech are pretty lofty. How do investors know they're not getting in at the top and are those areas sustainable?

Mike Murray: You ask a really good question around valuations. In terms of earnings growth: yes, we think the trends are sustainable. For example, in healthcare you've got these three drivers of an ageing population, as economies grow in GDP terms consumers tend to spend more on healthcare goods and services. And finally, technology, which gives you a really good example of that, this whole new area of immunotherapy as a cancer treatment is having some transformative outcomes for cancer patients. That's the most important thing, but it's also led to a huge new industry after many years where cancer treatments had really been limited to chemotherapy for a lot of indications.

And I don't really need to talk about the transformation happening in the information technology industry, it's self-evident. So, we think there's a very long runway in both those areas. It is tough to find new ideas. There's no guarantee that let's say the ASX 200 healthcare and tech sectors will do what they've done in the next 10 years as they have in the last, and maybe we'll see a change in leadership in markets.

But what you can do is try to identify companies with a special edge or access to a particular market or particular intellectual property and where we can find those bottom-up opportunities, and we still can, in companies that make sense to us, we're happy to own them.

Ally Selby: Can you share two companies that have an edge within technology and healthcare for us today?

Mike Murray: I'll give you one you might not have heard of, and one that you certainly will have heard of, and you maybe don't think of as a healthcare technology company. But the first one is, is really at the intersection of healthcare and technology. It's outside the ASX 300, so it's typically classified as a micro-cap, Mach7 Technologies (ASX: M7T). Now, you may have heard of a company called Pro Medicus (ASX: PME), it operates in a similar area.

Mach7 really grew out of a company that specialised in archiving the images that come out of radiology practices in hospitals. And increasingly it's moved into actually the software around the viewing of those images, which is where Pro Medicus operates. We think they've got a really low footprint piece of software or certainly the enterprise software and is taking market share. They've won some very big contracts, they're generating a nice rate of growth and you don't pay the multiples that you pay for Pro Medicus. So that's an example of a company where we think we're not paying over the top and it's a smaller company, so it's got quite a long runway of growth ahead of it.

And the second is a much more established company, NIB Healthcare (ASX: NHF). You kind of think, "Oh, well, that's just a boring, old health firm." But it's actually a very innovative company that has been diversifying out of health insurance. And some of the things they've been doing include a joint venture called Honeysuckle Health. It's really a data science play and it's really all about developing new programs to help people manage their health better and investing in prevention. And ultimately prevention helps the end customer and it also helps the health insurer. It helps our system, which has some affordability problems.

Ally Selby: Over to you, Nathan. Is there a copper company and a retailer that has caught your attention at the moment that you think could become a small-cap champion?

Nathan Hughes: The two companies I'd point to are probably at the upper end and maybe closer to mid-caps. In the copper space, there’s OZ Minerals (ASX: OZL). I think it's matured as a company, it still has a long runway of growth ahead of it. The Carrapateena project has been built to be expandable and scalable, and there's also some further upside from the West Musgrave Project that we think the stock will deliver.

In retail, I'd point to Premier Investments (ASX: PMV). It's a company that's done tremendously well, rolling out Smiggle and Peter Alexander and more recently it’s had a lot of success online with huge scope for continued growth there. That’s both in taking those brands into additional markets and continuing to grow their online presence. Even though that's grown nicely, we still think there's a long runway ahead of that stock.

Ally Selby: Well, thank you so much for joining me today. I hope you enjoyed this episode of Buy, Hold, Sell. If you did, why not give it a like? And remember to subscribe to our YouTube channel, we're adding new content every week.

What companies do you believe can become small-cap champions? 

What micro, small and mid-cap stocks do you believe can climb their way up the Small Ords index to become the darlings of the ASX? Let us know in the comments section below. 

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