M&A is starting to pick up in microcaps. Here’s why that’s positive news

There’s no question that the last year has been a challenging period for the microcap space. Tighter market conditions hit hard, just as funding dried up and higher interest rates hit debt repayments. But, Joel Fleming, head of microcaps at Yarra Capital Management, believes there are signs of a more positive future.

“We are starting to see M&A pick up. That goes to show there is some real value on offer. And in times of stress or uncertainty, good businesses are looking to allocate capital,” Fleming says.

It’s a key metric for Fleming. After all, M&A is a significant driver of activity, as well as returns over time.

He also anticipates a return in IPOs in the next 12 months and expects some early movement in the resources space.

In this episode of Expert Insights, Fleming discusses the macro outlook for, and unique nature of, Australian microcaps, and the market for IPOs and M&A activity.

Edited transcript

What has the macro environment meant for microcaps?

You’ve got to break it into two parts.

The first is the sentiment piece. Rates start to rise and there’s uncertainty in the world. As a result, investors look to sell risk and move up the market-cap spectrum. That’s the first thing we saw. A lot of people moved out of microcaps. They typically thought: "this is a great business, there’s a lot of opportunity but I’m unsure what’s happening and I need to move out of this sector".

The second piece is the impact on the ability to fund a business. A lot of these companies need equity funding to grow, to continue to move their business models forward. When you've got an environment of slowing growth and rising costs, the impact on the underlying earnings soon becomes another important factor.

But overall, it was the sentiment piece and I think that increased uncertainty which has driven the performance of microcaps over this period of rising rates.

How does the Australian micro-cap space compare with its global peers?

In the large cap part of the market, it's really, really concentrated as we know. The major banks and the big resource companies are dominant.

In microcaps, though, we've got a huge number of stocks on offer and they touch every part of the economy. 

It’s really exciting in terms of emerging themes. Often the first place you'll find one is in the microcap space.

When we look internationally, often those stocks are a lot bigger, more liquid, and that's an attribute that people find positive in terms of investing. But just in terms of breadth of stock on offer and the number of different businesses that we have available to us here in Australia, I think it's quite unique from a global perspective..

Do you expect the market for microcap IPOs to shift in the coming year?

It’s been a really quiet period for IPOs, and that in itself is a really good indicator of sentiment. When you start to see that activity picking up, it’s a sign that the demand is there and that people are feeling more positive about the environment. Over the coming 12 months, I would expect there to be an increased number of IPOs in our space.

Are there certain sectors you expect to see more IPO activity?

Investment banks are very good at timing these things, around the themes that are capturing investor attention at the time. Companies exposed to the decarbonisation thematic or anything involved with the ageing population will probably be businesses that are early to come through, where there is that real appetite and people have a great understanding of the thematic. Those would be some of the areas that I would be looking into. And, of course, the resources space too. There are always interesting things happening there. It’s another area where we'd expect to see some early movement in the IPO space.

Are you seeing more or less M&A activity and what has this meant for your strategy?

M&A has been an important driver of our returns through time. These companies operate under ASX listing rules, audited accounts, etc., and that visibility really helps you to see how these businesses are travelling.

M&A is an important part of what happens in the microcap space. It’s been pretty tough generally in the current environment, but we are starting to see activity pick up. 

That goes to show there is some real value on offer and, in times of stress and uncertainty, good businesses are always the ones first looking to allocate capital.

The fact that we’ve seen a bit of a pickup, particularly in the microcap space, is really encouraging and that’s something we’d expect to continue to observe in the period ahead.

What opportunities and risks are you seeing at the moment?

There are lots of risks, whether that be geopolitical, whether it’s how much further already high interest rates have to go, how much inflation continues to be an issue, and what happens in terms of global growth expectations.

Markets are very focused on the short-term at the moment. They’re moving a lot on single, short-term data points. Where microcaps exist is an inefficient part of the market generally, but at the moment they’re trading as some of the most undervalued parts of the market on offer. There are lots of risks to the earnings piece which makes it a very uncertain environment.

I think we all understand the areas that are causing people concern, but when we look at the microcap space we see some fantastic stocks. We’re seeing companies that are well-managed and growing – they’re turning into something more sustainable and more durable. In time, the market will either price that appropriately, or we’ll start to see M&A where another party does. We are really optimistic about some of those opportunities that are emerging.

Have you made any changes to your strategy on the basis of the outlook for microcaps?

We take a fundamental and bottom-up approach. We go and find businesses and understand everything we can about the industry in which they operate. Is that industry growing? Are there tailwinds? Are there opportunities? Is the company taking market share? All these things are important when we’re doing our initial due diligence.

When we think about the portfolio, we’re not changing the way we do things unless the facts change. It’s been really successful strategy for us over an almost 10-year period.

In an environment like this, fundamental value really comes to the fore. We’re confident that’s going to hold us in good stead going forward.

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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.