QVG Capital explores ‘micro-cap hell’ on the ASX

Winston Churchill once said “If you’re going through hell, keep going.” With that cheery note, on Tuesday my colleagues and I at QVG Capital hosted our biannual webinar. Much to my disappointment, it was Josh Clark’s, not my, presentation that stole the show. Josh manages a ‘go-anywhere’ all-cap fund that can invest across the market-cap spectrum. But most comments were directed at a slide depicting what we’re calling ‘micro-cap hell’.

Elsewhere, our colleague Tony described micro-cap investing as a “killing field”. And indeed, it’s been a very rough year for micro-cap companies. By way of reference, the S&P/ASX Emerging Companies Index is down -23% on a rolling 12-month basis and -26% from its recent highs.

Sentiment towards equities is currently very poor. Josh presented the results of a survey by JP Morgan suggesting as much. JPM surveyed their clients to ask them whether they were planning to increase their equity exposure. The answer? No thank you! Just 29% plan to do so; the lowest in several years.

The manifestation of this poor sentiment is that there are likely net outflows from equity funds in the market right now as investors are tired of losing money and see more stable returns in fixed-interest investments.

Outflows appear especially acute in micro-cap funds. Outflows have a disproportionate impact on micro-cap companies as their registers are often populated with retail shareholders and institutional fundamental investors and they typically have few quantitative funds or index managers on board.

With a lack of index funds or quant funds, and retail shareholders being small and fragmented, the lack of liquidity in micro-caps makes them vulnerable in market downturns. Josh presented a couple of examples of quality micro-caps we own that we think are showing compelling value:

Pacific Smiles was one of the most impacted of our portfolio companies by Covid. Patient volumes have yet to fully recover. When they do we can see the business generating more than $10m of free cash flow per half which would make the stock extremely inexpensive.

PeopleIn is a labour-hire company. The head-scratcher here is that the business is trading very well with strong organic growth complemented by accretive acquisitions. The track record of execution is very good, so we think the low valuation is largely driven by the stock being in ‘microcap hell’ (i.e. liquidity driven).

Of course, we can’t know when sentiment turns for this part of the market but it’s clear from the compelling valuations on offer that when it does the moves will be powerful.

For those who missed the webinar you’ll find a recording here