The battle of the small caps

Try picturing some of the great contests of the recent past. Ali versus Foreman! Fischer versus Spassky! Federer versus Nadal! Gatting versus Warne!

Actually, maybe scratch that last one - but you get the picture. These were titanic tussles with everything at stake, all to play for, and no quarter given. These were glorious triumphs and disastrous defeats that could bring a tear to any eye. 

Now, in a worldwide first (we assume), we give you the Battle of the Small Caps!

Chief adjudicators of this soon to be fabled duel include Marcus Burns from Spheria and Chris Stott from 1851 Capital. In this very special thematic episode of Buy Hold Sell, the two small-cap specialists pit fan favourites against each other and crown winning stocks from each sector, leaving the rest out to dry.

We'll pit NRW Holdings against Mader Group. Temple and Webster against Nick Scali. CSR against Fletcher Building. And Pro Medicus against Healius. 

And just because we are feeling generous, our fundies also throw in two exciting opportunities within the small-cap arena. 

Who knew that Buy Hold Sell could get any better? 

Note: You can watch, read or listen to the discussion below. This episode was filmed on 27 May 2021.

Edited Transcript

Ally Selby: Hello and welcome to Livewire's Buy Hold Sell. I'm Ally Selby. And today, we have a very special one for you. We'll be pitting fan favourites against each other in what we're calling the Battle of the Small Caps. Today, I'm joined by Chris Stott from 1851 Capital and Marcus Burns from Spheria. Thank you so much for joining me, gents.

First up, let's talk about your investment strategy. Both of you are bottom-up stock pickers. How much does the macro environment play into your investment decision process? I'll start on you, Chris.

Chris Stott: Look, it's always a critical factor overseeing what's going on at the moment. The backdrop's probably the best we've ever seen it for a decade; low-interest rates, low unemployment, wages growth is going to come back, and inflation's going to come back, which we think's a good thing. So, it certainly is a really critical, important factor in our overall investment process. But at heart, we are bottom-up stock pickers, looking for those companies that are growing, no matter what the economy or the economic conditions present.

Ally Selby: How about for you, Marcus? How much does the macro environment play into your process?

Marcus Burns: Yeah, it's a bit similar to Chris. We are bottom-up stock pickers, we focus on good cash flow businesses. I think the biggest change could be what happens to long-term interest rates or at least perception of long-term interest rates if they start to rise. I think a lot of the froth and bubble's gone on in the micro-cap end will probably come undone. And so that'll probably play pretty well into our style with cash flow as a key focus.

Ally Selby: What kind of companies will flourish in this environment?

Marcus Burns: I think it's more about stocks that have valuation support that will do better than ones that don't have valuation support. So, if rates rise over the medium term, which we think is likely, then stocks that have no valuation support or are priced off extremely short-term fundamentals, I think would really struggle. If long-term input costs rise, I'm talking about labour rates rising over time and the cost of capital - so anything that's very capital-intensive that requires increasing capital expenditures - is going to fund that inflation cost. If there's no pricing power, then those businesses could really struggle in the current environment.

Ally Selby: Do you have anything to add on the kind of companies that could flourish right now?

Chris Stott: Look, I echo Marcus's thoughts there. We're looking for companies right now with significant pricing power. I think that's going to be really critical over the next few years as inflation returns to the system and the ability for companies to pass those high costs through their products is going to be really, really important going forward. And also, echoing the thoughts around having valuation support. Right now, we've seen a sell-off in the tech sector. A lot of these companies that have been red hot in the last 12 months, no valuation support, particularly those companies who obviously don't make money. So I think you'll see further downside to those particular stocks over the next six months.

Ally Selby: Okay. Let's talk stocks and get into the Battle of the Small Caps. First up, we have mining services favourites, NRW Holdings and Mader Group. Which of these two companies do you prefer and why?

NRW Holdings (ASX:NRW) v Mader Group (ASX:MAD)

Chris Stott: Look, it's very close, line-ball. NRW's been sold off significantly. So, we are starting to have a good look at that again, but we would lean towards Mader Group at this point in the cycle. They've got a better ability to recoup those higher labour costs that we're seeing at the moment over in the west. So we'll lean, albeit very slightly, towards Mader Group, but very much think that NRW's interesting at these levels.

Ally Selby: How about you, Marcus? Which do you prefer?

Marcus Burns: Definitely towards Mader Group. Same sort of rationality. It's got really good growth behind it, a very good management team, valuation's very supportive. NRW, when it is taking on contracts, takes on quite a lot of risk with their contracts. So, we find those type of businesses carry inherently more risk and thus a real risk of not delivering or having cost blowouts, which we like to try and avoid.

Temple & Webster (ASX:TPW) v Nick Scali (ASX:NCK)

Ally Selby: I'll stay on you. Next up, we have consumer staples favourites, Temple & Webster and Nick Scali. Both enjoyed massive success last year.

Marcus Burns: Huge success, yeah.

Ally Selby: Which one do you prefer and why?

Marcus Burns: I think Temple & Webster's done a great job at building that website and getting real traction. Obviously, had a lot of benefit last year from COVID. People went online and stayed at home. But I think if I had to pick one of those two, we'd probably back Nick Scali. The reason there is it's done incredibly well as well with real-world retail. It's moving online. I think their business is probably a little more insulated from online because it's got very heavy, heavy, heavy furniture, which is hard to transfer online. But to the extent they push online, there's some growth rate there and the valuation's more supportive than TPW.

Ally Selby: How about you, Chris? Which one do you prefer?

Chris Stott: Entirely agree with Marcus. We'd lean towards Nick Scali at a sixth of the multiple compared to Temple & Webster. Anthony Scali in our opinion's one of the best retailers in Australia. He's been through many, many cycles. And you want to own Nick Scali at the start of a housing boom. And we think we're at the early stages of that at the moment. So, we think that really Nick Scali with a net cash balance sheet is in a terrific position to take advantage of the strong housing market over the next few years.

CSR (ASX:CSR) v Fletcher Building (ASX:FBU)

Ally Selby: Okay. Speaking of housing, we have housing stocks, CSR and Fletcher Building. Which of these two stocks do you think has the most room to run?

Chris Stott: CSR for us. So, we're quite attracted to the earnings stability in the aluminium space, particularly over the next 12 months with the hedging that's been put in place there. The land bank that's been released is certainly good from a balance sheet perspective. And we know what's happening in the housing market and the tightness, particularly in the materials space. So CSR, we think, are in a great position to leverage that over the next couple of years.

Ally Selby: Marcus, same question to you. CSR or Fletcher Building?

Marcus Burns: Interestingly, we'd probably back Fletchers in this case. CSR's done a good job, sold lots of assets, but we lean towards Fletcher. Fletcher's has got more exposure in New Zealand, roughly 70% of business is in New Zealand, which we think is doing incredibly well. And the business in Australia has really got very trim margins and there are tonnes of room, we think, for them to cut costs and expand margins in Australia. So, net-net, we think there's more leverage there. They're also buying back their stock, which we think's a smart way to allocate capital. So at that margin, we back Fletchers. 

Pro Medicus (ASX:PME) v Healius (ASX:HLS)

Ally Selby: Okay. And last up, we have healthcare favourites, Pro Medicus and Healius, both within the diagnostic imaging arena. Which of these stocks do you think has more upside ahead of it?

Marcus Burns: We'd back Healius, despite Pro Medicus' incredible run. I mean, PME's been a stellar share the last two or three years. We find the valuation pretty hard to substantiate at these levels. It's growing, but not anywhere quickly enough in our view to kind of support the 100-times-plus multiple it's trading on. Healius is almost geared post its sale of medical centres last year and is getting a real benefit from COVID testing right now. So, it's definitely Healius over Pro Medicus for us.

Ally Selby: Chris, what do you think? Pro Medicus or Healius?

Chris Stott: Healius for us as well, purely on a valuation argument. Pro Medicus is almost at 150 times P/E, compared to Healius at around 18 to 20 times. So, its done a really good job there in terms of cleaning up the balance sheet over the last few years. And as Marcus said, exposure to the COVID testing, which we suspect will go on for a little while longer. So, Healius for us compared to the other one.

Fundies small-cap picks

Ally Selby: And last up. I did ask our fundies to bring in one stock that they're really liking at the moment. Chris, I'll stay on you. What did you bring in for us?

Chris Stott: Praemium, PPS is the code. So, it's the number three platform provider in Australia behind Netwealth and HUB24. It has a market cap of around $400 million. The recent CEO departure has had no reason for concern in our opinion. The company at the same time have announced a strategic review of their overseas operations, which we would see as a positive for the stock over the medium-to-longer term. So, we quite like Praemium. It took out the number four player, Powerwrap, in recent times. So, industry consolidation continues to occur in that space.

Ally Selby: Marcus, your time in the hot seat. What stock did you bring in for us?

Marcus Burns: Look, I'm going to bring in a stock called Nitro Software. It's not particularly well-known. NTO's the code. It does basically something similar to Adobe Acrobat and DocuSign in one, so it's trying to just disrupt those two American giants. It's priced at a big discount to those products. And yet the usability is quite similar to those two. It's growing very quickly. It has an incredible retention of its client base and we think it's got a really good long-term future.

Ally Selby: Well, thank you for your picks. And thanks for watching. We hope you enjoyed this episode of Buy Hold Sell. If you did, why not give it a like? Remember to subscribe to our YouTube channel so you never miss another episode.

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