The Eley Griffiths guide to investing in ASX small cap stocks

The small-cap sector is known for its combination of heady highs and crushing lows – and we’ve seen the latter in recent times. The ASX Small Ords is down approximately 20% since last January and the Industrials segment of the ASX ex-200 segment has seen a 50% derate and is now below its pre-COVID level, says Nick Guidera, portfolio manager of the Eley Griffiths Emerging Companies Fund.

Speaking with me from a busy airport (something that wouldn’t have happened during the pandemic), he delved into ASX small-cap investing and the process his team follows. Guidera discussed the effect of macro forces and why investors have probably missed the boat on buying defensives. He also touched on some of his favourite themes for the next 12 to 18 months – including one on which Guidera has done a 180-degree turn since last January.

Among some of the hot-button topics he explored are:

• The outlook for small-cap lithium stocks
• What’s happening in consumer discretionary amid inflationary pressures, and
• Whether IPO activity is likely to recover in the short term.

And getting into the nuts and bolts of investing, Guidera explained how his team selects stocks, including the overarching “style-agnostic” approach and the groundwork required to determine which stocks make it into the portfolio. Just as important, he explains how and why they exit positions.

Edited transcript

What are some of the key elements of your investment process and how do they contribute to your performance?

Guidera: We're a style-agnostic fund manager, which means we can own both growth and value stocks at any one time during the cycle. It's been particularly helpful over the last 15 months as the market has corrected with no one style outperforming for more than a couple of months at a time.

We've had a tried-and-tested in-house investment process known as SCOPE, which we've used across our strategies for the past 20 years. Fundamentally, it equally weights qualitative factors such as the track record of management, alignment of interests at the stock ownership level, as well as considering things like the strategic plan of the business and the market opportunity.

We complement those qualitative factors with a quantitative process that looks at the time-weighted EPS growth profile of a stock against its current valuation. This process consistently delivers a group of stocks to consider.

Are you more defensive or are you on the hunt for opportunities, and why?

Guidera: During the drawdown, we gravitated to both low-risk stocks and those that are slightly up the market cap spectrum, even at the emerging end.

We think adding to core defensive exposures now, given the drawdown that we've seen, is probably not the right call and you should be relatively selective. Instead, we're spending our time on setting the portfolio up for the next 12 to 24 months.

This is why our focus is on spending time and dollars on the next lot of stocks that have the potential to drive the market over the next 12 to 18 months

What are the sectors/themes you are most interested in now?

The lithium space is incredibly topical right now. We've just had a bid for Liontown Resources (ASX: LTR) from Albemarle. The company's revealed it had multiple approaches, suggesting that we may well see consolidation within the sector.

The other sector I think is really interesting, and probably the most important call to get right in this market over the next 12 to 18 months, is consumer discretionary. The RBA has recently paused rates and cited a slowdown in household spending. So, it'll be interesting to see which parts of the consumer discretionary sector it impacts most.

Some retailers have already called out that the softening has emerged, but there's plenty of others like Eagers Automotive (ASX: APE) that aren't seeing the deterioration in new car orders that people had expected. So, I think right now, you want to be open to changing your view as the data comes to hand.

If the markets taught us anything over the last 15 months, it’s that there’s no consistent theme that's lasted longer than a couple of months, so you have to be open to what's happening next.

In consumer discretionary, investors will need to evaluate how a consumer slowdown will impact traditional retail versus tourism, versus larger consumer purchases. And I put Super Retail Group (ASX: SUL) and Accent Group ASX: AX1) in that traditional retail category.

In tourism, I'd reference companies like Tourism Holdings (ASX: THL) and Flight Centre (ASX: FLT).

And when it comes to serious consumer decisions, companies like Eagers Automotive (ASX: APE) and Peter Warren Automotive (ASX: PWR).

On the lithium side, I mentioned Liontown (ASX: LTR) earlier. And there are many other development and exploration plays that are at different stages of their evolution. Some are close to achieving funding for the project, or others are under construction. I’d call out Leo Lithium (ASX: LLL) as an interesting stock that has a JV with Ganfeng in Mali, where they're constructing a mine at the moment.

You also have resource exploration plays like Red Dirt Metals (ASX: RDT) that are nowhere near a producing mine but have potentially got a resource there that could become one.

How does the IPO space factor into your investment process and what’s your outlook for listings and M&A activity among Australian small caps?

Guidera: We’ve been incredibly selective when it comes to IPOs. Off the top of my head, in the last IPO cycle we played in only about 10% of listings.

Our reasoning is that we've been fortunate to have a huge pool of companies that are already listed with a history of audited financials and a track record that can be assessed. It also pays to be cautious when it comes to IPOs from the most recent cycle. We've done some work internally, which is headed up by our Head of Quant, Pieter Stolz. Our analysis points out that the median relative return is negative for the last five years of IPOs with only the 2017 cohort seeing both positive absolute and relative returns.

There are some companies contemplating their capital position as we speak, but we'll probably need a greater level of stability in global markets before investors are willing to bet on anything new. That's my take right now.

How do you decide which ASX small caps make it into your portfolio?

Guidera: There're literally hundreds of companies to choose from when it comes to the small end of the market, as well as New Zealand. So, we're regularly running screens on that universe to see which stocks are outperforming, which stocks look cheap relative to history, and which stocks we need to come up to speed on.

And as I alluded to as part of our earlier discussion, we also consider the appropriate relative valuation for the EPS growth profile of the stock. After following our process, it’s these factors that dictate what stocks can be included in the portfolio.

But portfolios are typically made up of a group of stocks from different sectors. For example, we might find 50 good tech ideas but we can't include them all. Otherwise, we have a very significant active weight towards a particular sector. So we have an eye to the index to ensure we don't extend too far one way or the other.

But fundamentally, we're stock pickers and we try to find good companies. And the art of portfolio construction is to make sure that we have an appropriate balance across all sectors, so that every stock can play its role in the portfolio.

What's your highest conviction or your largest position in the portfolios at the moment?

Guidera: A company that we think fits really nicely in our process is PSC Insurance (ASX: PSI) Management has a good track record of both organic growth coupled with an acquisition strategy that continues to grow its footprint both in Australia and the UK. Management owns a significant amount of stock in the business and is aligned with shareholders. They've got a sound strategic plan to continue to expand in both geographies and distribution.

They recently upgraded their guidance in the first half result. And we think the stock is appropriately valued for the growth expected in FY24.

Guidera: Maybe cash rates haven't peaked. There's a school of thought that the RBA's pause is only temporary, and also the market still believes that the Fed may well raise rates again in May, pending the inflation outlook. So, that would probably force the market to adjust their expectations around where peak rates are for this cycle.

What does it take for you to exit a position? 

Often, you try and mould your thesis to suit the story of the day. And I think that's a real risk.  You can get caught out trying to justify why you are in a stock if it's not working, when the thing that's actually changed is the very reason you bought it. That is typically a reason we'll exit a stock.

And as my colleague Ben Griffiths has always said, sell your winners slowly. Typically, when we do exit a significant winner, it will be because our investment thesis has played out. And if we do our jobs right at the small and emerging end of the market, all of our portfolio holdings should graduate into the ASX 200 in theory, or the ASX 100 if we're really lucky.

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