The secret to finding the best small and micro-cap stocks on the ASX

Dreaming of the next big thing in your portfolio? well, like most things in life, you won't find it by chance. Instead, finding the next unicorn in the small and micro-cap world will likely come about by putting in the hard yards.

Think of it like going from couch potato to marathon running – it’s all about the training, the extras you put in and the supporters. There will be highs and lows along the journey.

Small and micro-cap investors have endured their fair share of disappointments in the past few years. How often have we heard, “This will be the year of the small-cap?” But there is hope coming in the form of easing monetary policy—and we are starting to see a rotation towards smaller businesses, particularly as valuations in the big end of the market look increasingly stretched.

For those who don’t want to rely on the hope of better, there’s also the option of looking at tried-and-true approaches to investing in the small end of town. To that end, I spoke to Ellerston Capital’s Alexandra Clarke and James Barker, who manage the Ellerston Australian Emerging Leaders Fund. Even in a tougher environment, the fund outperformed the market by 21.2% in the last year alone, and by 7.3% since inception (July 2021). 

Clarke and Barker shared the secret to the fund’s success, which companies they are watching and how they know when to exit a position.

What makes an emerging leader

If you want the next industry leader, you need to know what they might look like.

“We look for small-cap opportunities where businesses can deliver growth despite the macro headwinds faced,” says Barker.

Think of the likes of Pro Medicus (ASX: PME), which has a proven ability to grow.

He points to the concept of structural growth levers, such as pricing power, increasing market share, or expanding an addressable market. Such businesses should also be well-capitalised, with aligned management teams.

Some examples from the portfolio include Catapult (ASX: CAT), Tuas (ASX: TUA) and Life360 (ASX: 360).

Barker notes that using good-quality businesses like this can remove some of the volatility from the portfolio. In addition, smaller and micro-cap businesses can be much easier to ‘turn around’ in their fortunes compared to larger-cap companies.

Ellerston also doesn’t typically invest in pre-revenue biotechs or resources, to avoid the large risks involved in these types of businesses' early stages.

How to identify the top opportunities

When the universe includes 1600 stocks, there’s a lot involved in narrowing down the opportunities.

Barker also highlights that there’s not much broker coverage to support their work at this end of the market.

“If you look at broker coverage as an example. In the ASX 200, there’s an average of 13 brokers covering those stocks. 

In the ASX 300 to 500, there’s an average of 4 brokers covering those stocks, and then if you go 500 plus, the average broker coverage is 0.4,” he says.

This in itself is an opportunity, as it allows the team to find gems that the broader market may be missing. However, it also requires a ‘village’ behind the portfolio managers—a team of analysts, quantitative tools, their own expertise, and, of course, time on the road.

Barker estimates a third of the team’s time is spent on the road meeting with company management teams.

While their extensive time meeting with companies has meant Clarke and Barker have developed intrinsic knowledge of where to look and awareness of where movement is, they also use a quant screen that incorporates changes in volume, share prices, announcements, and earnings revisions.

An example of how this process might work is Zip (ASX: ZIP), which Clarke and Barker met with 12-18 months ago and invested in after noticing volumes were picking up because an investor was converting the convertible notes and shorting the stock.

“Without looking at that volume indicator, we would have put it in the ‘it’s broken’ bucket. We looked at a few announcements and thought it looked pretty broken, but there was a new management team, and we went to see them. We worked out a lot had changed in the business and it was an opportunity,” says Clarke.

The team maintains scorecards for the stocks they look at, factors in the individual drivers, opportunities, and risks per business, and is highly disciplined about a business's potential upside and downside.

“We look for businesses that can provide us with 50% upside over a three-year period,” says Clarke.

Ideally, they like a business to be ‘net-cash’ and can fund their operations from operating cash flow, and avoid those with heavy debt loads.

The exception to that is, “if you have debt for the right reason, like Propel Funerals (ASX: PFP), where there is a sticky earnings stream, the debt is associated with many of the property holdings and the book value is far greater than the debt on the balance sheet,” Clarke says.

The portfolio is composed of three buckets: prospects, high conviction and core.

The opportunities to watch in today’s market

“The winners of this year won’t be the winners of next year,” says Clarke.

She’s seeing money flowing into technology, financials and real estate sectors, and has been gradually increasing the portfolio weight to financials. Some of the favourable activity she sees for financials includes dovish interest rate expectations, stabilising funding costs, improving flows and improving consumer/business conditions – this is all supporting expanding Net Interest Margins (NIMs).

She names Zip, Australian Finance Group (ASX: AFG) and Judo Capital Holdings (ASX: JDO) as likely beneficiaries.

While Ellerston Capital are not thematic investors, Barker and Clarke do watch themes in terms of where spend is going.

Infrastructure spend is creating enormous opportunity and the team have been looking at the process the significant energy infrastructure transition underway, akin to the NBN build of the mid 2010s.

Some companies they have invested in include Genus Plus (ASX: GNP), Southern Cross Electrical (ASX: SXE), and data centre plays Macquarie Technology Group (ASX: MAQ) and SKS Technologies (ASX: SKS).

Clarke holds high conviction in Genus Plus, as it is “one of the few companies in Australia that can take on any of these projects at scale, and we are of the view that they will continue to win their share of these projects as larger transmission tenders come to market.”

A final tip to investors in small and micro-caps

You need to be active to invest in small and micro-caps – there’s little broker coverage and it can be a volatile space, so investors need to be prepared to put in the work to reap the rewards.

As Clarke points out, you need to be passionate about it. You are analysing data and meeting new businesses day in and day out.

However, you also need to be ready as an investor to distance yourself from your emotions when making decisions.

As Clarke puts it, you need to “be really disciplined not to fall in love with your investments because it’s pretty easy to do when you’ve known these companies for so long, you can get blinkers on and miss better opportunities.”

It’s an exciting space – the next industry leader is already in the market.