This small-cap fundie has a habit of outperforming the index – these are the stocks he's backing right now

Small caps occupy an enormous universe. Of the 2,000-odd companies listed on the ASX, the overwhelming majority are small caps.

Because of that scale, finding stocks worthy of investment is no easy task. Do it right, though, and the returns can be lucrative. 

In the latest episode of The Rules of Investing, I had the pleasure of speaking to Matthew Booker, a small-cap portfolio manager at Spheria Asset Management. 

The Spheria Australian Microcap Fund has outperformed the S&P/ASX Small Ordinaries Accumulation Index by more than 7% per annum since inception, while the Smaller Companies fund has outperformed that same index by over 3% per annum. 

Just as importantly, they’ve managed to preserve capital and outperform the Small Ords through the volatility of the past year - and they've done it without exposure to the booming lithium sector. 

This does two things: it preserves capital and provides a higher base to begin generating returns when the market picks up again. 

In this wire, I summarise some of the key things Booker looks for in a small-cap company, before listing some of the stocks that have made it into Spheria's portfolios. 

The Process

Cash is life

For a company to find favour with Spheria, it must be cash generative. Free cash flow is a company's lifeblood, believes Booker. 

"We are looking for high cash flow generate generative companies and when we talk about cash flow, we're talking about after capital expenditures."

"If it's got free cash flow, it can be self-sufficient through the cycle and that's really important."

Inverse broker

Spheria follow brokers, but not for the reasons you might imagine. 

"When brokers turn off a company or are very negatively [on a company] there's a potential opportunity in that, particularly if it meets our requirements in terms of cash flow generation, balance sheet returns and valuation."

EBITDA is overblown

Stay away from speculative commodities

Spheria have steered clear of lithium stocks, believing that the sector is overly expensive. 

That's hurt their performance of late. Liontown Resources (ASX: LTR), in particular, returned 90% last month. 

However, Spheria isn't targeting flash-in-the-pan stocks. 

"We know there's a strong demand cycle behind the lithium, um, lithium sector, but we just think the supply side is, has got a lot of high cost production that that probably won't exist in the long term, that prices will be below the cost of that production," says Booker.

"There's a risk to the downside from current levels and we've seen a big retracement in the lithium price in the last six months or so. We think that could continue and it's going to make the economics very difficult for a lot of those mines, which aren't even producing at the moment.

High conviction stakes

Invocare (ASX: IVC)

Price: $11.15
Market cap: $1.6 billion
P/E ratio: 21

Funeral home company Invocare has been in the private equity crosshairs, however, this recently fell through with TPG Capital formally withdrawing its $1.8 billion offer. 

Still, Spheria view it as the leading player in the funeral home market in Australia.

"It's got over 25% market share in that space. It's got monopolistic characteristics depending on regions and depending on which streams of the business you look at... it's the perfect business to be taken private."

"It can't be replicated. It's a high-returning business. It's been run ineffectively for probably five years or so, and there's upside just from managing it appropriately."

Blackmores (ASX: BKL)

Price: $78.19
Market cap: $1.52 billion
P/E ratio: 44.43

Booker reckons Blackmores is another under-performer primed for a takeover. 

"It's not been run effectively," he says. "Its margins are well below peer margins, and so we think there's huge upside from running it more effectively."

M&A aside, Booker remains bullish on the stock due to its position in South East Asia coupled with the potential to cut costs and increase margins. 

"It's undervalued  in those markets and I think there's a lot of growth to come as those markets move to more Western-type medicines," says Booker. 

All told, Booker could see the stock "doubling from here."

NZME. (ASX: NZM)

Price: $0.96
Market cap: $180,571

Microcap NZME. is an ASX-listed, New Zealand-based, integrated media and entertainment business with radio, digital and e-commerce and print brands.

Booker backs it for its low debt, high cash generation, good management, market position, and price - it's currently trading at about 4 to 5 times earnings. 

"But the big upside really is their property portal OneRoof, the second biggest player in the market. It used to be the fourth biggest player and it's very much like Fairfax used to be here with Domain."

"The New Zealand market's probably 10 years behind the Aussie market in terms of transforming from print digital in terms of real estate ads, um, being the number two player in that market, we think they're aligned to success as that, as that market transforms into a digital market."

Managed Fund

Spheria Australian Smaller Companies Fund

Australian Shares

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Managed Fund

Spheria Australian Microcap

Australian Shares

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