Three ASX small-caps to hold for the next five years

But it is exactly in these spaces that Richard Ivers, Portfolio Manager of the Emerging Opportunities Fund at Prime Value, has located his three small-cap companies to hold for the next five years.

He believes that the investor fear of small-caps comes down to a misunderstanding about the risk levels.

“They do have higher risk than large caps, but there’s also a bunch of really high-quality businesses that generate earnings growth through the cycle, year after year,” Ivers says.

In some ways, Ivers' stock selection takes a contrarian approach to it – but it’s always backed by the fundamentals. He selects those companies that he believes have sufficient quality and balance sheets to be long-term buys for his portfolio.

In this edition of Expert Insights, Ivers shares his top three small-caps to hold, why risk doesn’t need to scare off small-cap investors and the potential for this real estate company to continue to thrive despite rising interest rates and falling house prices.

Edited transcript:

What’s the biggest thing you think investors are missing when it comes to small-caps?

A lot of people think that small caps are a really high risk place to invest and they do have higher risk than large caps, but there’s also a bunch of really high-quality businesses that generate earnings growth through the cycle, year after year. Structurally growing businesses that we think provide a really attractive risk return profile. So you can get good compounding returns without taking on big risk. 

If you generate a return in small caps in the order of say 15% per annum, then you'll be one of the best performing small cap funds in Australia. You don't have to try and swing for the fences and double your money on every stock you hold in a short period of time. 

You can just generate good, consistent returns and have a relatively high return profile with a relatively low risk profile. That's the sweet spot that we invest in.

The largest allocations in the Emerging Opportunities Fund are industrials and financials. Why do you typically find more opportunities in these sectors?

In small caps, the sector can a bit misleading at times. In the large caps it's more relevant because you have companies like banks. In financials, we'll have a bunch of very different uncorrelated businesses that are all classified as financials. To give you some examples, we hold an insurance broker called AUB Group (ASX: AUB). That's classified as a financial. We also hold EQT Holdings (ASX: EQT), a trustee business, which is not correlated at all with insurance broking. NIB Holdings (ASX: NHF), a health insurer is also a financial. There's a lot of different types of business models with very different drivers and uncorrelated returns, but classified as financial.

We're stock pickers. We don't invest in sectors. We invest in stocks and the returns and risk profile potential from those specific stocks. 

If you could only pick three companies to invest in for the next five years, which companies would you choose?

I really love this question because that's the way we think about investing. We think about long-term investing, not short-term trading. I'll give you a few examples of the stocks that, that we hold.

1. News Corporation (ASX: NWS) 

NewsCorp is one that I think is a great stock you could hold for multiple years. It has a bunch of really, really high quality assets. For example, realestate.com (REA Group (ASX: REA)), DOW Jones, which owns the Wall Street Journal in the US, move.com which is the equivalent to Domain Holdings (ASX: DHG) here in Australia. It's a portal for real estate listings in the US. It's the second largest player over there, which recently is rumoured to have a bid of about US$3 billion, which is equivalent to $7m in Australia when NewsCorp is trading at around $30. It's big and we don't think that's in the stock price at all.

We take a longer term view and say, well, the businesses within that business are structurally growing high quality businesses that will increase in value over time. At some point in future, you may get a potential balloon payment where the value that is realised from the sum of the parts in that business.

2. Regis Healthcare (ASX: REG)

Another example that we like at the moment is one that's a bit contrarian. It's a business called Regis Healthcare. It's in the aged care space, which is an area that's had trouble with industry funding from the government in recent years. We think that the industry is at the bottom of the cycle in terms of government funding.

The lack of funding in the industry the last few years means that supply has been very weak coming into the industry, but demand is growing through an ageing population and we're potentially at the bottom of the industry funding cycle from the federal government, which is looking to increase funding as well. 

If you look out multiple years, I think it's highly like that funding will improve and the earnings growth and returns on that business will improve. So it's a bit of a contrarian one. 

3. Domain Holdings (ASX: DHG) 

Another one that we like that is also a bit contrarian is Domain, which is the second largest real estate portal here in Australia behind REA Group (ASX: REA). 

That stock has halved in the last 12 months from $6 down to about $3 as the number of houses being for sale or or listing on their website has been declining and slowing. That bad news is well known by the market and we take the view that the listing numbers are potentially at a cyclical low. 

With the stock having halved, there's a great opportunity to buy a very high quality business with structural growth. It has very strong pricing power with little incremental cost as the prices go up. 

So you get strong earnings growth and potential margin expansion. It's margins are about half the level of its largest peer REA Group. It's also a fantastic funnel for consumers to purchase houses. It's becoming increasingly valuable for the likes of mortgages. We saw last week, ANZ (ASX: ANZ) took a an equity stake in View, which holds the business realestateview.com au. This highlights the value that we think of in these funnels in terms of the whole value chain of property transactions. Very rarely do people go into branches these days to purchase mortgages. The value of a portal, which is the beginning of the purchase process, is a very, very valuable asset. 

We're happy to take a contrarian view on Domain. We've built a small position in the last couple of months and we take a view that holding this business for a long period of time with the price of at moment half of what it was 12 months ago, is a fantastic opportunity to buy a high quality business at a very attractive price.

Are you concerned about the impact of rising interest rates and falling house prices on a company like Domain?

When you look at it from that perspective, they're already at a relatively low point and potentially don't have too much further to go down. 

We think all of that is in the price and well known by investors. Domain updated the market in December last year and downgraded earnings because of that. That's when we became more attracted to the stock. The stock fell on the back of it and a lot of the bad news was priced into the stock.

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