Volatility in small and micro-caps could be an opportunity. Here are 3 companies NovaPort likes

You’d be hard-pressed to find an investor who doesn’t dream of finding that unicorn stock that rewards them with a huge upside. We’ve all heard the stories about those lucky investors who’ve made those elusive wins, but what if there was a formula that identified those stocks for you in volatile markets?

NovaPort Capital are that confident in their approach that a 50% upside return hurdle over three years forms part of their investment philosophy for investing in Australian small and micro-cap companies. So what does that approach look like and where is the investment manager seeing the opportunities right now?

I interviewed Sinclair Currie, portfolio manager for NovaPort Capital, to find out what he is expecting for markets, how to identify stocks with a 50% return upside and the stocks that he holds a high conviction on in the current market.

Volatile markets ahead

It’s no secret that small and micro-cap companies can be volatile to invest in. After all, their size and asset base leaves them vulnerable to market activities and events in a way that larger companies can better withstand.

Looking at the S&P/ASX Small Ordinaries in the last year provides a case in point.

“We believe the decline in liquidity seen this year is explained by elevated uncertainty about the direction of the economy and markets, which indicates low confidence in the 12-18 month outlook,” he says.

Investors shouldn’t take this as a signal to steer clear though.

“In our view, this creates opportunities for investors. However, the lagged and ongoing impact of tighter monetary policy on businesses means we have to carefully select which opportunities to back,” says Currie.

He suggests that investors focus on high quality and financial resilience to weather coming volatility. Volatility is not something to be feared, provided that the company “can be expected to maintain or grow its market share through cycles.”

Positioning and opportunities for the market

In anticipation of the environment NovaPort Capital sees, the portfolios are positioned with overweights in healthcare (to take advantage of income). The team are also taking advantage of selective opportunities for margin growth.

“The weaker market sentiment has created an opportunity for us to initiate exposures to quality growth companies, including Breville Group (ASX: BRG) and Netwealth (ASX: NWL),” Currie says.

“Recent announcements of a new funding model and reformed pricing oversight has removed some of the overhang of uncertainty which had weighed on aged care operators. Further progress is required however we believe the shift in momentum is only just being appreciated by the market,” he says.

On the flip side, both micro and small cap portfolios are underweighted towards materials and energy with good reason. That is, the higher costs and risks involved in the early-stage explorers and development companies which are typically found in the S&P/ASX Small Ordinaries index.

“With respect to the battery materials sector in particular, we remain wary of the highly opaque pricing dynamics for these commodities in which demand and supply are both moving quickly in and out of balance,” Currie says.

How to find quality and sustainability in small and micro-caps (and that 50% upside return hurdle)

NovaPort Capital’s process aims to ‘buy companies, not stocks’. What it comes down to is a view on genuine belief in a company and deep understanding of it compared to the desire to trade quickly and regularly for returns.

“In our experience, speculative bubbles percolate up through small caps and often leave investors with burnt fingers.”

Quality and sustainability are effectively interchangeable for Currie when it comes to identifying the right companies for the strategy.

“A sustainable business has customers which value its products (or services) and are less likely to search for alternatives. Quality businesses are sometimes exposed to the ups and downs of business cycles, however we should expect them to maintain market share throughout.

In small caps, management also has a significant bearing on quality. Their strategy must ensure the business addresses the fundamental current and future needs of all stakeholders. For example, Domain Holdings (ASX: DHG) business has many characteristics of a quality business, yet it is also exposed to the residential property cycle,” he says.

Domain is an example of how NovaPort Capital approaches researching and investing in companies with a potential 50% upside return hurdle.

That monitoring is critical.

NovaPort Capital will take the steps to sell companies that deviate from the outlook it holds, be it due to a change in strategy, shift in competitive dynamics, a regulatory change or even the identification of a more attractive opportunity.

Three high conviction small and micro-cap picks

While Currie also nominated Breville Group, Netwealth and Domain Group Holdings as companies NovaPort sees potential in (and has taken the opportunity to initiate positions in), there are three more companies Currie has high hopes for.

1. Aroa Biosurgery (ASX: ARX)

Market Capitalisation $341.39m

“Aroa Biosurgery is an ASX listed NZ based company has developed innovative products used for complex wound care and in abdominal surgery. Aroa’s products are well accepted by clinicians and has continued to generate impressive market penetration growth, supported by clinical data and experience.”

2. Capral Aluminium (ASX: CAA) 

Market capitalisation $127.44m

“Capral Aluminium has been transformed via rationalising costs and improving operational efficiency and customer service. Capral’s share price has recently weakened in sympathy with declining outlook for near housing starts. However with strong population growth and high demand for housing we expect a shallow and short construction cycle.”

3. IVE Group (ASX: IGL) 

Market capitalisation $331.57m

For more information on NovaPort Capital and the small and micro-cap investment strategies, please select from the below:

Managed Fund

NovaPort Smaller Companies Fund

Australian Shares

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Managed Fund

NovaPort Microcap Fund

Australian Shares

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