Why ASX small-caps are due a re-rate (and 2 stocks these investors are backing)

The slowing Australian economy affects different types of companies in various ways. For example, those in more cyclically exposed sectors have been some of the most “aggressively sold,” according to Spheria Asset Management Portfolio Manager Matthew Booker.

Another small-cap-focused investor, Melinda White from Longwave Capital Partners, discussed how her team assesses companies to find those in the “sweet spot” of their lifecycle.

Both White and Booker spoke with us ahead of their appearances at the upcoming Pinnacle Investment Summit 2024. In the following wire, they discuss the macro setup for ASX small-caps and explore their stock selection process. They also each nominate a single stock they hold and delve into their investment thesis for the company.

What is your team’s view on the outlook for ASX small-caps and why is it important investors maintain or add exposure to small caps?

Booker: The last two years have been a challenging environment for small-cap investing with rates rising rapidly to combat inflation, leading to a weakening economy and investors shifting their investments to more diversified larger companies.

We think the economy is clearly showing signs of strain which is likely to lead to an easing of monetary policy. We believe investors will look forward at this point and seek more attractively priced investments with the potential for greater economic leverage.

White: We've been talking about this phenomenon since mid-2023. If you step back and think about the long-term role of small caps in an investor's portfolio, 30 years of Morningstar data tells us that the median active small-cap manager has delivered annualised returns (+12.5%pa) that are both above the All Ords index (+9.9% p.a) and above the median large-cap active manager (+9.8% p.a). This indicates to us that an allocation to an active small-cap manager should, over the long term, give investors access to a source of non-redundant alpha.

With markets at all-time highs, what are the attributes you focus on when looking for smaller companies to add to your portfolio?

Booker: The core philosophy at Spheria remains unchanged. We aim to find businesses with consistent free cash flow, low-gearing and that trade at a discount to our assessment of the underlying valuation.

With the slowing economy the market has aggressively sold cyclically exposed stocks many of which are now trading at multi-year lows. We see this as a relatively attractive opportunity, where the combination of low valuations and strong balance sheets is likely to lead to strong future performance.

White: Longwave combines rigorous and repeatable systematic and fundamental investment processes to identify quality small-cap companies that have entered and are remaining in what we call the 'sweet spot' of a company lifecycle.

We look for small-cap companies that can internally fund their growth and also have sound balance sheets. We then hold a more diversified basket of those companies to generate a more consistent alpha journey for our clients.

Can you give us the thesis on one company for which you hold a positive outlook for the coming year?

Booker: Imdex (ASX: IMD) is a mining services company specialising in the provision of sensors that help assess mining orebodies. IMD is the world leader in core orientation, orebody structure and mining drilling muds. In addition, IMD retains a vast knowledge of drilling data from fields all over the world.

As exploration costs and extraction costs rise greater accuracy around exploration is key and IMD provides both the tools and software to lift mining discovery and extraction rates. IMD’s revenue measured as a share of global mining exploration has consistently grown meaning the business is and has taken its share of mining spend.

With a deal 18 months ago to buy out a major European competitor, IMD is now the clear leader in this mining technology space. They invest substantial amounts in R&D to drive innovation and future revenue generation and are also highly cash-generative.

White: RPM Global (ASX: RUL) is a company that is bringing 21st-century integrated and cloud-based software to the old-world industry of mining production. RPM offer a suite of software modules to tier 1 mining companies that help mine planners and operators with the complex task of building and operating large mines.

RPM’s customer offering is differentiated from its competitors in two key ways. Underlying RPM’s software is a spatial database that is more efficient in the way it handles the data used in building and operating a mine. And it integrates with SAP systems (incredibly important for large tier-1 miners). These aspects of the technology, along with an integrated set of modules designed to help operators with many aspects of mining production and design have led to their Tier 1 mining customer base continuing to expand their subscriptions, creating a growing recurring revenue base on long-term contracts.

RPM generates enough cash to internally fund its growth and is reasonably valued given its longer-term growth prospects.

Managed Fund

Longwave Australian Small Companies Fund

Australian Shares

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Managed Fund

Spheria Australian Smaller Companies Fund

Australian Shares

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Attend the 2024 Pinnacle Investment Summit

If you’re a financial adviser or qualify as a wholesale investor, you can hear more from Longwave and Spheria at the 2024 Pinnacle Investment Summit in Sydney on Wednesday July 24 and also receive CPD points for your attendance. Register to attend and see full event details here.

You can also register to attend the Summit in other major cities across the country here.