Why microcaps could be the biggest opportunity in markets today

According to Joel Fleming, portfolio manager, microcaps for Yarra Capital Management, it’s an interesting time to be looking at microcaps. Sentiment has been poor and it’s a highly inefficient market.

“The underperformance has been significant. When we look at an index level, one-year returns for microcaps are down around 10% against +6% for the ASX100,” he says.

He points out that the uncertain market environment has only served to increase inefficiency and that investors have veered towards large caps in the hope of better certainty in performance. But, he also sees this as one of the biggest opportunities in the current market.

“Earnings growth is going to be a lot stronger and they’re trading at valuations that are significantly discounted to other parts of the market,” Fleming says.

But while valuations look promising, investors may wonder, can another Pro Medicus (ASX: PME) or Pilbara Minerals (ASX: PLS) be found in the microcap space today? Fleming thinks there are lots of opportunities for patient investors willing to do the research.

In this episode of Expert Insights, Fleming shares why investors should look at microcaps now, where to look for opportunities, and his advice to investors in this space.

Edited transcript:

Why should investors look at Australian microcap companies now?

The underperformance has been significant. When we look at an index level, microcaps one-year returns are down around 10% against +6% for the ASX100. Earnings growth is going to be a lot stronger, and they’re trading at valuations that are significantly discounted to other parts of the market.

There’s a sentiment impact that’s affecting the valuations, but it’s really inefficient. In an environment like this, the inefficiency only increases, and the fact is, the world continues to change. 

The next Pilbara Minerals and the next Pro Medicus - that stock that starts very small and then builds out a business based on a compelling theme - those opportunities are always going to exist. From a valuation perspective, I think it’s looking really attractive because of the inefficiency and the huge number of businesses we have on offer.

It is a really interesting time to start looking at Microcaps.

What’s the biggest opportunity you see in microcaps right now?

It’s that inefficiency piece. We look at broker research, it only confirms a lack of interest in smaller companies generally. We have the privilege of going out and meeting these people, understanding their businesses, investing and building portfolios. I think where valuations are, there is really compelling value on offer for investors although it’s going to be bumpy as it always is.

We don’t know if the global economy is going into recession or if we’ll continue to sail through, but we think there’s some significant value creation potential available based on the underlying earnings, the growth potential and how some of these businesses can build out over the next few years.

Which sectors should investors focus on or avoid in the next year for micro-caps and why?

It’s difficult because we want to be focused on things that are forward-looking. 

Sometimes things that seem boring and mundane become things that are very important because the world changes.

Electricity networks are assets we generally think are pretty boring, but ones that we have to have. The energy transition and the need to reinvest there is going to create some amazing opportunities on the back of the amount of spend required to change our economy and how we work. They’re the kind of opportunities we’re looking for within sectors.

There are always good companies with bad management teams or bad companies with good management. For us, it’s about finding those businesses that are undiscovered and which have great potential and a team that can really take advantage of that.

We’re looking for areas where there’s increasing spend. We’re looking for areas where someone’s building out a real skillset and able to really capture market changes as the world changes. We’re working to find those companies that can really benefit from that.

What is one piece of advice you have for investors in microcaps?

I love what I do, and I consider it a great privilege that we get to meet with so many interesting people and then watch as they try to execute their plans. I think it’s really important to do your own research.

If you really are interested, there are so many data points and so much information that’s widely available to try and get a real understanding of a business. At the end of the day, if you understand what drives the revenue line and what drives the cost base, you’ll be quite a way down the path to understanding the opportunities a business has and how profitable and how quickly it can scale and grow. 

Just having an interest in doing the research can really help you unlock real value in what is an inefficient part of the market.

Discover microcap potential

Joel Fleming is the Portfolio Manager for the UBS Microcap Fund , a fund which has been managed by Yarra Capital Management since August 2014. The Fund aims to deliver superior returns and long-term capital growth by investing in undervalued, high quality micro-sized companies in their early stages of rapid growth.