Small caps: picks of the crop

They can be hard to get to know but small companies represent some of the most exciting long-term growth plays

As long as Australian investors remain fixated on the ASX’s top 200 companies, dominated by big banks and miners, they’ll continue missing out on a rich seam of successful yet unknown small caps with strong growth trajectories. The S&P/ ASX 200 Index gets all the attention but at 8.3% its performance over the past financial year pales in comparison with the S&P/ASX Small Ordinaries Index at 25%.

The Small Ords Index is an obvious place to start looking for companies that don’t dominate the headlines. But given that it includes everything except the ASX’s top 100, it doesn’t truly reflect the performance of small caps, which many analysts regard as having market caps below $500 million.

Investors wanting to drill even deeper can also find rich pickings within micro caps, with the MSCI Micro Cap Index (average market cap $124 million) returning 17.80% in the 12 months to June 29, 2018. With broking analysts struggling to cover even the top 100 stocks, investors who bother to become stock pickers or hitch a ride with fund managers are more likely to unearth small or micro-cap stocks with untold growth stories.

Off the radar

The magic of most small caps remaining off-radar is that they tend to be mispriced due to an inconsistent interpretation of limited information among investors, says James Spenceley, a former telco boss turned fund manager. He reminds investors that the real excitement is in unearthing smaller companies with the potential to become one of tomorrow’s ASX stars.

Dawn Kanelleas, senior portfolio manager (Australian equities small companies) with Colonial First State Global Asset Management, points out that around two-thirds of the companies in today’s S&P/ASX MidCap 50 Index have graduated from the Small Ords index in the past seven years.

One small cap that Spenceley is banking on to do just this is the cleantech stock Inte-

grated Green Energy Solutions. If you like the idea of cleantech, two more companies in this space favoured by John O’Brien, of Australian CleanTech, are Pacific Energy and waste management company Bingo Industries.

As a thematic investor, Spenceley also expects a recovering mining sector to improve the outlook for mining services small caps such as NRW Holdings and Alliance Aviation. He’s also excited about favourable dynamics playing out in the childcare sector and expects Think Childcare and larger counterpart G8 Education to benefit from the overhaul of childcare payments from July 1, 2018.

Beyond childcare but still in education, Robert Bruce, portfolio manager at Acorn Capital, expects RedHill Education to benefit from the surge in Australia’s international student numbers, now nudging 500,000.

Signs of success

When running a ruler over small caps, Spenceley, CEO of MHOR Asset Management, a small caps investment fund, wants to know that there’s sufficient demand for a company’s products and that management knows how to execute and grow the business. Looking past investor presentations, he focuses on how well management understands the businesses capital requirements and what growth assumptions they’re based on.

As well as focusing on the valuations of comparable stocks, Spenceley likes to compare the multiples that small caps are trading at within the broader market and avoids those where extreme multiples suggest future upside is already priced in.

“I also look for disconnects between the triangle of value metrics, growth and the quality of the business,” he says.

Direct shares

If you want to invest directly, five small caps with exceptional growth potential are:

• Green Energy Solutions (ASX: IGE) : Hailed by Spenceley as one of the ASX’s most interesting stocks for 2019, Green Energy is focused on converting waste plastic that’s destined for landfill or discarded into the environment into valuable road-ready fuels. It has sites approved to build plants in China, the UK and the US, and is set to launch its first plant in Amsterdam in November this year, using unwanted plastics from the UK and Europe to create its patented fuel technology.

“A company that can solve the problem of plastic waste and turn it into fuel was a no-brainer as an investment,” says Spenceley, whose fund recently invested $1 million in the stock.

Assuming Green Energy can fulfil its potential, he expects the upside growth to be between 10 and 20 times what it is now.

However, Australian CleanTech’s O’Brien says that once Green Energy gets a couple of plants going, it will be ripe to be taken out by one of the big guys, the same way ToxFree was recently snapped up. “But if they can get the economics working, there should be plenty of demand,” he says.

• Alliance Aviation (AQZ): The national air charter operates services in various sectors including tourism, corporate, sporting, media, education and government. It’s expected to benefit from an uptick in mining, and recently extended contracts with Newmont and Glencore. While the stock is no longer as cheap as it was (forecast 2018 PE 12.60), Spenceley says it’s the kind of investment opportunity he’s constantly screening for, with a strong management team, solid balance sheet, improving earnings and cash flow momentum that’s been completely mispriced by the market. While the share price is up 84% since mid-July 2017, consensus forecasts from three analysts expect 20% annual growth for the next three years, based on an extremely positive earnings outlook. It’s expected to generate underlying earnings of $59 million from operating revenue of $230 million for the full year.

• Spirit Telecom (ST1): With huge operational leverage, this provider of wireless services is a good way to play the telco sector, without “NBN risk”. The company acquired business telecommunications and phone systems provider Voxcom in 2012, My Telecom in 2015, Phone Name Marketing in 2016 and Queensland-based World Without Wires in 2017. It closed the 2017 financial year with a 30% year-on-year rise in revenue to $11.5 million, and first-half 2018 revenue increased by 54% to $8.1 million, with earnings per share up 83%. According to Dean Fergie, of Cyan Investment Management, Spirit remains an under-researched gem that’s taking advantage of “the opportunity created by the telecom/ NBN stumble”.

• NRW Holdings (NWH): This is an undervalued global cyclical mining services provider with excellent management, offering a play on the rising quality of commodities required by China for pollution/environmental reasons. Having recently won contracts with Baralaba Coal, Coronado and Stanmore Coal, the company recently released a 40% revenue growth outlook for the 2018 and 2019 financial years, based on an order book now at a record high of over $2 billion. CEO Jules Pemberton expects the company to capitalise on the significant strength in the Australian resources and infrastructure sectors, as well as replacement projects in the iron ore industry.

• RedHill Education (RDH): Established in Sydney in 2006, RedHill operates school and university courses in business, English language and IT-related subjects for domestic and overseas students. It opened a Melbourne campus in 2015 and owns the student agency business

Go Study. Operating independently of government funding, RedHill focuses on specialist industries with growing demand for graduates, and receives most of its cash flow in advance. Acorn Capital expects RedHill’s revenue to grow 20%-plus annually over the next two years (to $68 million), with earnings before interest, tax, depreciation and amortisation (EBITDA) rising to around $10 million in full year 2019.

Managed funds

In addition to not having to play stock picker, the beauty of investors looking to fund managers to unearth standout small caps is their ability to complete independent and thorough analysis. “They may have participated in capital management initiatives, been a cornerstone investor, or helped to guide the business strategy,” says Kanelleas. “They also have entrenched relationships with senior management, plus a deep understanding of the business and the journey it’s taken.”

This is why small-cap fund managers, despite earning fees estimated by Schroder Australia to be around 60% higher than large-cap portfolios, are able to generate favourable long-term returns, and successfully outperform the index.

Getting a fund manager to handle their small-caps portfolio also saves investors from reading too much into what’s happening on their trading screen and getting it horribly wrong, adds Spenceley.

The seven managed funds highlighted by Money here have an average one-year return of 22.5%. These include five small caps: NovaPort Smaller Companies Fund (fee 0.90% and one-year return 10.67%); Investors Mutual WS Australian Smaller Companies Fund (0.99% and 10.61%); Spheria Australian Smaller Fund (1.10% and 21.98%); MHOR Australian Small Cap Fund (2.59% and 24.09%); and Lazard Global Small Cap Fund (1.12% and 19.67%).

Then there are two micro caps: the Perennial Value Microcap Opportunities Trust (fee 1.20% and one-year return 50.24%) and Acorn Capital Microcap Retail Managed Fund (2.50% and 20.67%).

Exchange traded funds

Another way to gain diversified exposure to small caps is via low-cost ETFs. While some small-cap ETFs in Australia are based on benchmark market cap indices, there’s growing interest in what’s called “smart beta index development” to provide more opportunities to investors.

According to a recent VanEck white paper, an index strategy in liquid Australian small companies that pay regular dividends is likely to produce superior returns and lower downside over the long term.

With that in mind, here are four ASX-listed small-cap ETFs worth exploring: • VanEck Vectors Small Companies Masters (MVS): MVIS Small Companies Dividend Payers Index; 18.51% return in the 12 months to June 30, fee 0.49%.

• iShares S&P/ASX Small Ordinaries (ISO): S&P/ASX Small Ordinaries Index; 23.31% return, fee 0.55%.

• Vanguard MSCI Australian Small Companies (VSO): MSCI Australian Shares Small Cap Index; 18.96% return, fee 0.30%.

• SPDR S&P/ASX Small Ordinaries (SSO): S&P/ASX Small Ordinaries Index; 23.59% return, fee 0.50%.

“Getting a fund manager to handle the portfolio saves investors from getting it horribly wrong”