Small Caps provide investors on the ASX with great opportunities for growth. But you need thorough analysis on the financials and the business before you invest in Small Caps. So, how did Under the Radar's Richard Hemming start to learn about small caps and what does he look for when investing in small companies?
How did small caps end up on Richard Hemming’s radar?
It started early on when his family invested in a small mining company that delivered many multiples on the initial investment, and this had an immediate effect.
Further down the line, as an analyst at a big research house, he analysed many of the big companies. It was here Richard realised how many analysts covered the same companies over and over, and how they were all searching for an edge and asking incredibly detailed questions. In contrast at small company briefings he was sometimes the only analyst there, and it was obvious there was an information deficit.
It became apparent that there was an opportunity for super returns to be made, if a good analyst covered small companies.
What does Under the Radar Report look for in a small cap stock?
1. We look for Growth stocks
Growth stocks are companies that can grow no matter what the economic conditions, and are typically export-orientated companies because markets are so much bigger offshore.
We screen stocks to look for growth stocks, but it is hard to find growth stocks that are cheap.
Under the Radar Report looks for stocks “that have global potential, but are priced as if they’re a corner store.''
Medical Technology has delivered returns.
Success in the medical technology sector is a testament to that. There have been some blow-ups, but they have been more than made up for from profits on stocks. Examples being diagnostic device specialist ImpediMed (IPD), the “green whistle” or Penthrox producer Medical Developments (MVP) and the liver cancer treatment company Sirtex (SRX).
The stock market is favouring such companies now because of a weaker exchange rate; in general the costs of doing so are not prohibitive as they once were. The information gap between countries is less important and now there are high profile trade agreements, opening up the giant Asian market (read China).
In the coming issue we speak to Mark Bouris, who made a fortune selling his home loan company. He is the chairman of a small ASX listed technology company, and he talks about the excitement of helping it transform into an industrial company, exporting its product to a global customer base.
What is a growth stock?
A “growth” stock is one whose earnings grow at a steady or accelerating rate. As soon as growth starts slowing growth, the story comes under question. Post the Fed’s decision to start hiking interest rates, investors are now much more sceptical of so-called growth stories.
We have just been through a long period where prices of everything moved up and stocks moved in herds; particularly at the big end town. When the US Federal Reserve decided to start increasing official interest rates last December, this changed. It’s clear that there has been an underlying change in conditions, which favours stock picking this calendar year.
2. Value predominates in the Small Cap marketplace
Value predominates in the Small Cap marketplace. Let me tell you, we do not like paying much for anything!
What about value?
Value can occur in many forms: cheap relative to earnings or to assets or to prospects. Whereas in “growth” you’re paying up for the future; in a “value” scenario” you’re paying nothing for that potential. You’re getting the future for free if the present can work itself out.
Good small companies are being overlooked.
We’ve had a lot of success in this space simply because most small caps are ignored by fund managers and stock brokers. Gold stocks like Northern Star was once a value play; so was Silver Chef, APN, Nick Scali, Elders and Cabcharge.
We look at the balance sheet, we look at cash flow, we analyse all the financials and we talk to management.
IT Service companies are in transition
More recently we have covered two companies in the IT services space – SMX Management and Technology and Data3. These are companies which were once high profile stocks, with an accompanying high valuation. Now that they’re being forced to transition from a body shop business where they provide services based on billable hours to one involving the cloud and its associated software as a service (SaaS) model, they’re not finding life as easy. Investors big and small have deserted them. This is where the opportunity lies.
In our next issue we cover a company that has been ignored by institutions, and has transformed its operations through merger and acquisition. It’s definitely one to have a look at.
What should you be aware of when considering risk?
Diversify your Small Cap portfolio to mitigate risk.
There are risks in investing in small caps. Most significantly, the risk is in the lack of diversification in an individual company's earnings stream. A long time ago we covered a gold mining company called Red5 which suffered a collapse in the walls of its Philippine based mine. It almost destroyed the company, which has hung on (against the odds). It certainly wrecked the share price. In contrast, while BHP’s mine disaster in Brazil was a human and ecological tragedy, its impact upon that company will be much less.
To mitigate against risk diversification is the key, but also look closely at the balance sheet. Your backstop as an investor is the balance sheet.
How does the reward profile differ for Small Caps?
On the other side, there is the reward. Because big companies have been associated with certainty, as interest rates have fallen, their share prices have become very expensive. There is much more price risk associated at the big end.
Lower interest rates has made large caps expensive. Don’t think large caps will give bond-like returns.
Greater Leverage means more potential in the Small Cap world. The big opportunities to make money are in Small Caps.
We think small caps provide a lot more bank for your investment buck.