Three Small Caps where Patience is Paying Off

Richard Hemming

One thing I've learned through the years of investing, is the difficulty of trying to predict the market. The lesson here is you can't. We've seen stocks like Gamestop rocket out of internet culture, and many, many others fall by the wayside. 

What’s the key? The other thing I've learned is that losses are only 100%, but success is unlimited. Numerous Small Caps we’ve tipped have become 10 baggers, but this doesn’t happen in a linear fashion.

Many of our these spluttered to begin with, including City Chic Collective (CCX), Nick Scali (NCK), Macquarie Telecom (MAQ), Pilbara Minerals (PLS), Collins Foods (CKF) and Evolution Mining (EVN).

The key to investing for smaller investors is to be diverse, invest in the Small Caps and be patient. While some achieve success relatively quickly, the best returns come over time. Consistent rewards and safety in investing comes from the small investor’s ability to hold on.

Here are THREE Stocks that we have been recommending and are rewarding patient investors.

1. Senex Energy (ASX:SXY) – oil and gas producer

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Share price: $4.52

We only tipped Senex Energy (SXY) three months ago (Issue 455, 15 July 2021) and it’s already up 34%. South Korea’s Posco International has made a $4.40 bid for the stock, and the stock is trading higher, signalling potential for more.

We like the stock because it’s all about growth, which is exactly what Posco wants. The company’s current production rate is 20 petajoules (PJ) of gas a year, with plans to increase 3-fold to 60PJ in the next few years. SXY also has exposure to East Coast Australian gas prices, where there is considerable demand and a lack of supply. This is one of the few east coast producers actually increasing production.

A market valuation not including control is reasonable at $4.40/share, in line with Posco’s bid. However, these valuations can be expected to rise in the future to levels above the bid price as growth capital expenditure is spent and cash flow starts to be generated from the company’s new gas production areas.

2. Pacific Current (ASX:PAC) – fund manager owner

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Share price: $7.85

We have recommended PAC below $6 for some time, recognising that this is a stock for the patient. Encouragingly the stock has come good in a big way in the past few weeks, climbing as high as $8 following news that its most successful recent fund investment, GQG Partners, will soon list on the ASX.

As we observed in September, the asymmetric risk for a PAC shareholder between the small cost of management getting investments wrong, and the large returns when investments go right, is a key feature of the stock, as the GQG investment has neatly demonstrated.

The IPO values GQG at $5.9bn-$6.5bn, and enough backing has been secured to suggest the listing will go ahead. PAC’s interest will be exchanged in the float for around 4% of the stock of GQG (escrowed until August 22), plus cash of about 1% of the value of GQG at the IPO price. In this way, PAC will receive value equivalent to around 5% of the equity of GQG, in line with its ultimate holding as we had described it number of times. GQG specialises in equity stock picking in global/emerging markets. Ironically this is an investing style PAC has been trying to reduce its dependency on. GQG has grown assets under management from a standing start to almost US$100bn in about 5 years.

When we last covered PAC, we emphasised that it was “difficult to value”. The company has made some missteps (notably Seizer) but has now got it spectacularly right, more than making up for losses. Having invested only $2.7m in 2016 for a stake in GQG, PAC’s stake is about to be valued at almost $250m, or $5 per PAC share! Tax will reduce the per share gain, but the associated franking credit may create an incentive for PAC to make a special distribution at some point.

The transaction makes it easier to value PAC, since its cash and publicly traded stake in GQG now represents over 50% of its market cap.

PAC’s business is now also stronger and less reliant on the market movements. After the GQG event, management fees are an increased proportion of operating income, versus performance fees and sales commissions. PAC may hold its underlying minority investments in fund boutiques for a long time. Potential long term returns for investors are very sensitive to the price you pay for PAC stock, which is why we downgraded at $6.98 last time. But after the GQG deal, PAC is a strong hold below $10, which will still be a discount to its underlying NTA.

3. Superloop (ASX:SLC)* – telecommunications infrastructure

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Share price: $1.205

In the past week Superloop’s stock lived up to its name, spiking 22% on news it is selling its Hong Kong and the majority of its Singapore assets for $140m in a very good deal, representing a $32m premium over book value. SLC will now focus on filling its fibre networks and on its August acquisition of Exetel, previously Australia’s largest independent internet services provider, adding 110k consumer and business customers.

The sale will bring in net cash of $125m when it completes in early 2022, and EBITDA will fall by about 10%. SLC retains 15-year rights to use, which allows the sale of SLC services including delivery into those markets. The private equity purchasers of the networks will also sell capacity on SLC’s intercontinental Indigo subsea fibre.

The 1H22 results in February will be an important signpost and could herald further share price potential. SLC will announce a capital management strategy, plus we’ll be looking out for Exetel synergies beyond the $5m previously flagged, as well as evidence of earnings momentum.

SLC is now priced on a mid-teens FY21 cash flow (Enterprise Value/EBITDA) multiple, which seams on the low side, given the excess available network capacity at 70%. If management can deliver sales growth on its existing fibre, revenue drops pretty much straight to the bottom line.

We have had SLC on the Best Buy list a couple of times over the last year or two, and the Under the Radar Report portfolio bought 10,000 shares slowly in four transactions before and through the course of the Covid pandemic. We remain positive, despite the share price appreciation on the latest deal. Earnings quality is good, and we will review progress on the integration of the Exetel acquisition after an investor day on November 11, and the AGM in late October.

*The Under the Radar Report portfolio has 10,000 shares.

About the Author

Richard Hemming

Richard Hemming (r.hemming@undertheradarreport.com.au) is an independent analyst who edits www.undertheradarreport.com.au, which provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (AFSL: 409518). The author does not own shares in any of the stocks mentioned.

Under the Radar Report is licensed to give general financial advice only (ASFL: 409518). The author does not own shares in any of the stocks mentioned.

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