Watch this ASX Small Cap

When Warren Buffett announced in early May that he had got it wrong on airlines during the coronavirus pandemic and had sold Berkshire Hathaway’s entire stakes in four US carriers, he probably hadn’t heard of ASX Small Cap Alliance Aviation (AQZ).

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What is this ASX Small Cap?

The ASX Small Cap in Australia’s lesser-known regional carrier is trading at around $3.30, more than triple its levels of just over $1 in late March.

In business it’s not always the big that take advantage of the small; in the case of Brisbane based Alliance, it’s a niche operator taking advantage of a global pandemic that has severely wounded the aviation industry. The airline is benefiting from Australia’s big mines remaining open and social distancing, which has increased the number of flights to move the same number of workers, increasing revenue despite the loss of some charter and commercial passenger business.

On top of announcing a 29% increase in FY20 profit before tax, Alliance has recently purchased 14 Embraer E190 medium-bodied 100-seat aircraft for just under US$80m (A$110m), putting the airline in the frame to compete with the newly reconstructed and private equity backed Virgin Australia.

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Is this ASX Small Cap a buy?

The ASX Small Cap has risk attached to it, but as we all know, due to loose monetary policy, investors are embracing risk assets such as small caps that have growth potential. The big question this reporting season is how much do you pay for this ASX Small Cap. As numbers come through from companies as well as management statements on outlook, we’re finding for some growth stocks that it can be a case of the emperor having no clothes.

What other ASX Small Caps should investors be watching?

I’ll get back to Alliance in a moment, but let’s look at some other examples. Investors propelled Nick Scali’s stock up 15% last week, on evidence in its FY20 profit that consumers have been diverting travel related spending to comforting their bottoms; plus the long-running retailer is finally embracing online. The stock looks reasonably priced but you have to question how many sofas Australian consumers can own and for how long. We still own the same sofa we purchased 10 years ago. Maybe I’m a hard ass.

Then there is the high-flying online retailer Kogan (KGN). The company’s growth was slowing, and then COVID-19 came along. The pandemic has supercharged its customer numbers, but its shares have appreciated fivefold since March. It now trades on a forecast PE of over 45 times. One word for Ruslan & Co: Amazon. Okay, some more words: the growth rate will start to slow off the higher base and forward multiples will be hard to justify. There is only one Amazon; there are many Kogans.

A lesser-known big performer is the data centre owner and IT services group Macquarie Telecom (MAQ) whose shares have more than doubled from $20 in late March to $45 as the market starts to work out the implications of its growth strategy (another datacentre in Canberra). The thing is, the money won’t start rolling in for some time. As an investor, you don’t want to overstay your welcome.

At the big end of town, we’ve seen investors unimpressed, at least initially, with results from the likes of ventilator and CPAP provider ResMed (RMD) and Seek (SEK), which were both sold after indicating that profitability is being impacted to the point that dividends will be under pressure for some time. ResMed might be making sales from ventilators, but investors focused on slowing annuity revenues from its core CPAP product that treats sleep apnoea.

ASX investors are looking beyond COVID-19 and when you have finely tuned valuation models that are based on future earnings and dividend growth, the impact on the share price can be sustained, and not in a good way.

Back to Alliance, which is trading on a 12-month forward PE of 19 times on our numbers. At current levels, a new ASX investor is certainly paying for growth potential. While management deserves the benefit of the doubt, the economic uncertainty is so great that not taking profits when you are making big returns is sometimes a bigger risk than holding on.

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Richard Hemming

Richard Hemming

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Richard is a leading market commentator and expert on ASX Small Caps 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 (ASFL: 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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