[Editor’s Note: The term “small-cap” refers to companies that sit outside the largest 100 on ASX by market capitalisation. The S&P/ASX Small Ordinaries Index is used as a benchmark for the performance of small-cap shares on ASX. Companies in this index have a market capitalisation ranging from $150 million to almost $9 billion (at end-January 2023. Source S&P).
By virtue of their size, smaller listed companies tend to attract less research from stockbroking firms. That can create opportunities for individual investors and fund managers to do their homework on small-caps and find potentially undervalued companies. But this part of the market also has higher risk, on average, because small companies typically have fewer resources compared to larger companies and often a weaker market position. Some small-cap companies also have lower low share liquidity, which can increase volatility in their share price.
Some investors prefer using active managed funds or listed investment companies that specialise in small-caps, rather than investing directly in small-cap stocks. In doing so, they gain exposure to a diversified portfolio of small-cap stocks and the skills of a professional manager. Before investing in a small-cap fund, talk to a licensed financial adviser or do further research of your own.]
Are you looking for a different (and sensible) way to invest in the growth of ASX-listed small-cap companies?
If the Spheria team has hooked you with that line, we’d say there’s a good chance you might have been burnt by a small-cap company that told a good story. Perhaps you read about it in a forum or got a tip on the golf course.
In Spheria’s opinion, the small and micro-cap sector has its share of investor exuberance, which is usually concentrated around aspirational companies that tell a good story.
But as fund managers, responsible for protecting and growing our investors’ capital, Spheria is charged with investing in fundamentals, not narratives.
In the small-cap space, there can be good opportunities for investors who apply disciplined fundamental analysis to build exposure to great smaller companies. But Spheria believes investing in this space is as much about avoiding hyped-up stories as it is about finding the next stars.
Using a small-cap LIC
While unlisted unit trusts are the most common way that most traditional fund managers offer investors access to their small-cap strategies, Spheria launched the Spheria Emerging Companies LIC (ASX: SEC) in 2017. Our aim was to provide individual investors with a sensible way to get exposure to smaller companies.
To summarise Spheria’s core investment process, we have a strong focus on seeking out companies that generate consistent cash flow (or free cash flow as we call it – that is, the cash the business earns after all capital expenditures).
The importance of free cash flow is illustrated in the chart below. The dark blue line (+872%) represents a bundle of all ASX small-caps stock with positive operating cash flow. The orange line (+323%) represents the index and the light blue line, a portfolio of stocks with negative operating cash flow (-5%).
Source: Spheria
[Editor’s Note: Do not read the following commentary as stock or LIC recommendations. Talk to a licensed financial adviser or do further research of your own before acting on themes in this article].
Two stocks in Spheria’s portfolio that exemplify its investment philosophy are Monadelphous Group (ASX: MND) and Michael Hill International (ASX: MHJ).
Monadelphous provides construction, maintenance and industrial services to resources, energy, and infrastructure industries. The company has been a good performer in Spheria’s portfolio over the past 12 months, after we bought it when it was seemingly out of favour with the small -cap crowd. Monadelphous has benefited from commodity prices firming, the capital-expenditure cycle finding a new gear and labour markets loosening.
Michael Hill International is a retailer of fine jewellery in Australia, New Zealand and Canada that you probably have heard of.
The company fell out of favour a couple of years ago after reporting some terrible financial results under a previous management team. However, since joining Michael Hill, current CEO Daniel Bracken has invested in technology, changed the pricing strategy, introduced a loyalty program and increased online penetration. These changes have increased revenues and led to improved company results, in Spheria’s opinion.
Why invest in small-caps via a Listed Investment Company (LIC)?
When compared to Exchange Traded Funds, managers of small-cap LICs can take a longer-term approach to their portfolio. This is in-part due to the closed-end nature of a LIC.
Unlike open-end ETFs, the manager need not worry about fund outflows from investor redemptions. These redemptions often happen at the worst possible time – during a market selloff – which forces managers to liquidate their portfolio at market lows, instead of taking advantage of opportunities to buy great businesses at a discount.
Another potential benefit of the LIC structure is dividends and the additional income generated via franking credits.
LICs can provide a vehicle for shareholders to receive regular fully franked dividends. For retirees and other low-tax investors, franked dividends are the most valuable form of income. LICs can retain profits, as well as valuable franking credits, to enable the smoothing of dividend income.
On the other hand, trusts like ETFs and managed funds must distribute income and capital gains in a financial year.
Spheria Emerging Companies recently introduced a quarterly dividend equal to 1% of the company’s Net Tangible Asset (NTA) value per share.
Finally, another perceived benefit of investing via a LIC also happens to be one of the greatest frustrations for many - when a share-price discount to the LIC’s net tangible assets (NTA) arises.
Buying a LIC at a discount can be an attractive proposition, as you are buying the underlying stocks in the portfolio at a discount. If, over the long term, the discount narrows, the shareholder gets the growth from the portfolio plus any return from the discount narrowing.
However, the opposite also holds true where a widening of the discount occurs.
Conclusion
Spheria believes that if you want the growth of some of Australia’s great small-cap companies in your portfolio, it’s worth avoiding the fairy tales and researching what small-cap LICs may offer.
Small caps can be a lucrative part of market, but only if investors get it right. Spheria believes it’s critical that serious long-term investors have a sensible allocation to the small-cap asset class.
About the author
DISCLAIMER
This communication is prepared by Spheria Asset Management Pty Limited ('Spheria') (ABN 42 611 081 326, Corporate Authorised Representative No. 1240979) as the investment manager of the Spheria Emerging Companies Limited ('SEC', 'Company') (ABN 84 621 402 588) and Spheria Australian Microcap Fund (ARSN 611 819 651), Spheria Australian Smaller Companies Fund (ARSN 117 083 762), Spheria Global Microcap Fund (ARSN 627 330287) and Spheria Opportunities Fund (ARSN 144 032 431) (‘the Funds’). Pinnacle Fund Services Limited ('PFSL') (ABN 29 082 494 362, AFSL 238371) is the product issuer of the Funds. PFSL is not licensed to provide financial product advice. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) (ABN 22 100 325 184). The Product Disclosure Statement (‘PDS’) and Target Market Determination (‘TMD’) of the relevant Fund are available via the links below. Any potential investor should consider the PDS and TMD before deciding whether to acquire, or continue to hold units in, the Fund.
Links to the Product Disclosure Statement: WHT0066AU, WHT0008AU, WHT0025AU, WHT6704AU
Links to the Target Market Determination: WHT0066AU, WHT0008AU, WHT0025AU, WHT6704AU
For historic TMD’s please contact Pinnacle client service Phone 1300 010 311 or Email service@pinnacleinvestment.com
This communication is for general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.
Whilst Spheria, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Spheria, PFSL and Pinnacle disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information. This disclaimer extends to any entity that may distribute this communication.
Any opinions and forecasts reflect the judgment and assumptions of Spheria and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future.
Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this communication is prohibited without obtaining prior written permission from Spheria. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.
This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Spheria.
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