3 small-cap stocks on Emanuel Datt's $10,000 shopping list

To say Emanuel Datt knows how to find a winner is an understatement. Datt's wholesale-only Absolute Return fund has returned a lazy 15.6% since inception. 

In the five years since its launch, Datt has uncovered a litany of success stories including Afterpay at $6, Whitehaven Coal when it was among the most unloved trades of them all, and Selfwealth when COVID first created a frenzy among retail traders needing somewhere to place their bets.

To capitalise on this success, Datt is about to launch a second fund which will focus on a concentrated portfolio of between 15 and 25 Australian-listed small cap equities across a range of sectors. 

But before he hits the live button on that new fund, he's found some time to share with us three of his most interesting stock ideas for right now as part of Livewire's newest challenge - The $10,000 Idea. 

Emanuel Datt, Datt Capital

The premise for this series is simple. We've asked a range of Australia's top fund managers to tell us how they would invest $10,000 in new capital. 

After answering a couple of quick-fire questions about their process and views on valuations, each participant can invest the (hypothetical) cash in up to three individual assets with any spare money going into a term deposit that will fetch 4% yield.

What's your read on market valuations at the moment?

We cover all areas of the ASX-listed market and the most prominent anomaly is the large divergence in valuations between the top 100 ASX stocks (ASX 100) and the Small Ordinaries Index (XSO) comprised of the largest ex-ASX100 stocks.

This has only occurred in three instances over the last 30 years: post-dot-com bust in 2002-3; post-GFC bust in 2009 and 2013 during the post-GFC energy boom. In the years that followed, active small-cap investors provided strong returns and in many cases, provided superior returns relative to the broader market.

We have seen some contrary opinions here on Livewire that analyse index performance in the US as the basis of their argument. We think this is entirely inappropriate given the vastly different factors that drive Australian markets. Indeed, there is significant academic research conducted by Australian institutions on Australian markets that indicates that investment manager skill in small caps is demonstrable from a statistical and economic perspective, within their representative sample.

In addition, these commentators ignore very practical elements of corporate finance such as the fact that statistically smaller companies are less covered by professional investors, that smaller companies make up the lion's share of M&A transactions as targets, and that a larger portion of returns in small caps derive from stock-specific factors versus broader industry or market factors.

How did you pick the assets you did for this experiment?

We tend to invest in assets that are of greater strategic importance than the market appreciates, multiple avenues of potential value realisation as well as an asymmetric return profile (limited downside with many times potential upside) driven by optionality embedded within the assets themselves. 

Our three stock picks tick all of these boxes by our reckoning despite the earlier stage nature of their operations. The strategic value of these assets to a potential acquirer, we believe, is not presently appreciated by the broader markets.

Datt's $10,000 ideas

The case for WA1 Resources (ASX: WA1)

WA1 Resources is a mineral explorer who has made a world-class niobium discovery in Western Australia. Niobium is a critical mineral whose main use is in HSLA (high strength, low alloy) steel with major applications in renewables, infrastructure, and vehicles. 

The addition of a small amount of niobium increases the strength of steel whilst decreasing the weight required by almost 30%. This has major implications for Scope 3 emissions going forward under ESG frameworks such as the GHG Protocol, given the significant asset improvement experienced with the adoption of HSLA steels. 

In addition to its more traditional applications in the steel industry, niobium-based technology breakthroughs are being experienced in the battery sector, where the adoption of niobium-based materials is reducing the charge times for electric vehicles down to a mere five minutes. This battery technology is still in the process of being commercialised but we expect a breakthrough to occur within the next two to three years. This breakthrough is vital for the greater adoption of electric vehicles; and will represent a potential 'moon-shot' in terms of growth for the niobium market.

Niobium is also a critically rare mineral, with over 80% of global production coming from the giant Araxa mine in Brazil; with only two other mines producing from low-quality ore bodies in Brazil and Canada. This concentration of supply has restricted the adoption of niobium over time, in a similar state to the rare earth market before Lynas (ASX: LYC) commenced production. 

WA1's aggressive but focused exploration program and work streams continue to build value rapidly for shareholders, especially given the very high-value nature of this commodity of around US$48,000 a tonne for a 65% niobium product. We see the natural owner of this project as a global miner, given the true scarcity of critical niobium production assets, the potential market growth from both conventional steel and battery demand as well as the renewed emphasis on reducing scope 2 & 3 emissions well into the future.

The case for Global Lithium (ASX: GL1)

Global Lithium Resources own two of the 14 defined lithium resources across Australia. Both these projects are located in Western Australia. Collectively, these deposits represent 50Mt lithium ores that lie close to existing lithium-producing operations, representing strong bolt-on potential for neighbouring producers. 

The company is currently undergoing an aggressive drilling program to increase confidence in its existing resources as well as to discover potential extensions of previously modelled mineralisation. 

We believe the company has strong potential to increase the size of its lithium resources as well as discover other critical commodities evidenced by the recent discovery of high-grade hard rock rare earths adjacent to one of its lithium deposits. The acquisitive Mineral Resources (ASX: MIN) holds 10% in the company and has been an active participant in the consolidation of the upstream lithium industry. Recently, it foiled a bid from IGO (ASX: IGO) for Essential Metals (ASX: ESS) before supporting Develop Global (ASX: DVP)'s recent bid for ESS. On a peer comparison, GL1 looks to be relatively undervalued.

The case for Neuren Pharmaceuticals (ASX: NEU)

Neuren Pharmaceuticals is a clinical pharmaceutical company focused on developing drugs that treat rare and complex neuro-developmental conditions. It has achieved FDA approval to treat Rett syndrome, the first ever approved drug to treat this condition. It has a strong clinical pipeline, where there is potential to utilise the same drug's mechanism of action across four to five other important neurological disorders.

Importantly, Neuren has a strong commercial agreement with major partner Acadia, that allows Acadia worldwide rights to manufacture and distribute this drug in exchange for ongoing royalties and milestone payments to Neuren. The latest agreement stipulates that for ex-North American rights, NEU may receive up to US$363 million in milestone payments in addition to tiered royalties on net sales between the mid-teens to low twenties per cent. 

All this is on top of its other commercial agreements covering North America. We believe that the company holds valuable, strategic pharmaceutical assets that would improve the portfolios of a range of larger pharmaceutical companies. 

Cash: 10%

We are most comfortable investing from a position of strength, and this means holding onto a reasonable percentage of cash at any given time.

This article was first published for Livewire Markets on Wednesday. 26 July 2023.