6 tips to avoid small-cap traps (and an unloved stock headed for a rerate)

The skills and experience of individuals heading up a company are key indicators of whether a stock is worth buying. They become increasingly important as you move further down the market cap spectrum, explains LSN Capital’s Nick Sladen.

Though LSN Emerging Companies isn’t a pure-play micro-cap fund – it targets companies outside the ASX 100 – Sladen and fellow portfolio manager Nick Leitl do invest in sub-$300 million companies.

In the latest wire in our multi-part micro-caps series, Sladen discusses how he finds opportunities among micro-caps. He provides six red flags to watch for and discusses the value of being a smaller player in this space.

Sladen explains how he rode a government infrastructure contractor from a market cap of $100 million to $300 million. He also identifies an unloved local healthcare stock on track to deliver 50% earnings growth over the next two years.

Nick Sladen, executive director and portfolio manager, LSN Capital

How do you find the best micro-cap opportunities?

Our ideas are sourced from an extensive network of contacts across all industries, connections that have been built up over 25 years of investing in listed companies.

While we apply the same investment approach across all companies we invest in, given the execution and liquidity risks involved in micro-cap investing, we place extra weight on management quality and the business’s capital structure. Because the path to success for micro-caps is often not linear, maintaining a close relationship with management helps keep our conviction over the journey.

What are the red flags that signal “avoid” to you?

We are focused on investing in companies that can sustainably grow their earnings over the long term and that have the ability to earn a strong return on capital. The profile and sustainability of that growth usually dictate the valuation investors are willing to pay.

We find these factors can often be a sign that risks outweigh the return opportunity:

• Management incentives that are not aligned with shareholders.

• Companies that have huge capital requirements to become sustainable.

• Track records of over-promising and under-delivering.

• Valuations that reflect perfect execution.

• Complicated or opaque business models.

• Products or services that aren’t differentiated from competitors via price, efficiency, or technology.

How do you use your smaller FUM as an advantage when investing in this part of the market?

Liquidity is an additional risk that investors take on when investing in microcaps. Risk and returns are correlated, hence the success or failure in microcap investing produces outsized returns in both directions.

With smaller FUM, this allows us to take advantage of investment opportunities in companies that are early in their growth trajectory and capture exceptional returns from taking the additional risk.

Conversely, it also helps manage the downside risk for investments that do not work. Founder-led companies are a common attribute among our investments and this usually adds to the liquidity constraints, as founders often retain a large shareholding at this point in their business life.

What has been your most successful microcap stock pick?

Duratec Ltd (ASX: DUR) has been one of the most successful micro-cap investments since the fund launched in December 2021. The company is founder-led and provides the technical expertise for upgrading and extending the life of, and use for, infrastructure. The Department of Defence is a significant client for Duratec and leverages the company to increased government spend on its ageing infrastructure assets.

At the time of our initial investment in March 2022, Duratec had a market cap of $100 million and held $40 million of cash on its balance sheet. We projected the company could double its profits over the next two years, which presented a compelling investment opportunity.

Since our investment, the management team has executed its organic growth strategy exceptionally and complemented this growth with an accretive acquisition.

The company is on track to more than double its profits from FY21 to FY24 and now has a market cap of $260 million. We exited our position when its market cap was over $300 million, as we felt the rate of growth was set to slow and the valuation was reflective of the growth outlook.

Duratec share price since it listed on the ASX (Source: Market Index)

What is one ASX micro-cap company you believe investors have missed, but which has the potential to re-rate higher from here?

Capitol Health (ASX: CAJ) is a diagnostic imaging company that is positioned to deliver strong growth in the years ahead. Capitol holds a market share of around 4% in the diagnostic imaging industry, with a network of 65 clinics across metropolitan Victoria, Tasmania, South Australia and Western Australia.

With the industry returning to more normalised operating conditions, the company is on the cusp of delivering earnings growth of more than 50% over the next two years – yet it trades on an enterprise value-to-EBITDA multiple of less than 6 times.

Capitol Health 5-year share price (Source: Market Index)

The healthcare industry is a happy hunting ground for corporate activity with dental operator Pacific Smiles (ASX: PSQ) currently under takeover, with an implied valuation of 9 times EV/EBITDA. We see significant earning and valuation upside for Capitol Health as it re-rates to historical levels.

Pacific Smiles 5-year share price (Source: Market Index)

This article originally appeared on Livewiremarkets.com on Tuesday 30 April 2024.