A mix of instinct and analysis key to finding promising micro-caps

Thu 09 May 24, 2:10pm (AEST)
Financial stock exchange market display screen board on the street marketsasx
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Key Points

  • Structured and unstructured activities help unearth opportunities at the smaller end of the market
  • 3 of HD Capital's top-performing microcap picks including one that was its fastest ever 10-bagger
  • A diversified waste management firm capable that is widely overlooked and capable of 50% profit growth

It takes a combination of gut instinct and structured analysis to unearth opportunities among emerging Australian companies. So says HD Capital Partners’ Harley Grosser, who maintains a dual watchlist of potential opportunities:

  • One with companies that tick all his boxes except valuation

  • The other with companies awaiting a catalyst such as an acquisition or management change.

The ability to respond quickly to new information is also crucial – something that is easier for smaller fund managers such as HD Capital. "But you must have done the work in advance to be able to do this,” Grosser says.

In the following Q&A, Grosser discusses how he finds opportunities and three red flags to watch for. He also names some of his most successful stock picks in the almost six years since launching the HD Capital Inception Fund.

Plus, he discusses an under-appreciated company whose earnings could easily grow by 50% in the next 12 months, while currently trading on a drastically discounted EV/EBITDA multiple.

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Harley Grosser, HD Capital

How do you find micro-cap opportunities?

It’s a combination of a structured and unstructured approach. On the structured side, we run two lists of companies: a primary list and a secondary list. The primary list shows the companies we’d love to own if the price was right, great businesses that we already know well and can react quickly to if the market gives us the opportunity.

The secondary list shows the companies we want to own if something changes – maybe an acquisition, change in management, or inflection in earnings.

There are around 60 companies on the primary list and 150 on the secondary, and we maintain up-to-date valuations on them, as well as trigger prices. Moving quickly in small caps is a real advantage, but you must have done the work in advance to be able to do this.

On the unstructured side, it’s also true that when you’ve been in the market for as long as we have, you tend to know most of the companies, the management teams and the stock codes. 

You can screen for stocks manually and maintain watch lists but sometimes it does come down to an element of feel or instinct for when a stock is worth taking a closer look.

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

There are many, but the big ones are things like a weak balance sheet or too much debt relative to the certainty of the cash flow.

Business-level risk can be things like excessive customer concentration, unattractive unit economics or unfavourable changes in the competitive landscape. At a management level we want to understand the track record of the key people and anything bad in their past is a big red flag, as is an incentive structure that runs opposite to those of shareholders.

How do you use your smaller size - in terms of AUM – as an advantage when investing in this part of the market?

If you look at the great fund managers in Australia, or even globally, you’ll note that most of them made their name and built their early track records in small caps, back when they managed smaller amounts of capital. With that success typically comes large fund flows, and those talented investors are then forced up the market cap spectrum into mid or large caps, or even into launching global funds and so on.

So, you have this constantly evolving market where the most talented and driven fund managers eventually need to graduate to larger companies. 

This segment is dominated primarily by retail investors, so there can often be an informational edge for those who do this as a career, but where liquidity is almost always poor. This has been exceptionally so over the last 24 months, as we come out of a small-cap bear market. 

There are constant opportunities in the small-cap space for those who do the work, but who are also "small enough" to play in a meaningful way. We think we’re currently the perfect size in terms of assets under management, where we are big enough to take meaningful positions in these small companies and have influence where necessary. But we can still acquire enough stock "on-market" to build positions that are material for our AUM base.

What have been your most successful micro-cap stock picks?

Some of our most successful stock picks over our almost six years in business include the following names:

McGrath (ASX: MEA)

A real estate company run by the Founder-CEO, McGrath's operations include residential sales, property management and auction services. The Inception Fund acquired a large stake in MEA 12-18 months ago and since then the share price has risen more than 70% and has paid out another +15% in fully franked dividends. It is currently under a takeover offer.

Screenshot 2024-05-07 at 11.44.57 AM
MEA 5-year share price (Source: Market Index)

HiTech Group (ASX: HIT)

A recruitment and employment services firm, HiTech provides staffing services across IT, finance and human resources for companies in Australia and offshore. HIT was the fastest 10-bagger for Capital H (the predecessor to HD Capital Inception Fund), moving from 5 cents to 50 cents in roughly a year back in 2015/16. Amazingly, it traded at cash backing while still generating a material net profit, and the market rapidly took notice. To management’s credit, the stock has continued to be an excellent performer to this day.

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HIT 5-year share price (Source: Market Index)

Lark Distilling Co (ASX: LRK)

Formerly known as Australian Whiskey Holdings, Lark identifies investment opportunities in the craft distilling industry. Its operations include the Lark, Nant, Overeem and Forty Spotted Gin Distilleries.

We first acquired the stock at 80 cents and doubled down in a capital raising in 2021, as a new CEO and growth strategy was emerging in the lockdown-fuelled alcohol boom. It had both elements of a value stock (discount to whiskey bank and hard assets) and growth story (growing volumes, average sale price and brand value) run by an experienced alcohol industry and consumer brands veteran who had invested his own cash.

We exited half the position at $5 (on valuation grounds) and the remaining half at $3.50 after the CEO's shock exit. Things rarely go exactly as planned but if you buy well (i.e. margin of safety), you can protect yourself from negative surprises.

Screenshot 2024-05-07 at 12.01.23 PM
LRK 5-year share price (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?

We still like The Environmental Group (ASX: EGLwhich we wrote about on Livewire here. The market is under-appreciating the long-term tailwinds supporting the business and how significantly earnings have grown since new management took over. It is well-managed and trades at roughly half where its larger peers trade.

In FY25 we expect EBITDA to grow by +20%, but NPATA to grow by around 50% from $5 million to $7 million-plus.

It is worth noting that for a business like EGL, EBITDA is a real number. It is capital-light and debt-free, so the reported EBITDA translates well to EBIT. This is a cash-generating business, which is impressive given how quickly it has grown over the last four years (fast growth often consumes cash for a business like this).

We expect further broker coverage and upgrades to FY25 numbers (the first broker recently upgraded to +17% EBITDA growth in FY25 putting it on 7x EV/EBITDA), continued earnings growth and increased market awareness to re-rate it towards a market multiple this year. 

There is also potential for a few blue-sky stories (PFAS removal, waste management) to get the market excited.

The share register is already excellent for a company of a sub-$100 million market cap and we have long believed it has the potential to one day be a market darling stock.

This article was originally published on on Wednesday 8 May 2024.

Written By

Glenn Freeman

Content Editor

Glenn is a Content Editor at Livewire Markets and Market Index. Glenn has almost 20 years’ experience in financial services writing and editing. Glenn’s journalistic experience also spans energy and automotive, in both Australia and abroad – including the Middle East – where he edited an oil and gas publication in the United Arab Emirates.

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