How to invest in small and micro-caps (and 4 emerging stocks for the next 5 years)

This anonymous writer has made a few poor decisions when it comes to investing in small and micro-cap stocks - like I assume many of you have, too.

Take Zip Co (ASX: ZIP), for example, which recently sold my shares even though I wasn't aware they would do so - and right before a spectacular rally, I might add.

So, how do you avoid the potholes and identify the fast-lane stocks on the highway to success?

In this episode, Livewire's Ally Selby was joined by Regal Funds Management's Jessica Farr-Jones and Spheria Asset Management's Brittany Isakka for their tips and tricks for investing in emerging ASX-listed stocks.

They also share their outlook on small and micro-caps for the year ahead, the recent major changes they have made to portfolios, and two stocks they are backing with exciting growth trajectories over the next five years.

Plus, because this anonymous writer loves a dash of drama, they also name one stock that they believe can no longer deliver growth for investors.

Note: This episode was recorded on Wednesday, 28 February 2024 and first appeared on Livewire Markets. You can watch the video, listen to the podcast, or read an edited transcript below.

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Edited Transcript

Ally Selby: Hello and welcome to Livewire's Buy Hold Sell. I'm Ally Selby, and today, we're taking a deep dive into the wonderful world of emerging companies. Our guests will be sharing how you can identify the winners and losers within this space, and they'll also be naming two companies with incredible growth trajectories over the coming five years. To do that, we're joined by Spheria's Brittany Isakka and Regal's Jess Farr-Jones. Thank you so much for joining us today on the show. Really excited to feature you both on the program for the first time. Let's get straight into it. Inflation appears to be cooling, and we also have a lot of investors betting big on rate cuts in 2024. Jess, I might start on you. What does that mean for growth investors?

Rate cuts and what they mean for investors

Jess Farr-Jones: You're right, Ally, that investors are betting on rates coming down this year. Earlier this year, actually, there were seven rate cuts being priced into the market that have been adjusted down to three rate cuts now by the Fed. However, the Australian CPI report that we had recently was supportive of this notion that rates shouldn't go much higher. A declining interest rate environment is very positive for stocks in general. At a very basic and fundamental level, the reason for this is that equity investors have a cost of capital, and they need to ensure that they're compensated for the risk in investing in equities as opposed to less risky asset classes such as cash or government debt.

So, as these interest rates and risk-free rates come down, the cost of equity can also come down, and that's supportive for asset prices. And this phenomenon is even better for growth investors as these stocks usually have longer-dated cash flows. So, the impact on their discounted cashflow valuation is even higher from utilising a lower risk-free rate or WACC. So, we believe that this kind of Goldilocks scenario at the moment of cooling inflation, strong GDP growth, slightly increasing unemployment, but still really strong employment, and declining interest rates, should be quite supportive for equity markets and especially growth stocks.

Ally Selby: Brittany, you play more within the value area of small and micro caps. What does this mean going forward that rates could be peaking, that inflation is cooling, that we could see rate cuts this year?

Brittany Isakka: Well, I agree with Jess. It is a key input into the way we value businesses. So it's definitely supportive for those cashflow generative businesses that have cashflow further into the future. I think, as well, that it can be supportive for businesses that are tied to the economy. So more cyclical names where they do benefit from falling rates - think consumer names. If rates do fall, consumers have more money to spend, mortgage rates will eventually be lower. And I think as well it's positive for interest rates, sensitive sectors such as REITs. So, I think generally, all-in-all, it's positive for growth investors, but can be also positive from a sector perspective.

Bullish outlook… but what are the risks?

Ally Selby: You both sound quite bullish. Are there any risks that you think investors need to be aware of?

Brittany Isakka: I think there are a couple. I think the expectation is now that inflation has peaked and interest rates are going to come down, but I think the actual pace of interest rate cuts will probably be longer than investors expect. I think in Australia, particularly, rising inflation was delayed relative to the US. So I think that pace of cuts might actually be later than investors are expecting. And I think the other thing that investors need to be aware of, Jess mentioned it, is that unemployment rate. It has stayed really low. But talking to some companies at the recent report, there's a lot of companies who are laying off staff and that's in order to combat this inflation. And I don't think we’ve felt that in the economy just yet. So I think that's something the unemployment rate and where that gets to is something that investors should be aware of.

Ally Selby: Jess, are there any other risks that you want to call out over the next 12 months?

Jess Farr-Jones: Yeah, absolutely. As history shows, as the central banks shift from rate hiking cycles to rate easing cycles, this is usually very positive for the stock market except in instances where the economy gets tipped into a severe recession. So that's obviously no longer the base case - that we're going to have a recession - but of course, it's still within the realm of possibility that it could eventuate. As Britt mentioned as well, markets are very forward-looking and so the rally that we've seen since October last year when 10-year yields got to 5%, the rally's been quite strong. And that is because investors are starting to price in these rate cuts. The risk, as Britt mentioned, is that if expectations continue to get revised, that the market has already started pricing in these rate cuts. There of course are also geopolitical risks at the moment. There's large fiscal budget deficits, there's definitely still risks.

Where the rubber meets the road – recent portfolio changes

Ally Selby: Okay. With all those risks in mind, have you made any major changes to the portfolio in recent months?

Jess Farr-Jones: Yes and no. What I would say is that we are bottom-up investors. We don't necessarily let the macro always dictate our largest high-conviction positions. Often, those positions are held over long periods of time and they don't shift from week to week as expectations around the economy shift. A lot of our core fundamental positions have been in the portfolio for a long time. But definitely, what we've gotten recently is conviction to add some of those longer duration growth stocks, for example, to the portfolio because now, we've got conviction that yields did peak in October last year.

So this new environment of lower rates should be positive for certain sectors, like some of these beaten up technology and software names. Healthcare and biotech was really beaten up as well during 2022. So that's an area that can probably outperform as well. And, of course, also some of the consumer names where people were very worried about the performance of the consumer. The consumer has been very resilient and we've seen very strong earnings results recently from some of these consumer names that are no longer cycling really difficult comps from the COVID era. So, adding some of these names in those sectors to the portfolio more recently has been something we've gotten conviction of over the last few months.

Ally Selby: We'll get into some of those names later on but I want to throw to you now, Brittany, what major changes have you made to the portfolio in recent months?

Brittany Isakka: I don't want to sound the same as Jess, but definitely similar in the sense we are long-term investors. So a lot of our core holdings, we tend to hold our stocks for a number of years. That hasn't changed. But what we have been assessing, similarly, is we have seen consumer names run in the last couple of months and tech names on this interest rate theme. But one sector that we think may have been left behind is the REIT sector. We think, obviously, with interest rates falling, that is a sector that should benefit, but a lot of the names in that space are still kind of underperformed. So, we've been revisiting the REIT sector.

The secret sauce for smalls and micros, and red flags

Ally Selby: Okay. Is there any secret sauce to investing within stocks within the smaller micro-cap arena?

Brittany Isakka: Secret sauce? So for us, we are bottom-up, fundamental investors and we focus on businesses with good free cashflow through the cycle. We want to buy businesses with a good balance sheet, so that's usually net cash or low gearing. And we like businesses that are trading at a discount to fundamental value. And so that's kind of 101 fundamentals, but we value every business we own and we think those metrics service really well through the cycle. So that's kind of our secret sauce.

Ally Selby: How about red flags? Is there something that you feel like investors really need to learn how to avoid when they're investing in the smaller micro cap stocks?

Brittany Isakka: I think, particularly in the small end of the market as you say, they tend to be a little bit more risky and I think retail investors particularly can definitely get caught up in say, hype names or themes. I mean, one example we saw was that EV thematic, which I think is definitely part of our future, but I think short-term in 2022, we saw all things lithium get bid up to crazy levels to only then collapse in 2023 as the lithium price fell over 80%. I think investors need to be wary about what they're buying when they get caught up in a theme. Go back to the fundamentals of those stocks and don't just see the hype and the theme name and jump into those names. So that's what I would say to investors.

Ally Selby: Jess, you're also a bottom-up investor. What's unique about your strategy and what's one red flag you think investors need to be aware of?

Jess Farr-Jones: I can relate to a lot of the things that Britt just said for sure, but I definitely believe that one of the best ways to predict the stock price is to try to predict the earnings because that's the best predictor of the fundamentals of the company and where the stock price should trend over time. So we're very focused on trying to invest in companies that have the ability to compound both revenue and earnings organically at a very high rate. And we're also looking for very high-quality businesses, and this is often exemplified through things like high gross margins, high EBITDA margins, high returns on equity and high free cash flow. So, of course, we're looking for those kinds of stocks.

What I would say on valuation is it's a very important input into our process, but when you're looking at small caps and micro caps, it's often not the best predictor of the share price going forward. Whether things are trading slightly cheap or expensive because there are a few turns above or below their long run historical average, that's not always the best predictor of the future share price. Things can stay expensive when they're performing well for a very long period of time. So we think that the best way often to invest and to predict future share price appreciation is to try to predict which companies are going to grow their earnings the strongest. And, of course, we also look back to really excellent founders and management teams. So we're looking for good alignment, lots of skin in the game, and a history of beating expectations underpromising and overdelivering.

Ally Selby: How about a red flag?

Jess Farr-Jones: It's kind of an old adage, but downgrades come in threes is often true. So one downgrade can often mean ongoing difficulties for the stock. Another thing is leverage in smaller micro-caps, they're often not the type of stocks where you want to see high debt levels because sometimes they're earlier stage and less capable of supporting leverage. And especially in environments like this where interest rates have been high. The other things is insider selling can sometimes be a red flag. And lastly, also M&A, I'm cautious around sometimes. Occasionally, companies can do fantastic deals and get a lot of synergies, but what we have also seen from time to time is M&A be value destructive. The sellers know more than the buyers when they're selling a business. Sometimes those synergies don't materialise. You often see goodwill impairments down the track. Also, with the benefit of hindsight, you see that one of the reasons the M&A was pursued was because the core business was slowing.

Ally Selby: We asked you to bring along two stocks that you believe have really impressive growth trajectories over the coming five years. Jess, what have you brought for us today?

Cettire (ASX: CTT) and NextDC (ASX: NXT)

Jess Farr-Jones: When I think about stocks that can experience really exciting growth stories over the next five years, two areas that I'm really attracted to are e-commerce and generative AI. So with the first bucket, there's a stock called Cettire - Regal is a substantial shareholder. It's a global luxury e-commerce platform. It's a founder-led business. It's only ever raised $40 million of capital in its history, and it's managed to use that to fund extraordinary organic growth, with the top line growing from $6 million in FY19 to over $700 million of revenue this year. So it's had absolutely extraordinary revenue and earnings growth and free cashflow. We think the opportunity is there for them to continue growing rapidly as they enter China, imminently the largest luxury market in the world, and it's still only trading on 27x FY25 earnings. And compared to another e-commerce name like Temple & Webster, which is on 80x, we think that there's still room for a rerate in that name.

The second stock that I want to talk about is NextDC because of its exposure to this amazing generative AI thematic. We obviously saw NVIDIA's results last year, and in a very basic level, every NVIDIA GPU has to go into a data centre and NextDC offers one of the biggest, largest, and fastest growing data centre plays in Australia. They had a great first half result, the stock was up 13%. One of the reasons for that was because they quantified the AI opportunity and said that contract sizes can go from 10 to 20 megawatts to over 100 megawatts. So we believe that there's ample room for the stock to continue to grow as they deploy more and more data centres and contract those out over the next few years.

Ally Selby: Awesome. Over to you, Brittany. What stocks do you believe have really impressive growth trajectories over the coming five years?

Mader (ASX: MAD) and Johns Lyng Group (ASX: JLG)

Brittany Isakka: So I'll give you two names which have a similar growth in that they've gone to North America. So one of those would be, Mader. We've owned it since IPO and it's been a really great performer. They're a mobile and fixed plan equipment maintenance company. They started in WA, they're a founder-led business, and they've recently entered North America in the last couple of years. Revenue has grown about 40% per annum over the last four years. That's been driven partly by North America where they've grown almost 120%. It's been an amazing growth story of a founder-led business. We think they can keep growing revenue at about 25% per annum because their share in North America is still quite small. It's got low gearing, founder-led business, and we think it's a business that can continue to grow and do really well.

The other business would be JLG, which is John Lyngs Group. They are the number one building repair and restoration insurance business in Australia. And they too have a growing presence in North America. They reported recently; in North America, growth was actually weaker than the market expected, but I think that creates an opportunity. They've had some just short-term headwinds in terms of getting projects started, but they've quoted a massive pipeline of opportunity. They also announced this month that they've recently entered the Allstate panel, which is one of the largest insurers in North America. They've got access to 16 million policies in order to do work over there. So we think the business has a massive runway for growth. It's got a net cash balance sheet, it's got great cash conversion, and great insider ownership. So that's another one we think can grow really strongly over the next five years.

Growth names under the pump

Ally Selby: Okay. We asked our guests to bring along one stock, one growth darling if you will, that can no longer deliver for investors. Brittany, what have you brought for us today?

Polynovo (ASX: PNV)

Brittany Isakka: I'll go with a name that's maybe the opposite of what we like in terms of businesses, and that's a cash-burning profitless business, and that would be PolyNovo. So the business over the last 10 years has continued to spend more than it earns in revenue. This half, they did report a small marginal profit, but they're still burning cash. And I think businesses like that, it's hard for us to invest in. It doesn't earn great returns. And for us, it'd be one that we would avoid as shareholders.

Ally Selby: Okay. It's definitely been in and out of favour with investors over the last few years. Jess, your time in the hot seat, which growth stock can no longer deliver for investors?

Nanosonics (ASX: NAN)

Jess Farr-Jones: Another healthcare name. And it's funny because often, a dangerous combo in small cap investing is names that trade on very high multiples, but then something in the fundamentals changes such that multiple is no longer justified. So an example of that that we've seen recently is Nanosonics. They have a market leading product called Trophon, which is used for disinfecting ultrasound probes. They've historically traded over the last five years at above 100x PE and above 60x EBITDA, and that's because they were doing a global rollout and growing very rapidly.

What we've seen recently is a very material derate, and that's been driven by what they reported this week, which was guidance now for FY24 with flat revenue and declining earnings. So you can see very large rerates when growth stocks are no longer growing rapidly. While we think that they have an excellent market leading product, we remain cautious on this name until they can start growing the top line and the bottom line. They do have a second product where they're seeking FDA approval, but they won't get that approval for more than 12 months. So we will remain cautious on that stock until that happens.

Ally Selby: Okay. Well, I hope you enjoyed that episode of Buy Hold Sell as much as I did. If you did, why not give it a like? Remember to subscribe to our YouTube channel. We're adding so much great content just like this every single week.