microcaps

Microcaps v the rest

Statistic
1-Year Forward

Micro Small S&P/ASX

caps Ords
100

Price-earnings ratio

14.3

16.4

14.6

Earnings per share

29.4%

14.5%

5.3%

Yield

3.3%

3.9%

4.7%

Return on equity

14.5%

13.1%

16.2%

Net debt: equity

11.0%

22.2%

36.2%

Avge market cap

$377m $1077m $12,938m

Beta (to ASX 300)

0.58

1.06

0.97

As at 30-Jun-14, using Contango MicroCaps portfolio of 69 ASXlisted microcap stocks as a proxy.

78 Money august 2014

When it comes to the

tiddlers, research and
discipline are vital

ness model; the attractiveness of the sector it

operates in; and its life cycle.
At each point of the cycle investors need
to have an appropriate understanding of cash
flows and profit expectations. The market
values a company and its assets differently
depending on where it is in the cycle. A mining company goes from exploration phase to
feasibility, to pre-bankable, to project construction, to construction, to production.
While investors often dont have access to
the information fund managers can source,
there are things they can do to better know a
company. Essentially, investors who do their
research can better determine what price to
pay and the best time to execute their trades.

Big
promise
Story BOYD PETERS

cap sector (using Contango MicroCaps portfolio of 69 ASX-listed microcap stocks as a

proxy) is attractive on both a relative and
absolute basis.

that disciplined investors with clearly defined

processes can find good stocks.

Do your own research

Fundamental and quantitative research will

never go out of style. Understanding the constructs of and the principles behind price- earnings (PE) ratios, EPS growth, balance sheets
and cash flows is non-negotiable. The same
applies to discounted cash flows you dont
have to be able to build a discounted cash flow
model but you must be able to understand it.
For instance, if the price of oil goes up 20%
or gold is discovered, you need to be able to
calculate how that will affect a share price.
Investors also must be able to deconstruct
a company: how it operates and generates its
profits; its key advantages; key risks in its busi-

Information is scarce on microcaps and share

prices are volatile. Research and discipline
are the core of microcap investing, where
knowing a company and understanding its
operations and industry are critical.
Information is limited because brokers
cant recover the cost of producing research
on them and media only cover better-known
companies. Good stories eventually break
through but in the early stages of a companys
development, information must be sought.
That is the opportunity with microcaps, in

DIY, unit trust or LIC?

Microcaps can be accessed directly via shares
or outsourced to an investment manager. Given
sufficient time, resources, skill and inclination, most investors can create a diversified
portfolio of 20 or so stocks robust enough
to withstand shocks to one or two of them.
But it is hard to do this continually never
mind to sleep comfortably at night (share
investing carries risks and microcaps prices
can be extremely volatile) where an event
such as an unexpected revenue fall can have
a significant impact on value. Its no surprise
that fund managers have teams of five to 10
people focusing full time on these companies.
There is no best or one-size-fits-all way to
manage your microcap exposure. One option
is to allocate 75% of your exposure to two or
three fund managers, and perhaps 5% in each
of five securities you know well.
In many instances, investors can only access
specific fund managers via listed investment
companies (LICs), which are increasingly
popular for their dividends and franking as
well as the transparency and control they
offer. LICs focusing on small and microcap
stocks include Mirrabooka, Ozgrowth, WAM
Capital and Contango MicroCap.

Know thy company

Getting in

getty images

n mid-2014, Commonwealth
Bank was worth more than the combined value of every ASX company
outside the S&P/ASX 200. Out of
nearly 2000 companies listed on the
ASX, the 13largest had a combined market cap
greater than that of all other listed companies.
This extreme concentration leads many
investors to miss those small company and
microcap opportunities that can provide
diversification, opportunity and performance
to their investment portfolio.
Generally, most sharemarket investors with
a time horizon beyond five years could comfortably allocate 5%-15% of their portfolio to
microcaps. Some investors may be surprised
to discover they have that much invested in
one or two large-cap stocks alone.
For 2014-15, microcap investment manager
Contango sees solid but not stellar growth of
around 3% as the economy transitions from
mining to non-mining investment and consumption. In this environment, the preference
is for companies with solid growth profiles
and high free-cash-flow yields, while avoiding low-growth defensives and pure yieldtype companies.
The small-cap sector typically outperforms
large caps when risk appetite is strong. While
that might not describe the current environment, there are always select opportunities,
particularly in well-managed, small industrial
companies with strong earnings per share (EPS)
growth prospects and solid balance sheets.
Investors may do well to remain cautious
about small companies exposed to mining,
particularly if they are at an early stage or have
large debt. In a stronger growth environment,
where bond yields and commodity prices typically rise, investors can increase their mining
exposure. Until then, find a combination of
high-quality companies with attractive valuations at the right point in the business cycle.
From a fundamentals perspective, the micro-

When choosing stocks, dont rely on stereotypes. Each company is unique and has a price,
so dont invest in a company because of one
feature, such as it being a rare earths company.
But dont not invest in it for the same reason.
Look for a balance and avoid holding too many
of the same type of company. A diversified
portfolio holds at least 20 microcaps.
Know why you are investing in the company. Create a folder for every investment
you consider, build an investment checklist
(an example at right) and stick to it. Be rigid,
disciplined and methodical. If you decide to

invest in a stock, detail why you like it, why you

invested in it and at what point you will exit it.
Plan your trading strategy and tactics for:
Getting set. How will you accumulate
your position and how might that affect the
share price?
Managing the investment. What are your
actions on price falls and after negative or
positive news?
Getting out. Is your eye always on the exit
door and what do you do as you get closer to
your target price?

Patience pays off

The sharemarket transfers wealth from the
impatient to the patient. There is a case for
investing in microcaps but discipline, research
and patience are required. A lack of microcap research gives hands-on investors the
opportunity to be ahead of the market and
find quality investments at the right prices.
Microcaps can be both exhilarating and
financially rewarding. But diversification
is critical to ensure portfolios are protected
from shocks for which even the best research
cannot prepare you.
Astute investors who prudently allocate to
microcaps will be well positioned to capture
the growth as they progress from micro into
successful, well-known companies.
Boyd Peters is national distribution manager
at Contango MicroCap.

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investor checklist

Be methodical and thorough

before and after you buy

Did I write a paragraph explaining

why I would invest in this company?

What information is in my research

folder for this investment?

Am I looking to generate income,

capital growth or both?

Which the valuation methodologies apply to this company?

Where is this company in relation

to its life cycle?

The time frame I give this

investment.

A list of my investment behaviour

traits.

How I have ensured I am avoiding

them?

What I like about the sector this

company is in.

What I dislike about the sector.

Where will the return(s) be generated on this investment?

What is my price target for this

company?

Why do I believe this is achievable?

What rate of return does this

investment indicate?

What other rates of return are

being offered at this time?

When did I last deconstruct the

company?

Who are their largest client(s)?

What impact would losing a client

have on its revenues?

What money is funding this investment?

What do I believe about the online

chatter I hear?

How do these shares tend to trade

on the sharemarket?

What I have observed about the

trading patterns for this stock.

Who at the company have I spoken to?

How accessible to shareholders is

the company?

Who are the largest shareholders

of the company?

Have I told someone why I will

purchase this stock?

Did I go for a walk before I pressed

buy?

Money august 2014 79