By Gabriel Yi, Managing Director of M3 Investment Group
In a turbulent year for Australian equity markets, we have seen many structural shifts in investor appetite: the commodity bulls have come out from years of hiding to make the mining and material sectors the best in class for 2016, the growth mid-cap sector has experienced weakness in recent months from risk-off trends, and the high yielding, bond proxy shares have also been sold off along with bonds.
It’s been more difficult to find many screaming undervaluations in the large cap stocks, we’ve been seeing weakness as well as much lower liquidity in the mid cap stocks, and the small caps have had a stellar year but many opportunities have become crowded. This leaves us with the microcap sector. We classify microcaps as stocks with market capitalization of under $250 million. We aim to identify the businesses in this space that are capable of becoming much larger over time and many of the same valuation principles used to identify small-mid cap opportunities are implemented to uncover the gems in the diverse microcap world.
Since microcaps generally lack the long track history of larger, more established businesses, it is important to focus on the quality of the management team and it is a good sign if they have had previous successes in growing businesses from the ground up in a similar field. We want to find companies that have a strong product or service, with strategies or disrupters in place to take market share from the larger competitors. While it is difficult to find in the microcap space, a strong balance sheet is a big confidence booster. The following 10 microcaps have piqued our interest and are ones to look out for in 2017:
- Data #3 (DTL)
A provider of corporate IT solutions, DTL generates revenue from the resale of its partners’ IT products (Microsoft, Cisco and HP), the provision of outsourced IT functions and the design and implementation of custom IT solutions.
The growing adoption of the cloud as an IT platform for businesses and large organisations drive DTL’s growth, as it takes advantage of its product knowledge and experience in designing, implementing and maintaining custom IT solutions to create new annuity-style revenue streams. The rock-solid balance sheet with $100m in cash and low debt makes DTL even more attractive.
- Gentrack (GTK)
An Auckland-based software company, GTK has been providing specialist software for utilities and airports for almost 3 decades. GTK is the clear market leader in mission critical CRM and billing software for utilities in New Zealand, and has a sizeable presence amongst Tier 2 utilities in Australia and the UK. GTK’s airport management software is also utilised in the majority of both New Zealand and Australia’s largest airports (including Sydney & Auckland Airports) with a sizeable presence in the UK. Profitable with no debt, we see GTK’s continued growth to be driven by the deregulation of the electricity and water utility sector in the UK, and then by the adoption of smart grids/metering which will require upgrades to existing billing systems.
- Adacel (ADA)
Adacel provides flight simulation and training as well as air-traffic management software and systems. It is a true global player (which is especially hard to find in the Australian market) with most of its revenues generated internationally from contracts with the US Department of Defence, various civil aviation authorities and other aviation organisations. Given its long history as a partner with these entities (ADA was founded in 1987), ADA has built a significant recurring revenue stream from servicing implemented systems that provide a degree of stability to earnings, in an industry that typically experiences lumpy earnings cycles.
- Clover Corporation (CLV)
Clover Corporation is a manufacturer of ready to blend Omega-3 fatty acids and other nutritional lipids for use in infant formula and other dietary supplements. CLV uses a proprietary encapsulation technology that masks unpleasant tastes and odours which makes its products ideal for use as a nutritional supplement.
Approximately 50% of CLV’s revenue is generated from customers in Australia and New Zealand, with about 40% generated in Asia and 10% in Europe and the Americas. It is leveraged to similar structural drivers behind the rising consumption of infant formula in Asia.
- Austin Engineering (ANG)
Austin Engineering is a manufacturer of specialist mining and earthmoving equipment used in the mining industry. It specialises in off-highway dump truck bodies along with mining excavator buckets manufactured under the JEC and Westech brands. Following an equity raising and asset sale in 2016, ANG’s debt load has been substantially reduced. With that stronger balance sheet, ANG is well placed to benefit from a potential turn in the mining investment cycle.
- Senatas (SEN)
Senetas is a manufacturer of defence-grade, high speed data encryption devices and solutions to governments and corporations globally. SEN focuses mainly on products for Layer 2 networks, which are typically high-bandwidth connections between multiple Local Area Networks. The continuing rapid expansion in data generation and traffic and the increasing awareness by governments and corporations of the need for security to protect this data from hackers and other malicious threats, should provide a strong secular tailwind for SEN’s core cybersecurity offerings. With strong earnings momentum, having 19% revenue growth / 30% NPAT growth over FY16, SEN is an interesting growth prospect for the future.
- RXP Services (RXP)
RXP Services is a digital design, IT and data consultancy firm and services a range of commercial industries and various government agencies. RXP operates five core specialist practices (customer experience, transformation management, data management, IT optimisation and software development) which provide significant cross-sell opportunities to its existing client base. Its growing diversified client base and focus on strategic acquisitions can help carry RXP’s strong momentum throughout FY17.
- LifeHealthcare Group (LHC)
LHC is a high end medical device distributor in Australia and New Zealand. Its strategic acquisitions in Interventional Cardiology and Ultrasound divisions have contributed to a strong FY16 earnings result with 15.6% revenue growth / 11.6% EBIDTA growth. The ageing population and introduction of new products and active surgeons underpin LHC’s prospects of future growth, and its strong historical dividend yield looks very attractive.
- Praemium (PPS)
A provider of investment platforms and administration tools, Praemium has continued to grow its asset inflows and this is evident in its 23% revenue growth in FY 16. PPS has no debt and its Software as a Service (SaaS) business model is subscription based which allows for recurring revenue. It’s had a stellar run this year but if they continue to win new contracts and inflows, we are excited for Praemium’s long term outlook.
- McPherson’s (MCP)
A consumer products business, MCP markets and distributes a diverse range of health and beauty products as well as household consumables and durables throughout APAC, UK/Europe and North America. McPherson’s have consolidated their products to focus on the high margin, market leading brands and it is looking to accelerate their expansion into China, devising multi-channel approaches to the distribution of its products. MCP’s high fully franked dividend is also attractive.
Microcaps can be an exciting space, more so if you are able to invest early and watch the businesses grow into blue chips over time. But as always there are risks. In order to avoid the common pitfalls of this space such as poor capital management and strategy execution risk, ongoing due diligence is a must. There are gems that can shine through with enough research, patience and a little bit of foresight.
This content has been prepared without taking into consideration any individual’s particular objectives, financial situation and needs. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.