Zeroing in on small-cap value

‘As one broker said to me, the bears have no shares’

A tiny sample of micro and small-cap technology stocks with elevated exposure to key mining and metals market themes has generally felt the brunt of headwinds impacting companies in the space globally in the first half of 2023, though Chrysos Corporation and New Zealand’s Scott Technology had a better time of it than others.

Mineral assay market disruptor, Chrysos, and robotics firm, Scott, traded 74% and 24% higher, respectively, during the period and both have basically defied gravity in also being up over the past 12 months.

At the micro end of the scale, Canada’s Minerva Intelligence more than doubled in price in the first half of 2023.

Larger companies with significantly higher annual recurring revenues and profits, ASX-listed Imdex and RPMGlobal, reflected broader global tech-sector stock buffeting during the period. Both finished June well down on highs reached during the previous 12 months.

Australian fund manager, Perennial Partners, which has small and microcap share funds, says portfolio company RPMGlobal might be typical of the “opportunities” available in the micro and small-cap space with its solid balance sheet, predictable sales and improving margins (increasing exposure to the mining software market).

“It’s still very early days … but we are seeing some signs of recovery,” Andrew Smith, head of smaller companies and microcaps, said of indications improved sentiment and liquidity in parts of the sector were pushing stocks higher.

“In many cases it’s as simple as one or two new investors appearing on a register.

“There are not many sellers left in these stocks and the stocks are starting to move higher.

“We’ve been talking to a panel of brokers every month about [their level of] interest in small and micro-cap companies. What inbound interest are you getting? And for a long time it was zero interest in any new small or micro-cap names.

“We’re now getting into double digits … Those same brokers are talking about 10 or 12 funds that are looking at new names. There’s an ability to be a bit more active across the space. Liquidity is improving, but still remains well off its highs.”

Beyond end-of-financial-year tax-loss selling of equities and other investor house-cleaning, “it’s very hard to see where the source of selling will be in this space”, Smith said.

“As one broker said to me, the bears have no shares.

“They’ve already sold; they left last year.”

Smith said on Perennial’s latest small/micro-cap investor webcast the firm “probably under-appreciated the length and the magnitude of the selling pressure” on Australian small-cap equities that followed changes to the country’s superannuation laws in 2021.

“[The changes] forced industry funds – big superannuation funds that are the largest player in the Australian market – to benchmark themselves against the ASX 300,” he said.

“So the risk return didn’t really stack up [for investors in] any stock outside the ASX 300. We saw a lot of redemptions from small-cap managers that industry funds were using and we saw them exit the microcap space almost completely. This put a huge amount of selling pressure on any small-caps but particularly any stocks outside that ASX 300.

“We saw many [small-cap fund] managers who can typically have between 10-15% held in microcaps take that right down to zero in many cases. Anything below half a billion dollars [market value] has largely been ignored by both industry funds and mainstream small-cap managers … and only now are they starting to look to come back into the micro-cap space.”

Smith said, at the index level, there was continuing “extreme divergence between small and large industrials”.

“Digging further down to micro-caps … it’s the best value we’ve seen since the GFC.”

In the US and Canada, small-cap public companies had seen similar “drastic under-performance versus large-cap” firms, BNY Mellon portfolio manager and analyst, Andrew Leger said on a recent webcast.

“On a relative basis [relative to the S&P 500] valuations are at 30-year lows,” he said.

“[But] valuation alone isn’t going to do much for you. The question becomes, when do the circumstances change?

“I think taking a step back what’s really changed is the break in the 30-year down trend in interest rates. Over the last 10-20 years capital has incrementally flowed more to private equity and venture capital at the expense of small-caps. PE and VC tend to … react unfavourably to higher interest rates, whereas small-cap … actually benefit relatively from higher interest rates.

“[Our] working assumption would be the reallocation of [financial] plans going forward would favour incremental capital flowing back into small-caps.

“Coming out of downturns, small caps typically start new cycles at the lows of current cycles. We’re coming off this period of under-performance [and] prospectively we like the set-up for small-caps as we head into a potential recession.”

Perennial’s Smith says in Australia a recent positive signal for small-cap public equities has been the nation’s circa-US$136 billion Future Fund flagging small-cap investment allocations, “for the first time in their history”.

“That’s one of the biggest investors in Australia who isn’t benchmarked against the ASX 300,” he said.

“They just have to beat inflation.

“And they’re seeing the inefficiencies in small-caps as a great way to do that.

“That money has started to find its way into the small-cap market. So that’s a positive first step.

“We’re also seeing quite a lot of corporate interest in the space … [and] this sort of corporate activity does create interest because other managers will start looking for excess returns in areas where they think there could be corporate interest and that could push some of those managers back to the microcap space.

“As I mentioned, small-cap managers typically have a 10-to-15% allocation to micro-caps [and] most are at zero now.

“Even if it comes back to 5% that incremental buying could be quite positive.”


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