8 stocks with untapped earnings growth potential

Investor sentiment can be an incredibly powerful tool for those in the know. Ongoing concerns about a global recession, caused by high inflation, big interest rate hikes, and ensuing liquidity crunches, have created a flight towards quality assets. 

Quality large-cap stocks, quality bonds, and even quality term deposits for the extremely risk-averse investor.

And especially after the experience of 2022, this move away from the illiquid and smaller end of equity markets would be understandable. But Forager Funds Management's global equities team sees things very differently. They argue that these companies actually present the best mis-pricing opportunities, leading to where the best risk-adjusted returns can be found. 

In this wire, I'll share the Forager International team's thoughts on why the set-up for small-caps is looking much better. Plus I'll share five small caps (and two large caps) that demonstrate why leaning into negative investor sentiment can pay off big time.

Managed Fund

Forager International Shares Fund

Global Shares

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Fast fund facts

• 20-40 stocks in the fund, with any ex-Australian stock a potential investment
• A mix of high quality and under-appreciated companies with growth and value qualities
  
• 66% of holdings have a market cap of under US$10 billion
• 55% based in US, 24% in consumer discretionary stocks
  
• The fund currently has 9.5% in cash, described as a "typical" positioning for the portfolio

Current market views

In his classic, no-filter way, Forager CIO Steve Johnson explained the fund's process.

"The whole approach is to build up a really nice list of businesses that we want to own and buy them when people are doing something stupid and selling them at silly prices," he said. "And it can be just wider market panic or sector-related panic when we take advantage of other people's distress."

As is with many things at Forager, there is a focus across both the small and large end of the markets. But in the context of this fund, Brown noted smaller companies make up more of its composition for one very simple reason.

"We tend to find the greatest potential for mis-pricing and therefore, outsized returns from those smaller stocks," he said.

Migotti also added that the small cap set-up is looking very attractive thanks to significant discounts. But when will those investments start to pay off?

"On a micro level, once people have a visibility that the earnings trough is in, stocks tend to re-rate and will move higher," he said.

Five of their highest conviction small-caps

In this next section, I'll go through five of the sub-US$10 billion companies with large positions in the portfolio. 

Blancco Technology (LON: BLTG) - The London-listed data erasure and diagnostics business is the fund's largest individual position. It's also a large bet that Brown admits will need to make substantial leaps and bounds if it's to maintain its place in the fund. 

"This is a globally dominant business but in a very tiny leach. It's a very illiquid stock. We think it can grow really quickly but we require it to grow quickly. If we don't get a 20% return annually in terms of sales growth and margin expansion, we're unlikely to continue owning it."

Installed Building Products (NYSE: IBP) - Despite housing sentiment being so poor in the US, the company's share price is up 23% this year. The team believe the company is still in the early innings of a major market opportunity in a fragmented industry.

At first, the team was impressed by the company's ability to acquire and integrate rivals into its core offering. But the thesis is now revenue and margins-centric.

"We think there is still a lot of runway to go in the consolidation opportunity and that IBP has proven themselves as a preferred acquirer in the market," Stokes said. "We're continuing to see margins expand year-on-year because of the company's pricing power."

Flutter (LON: FLTR) - Widely considered the global leader in the online sports betting market, the team is particularly excited by the fact its US operation will likely be profitable this year - well ahead of its industry peers. It also continues to win market share in an area that will likely lead to a lot of cannibalisation.

"We thought Flutter being an international conglomerate was a huge value-add rather than something that deserved the discount," Brown said.  

The fund's position in Flutter is also relevant given the recent sale of Pointsbet (ASX: PBH) to American rival Fanatics. When asked about the transaction, Brown described the Australian-run company as an "also-ran".

Open Lending (NASDAQ: LPRO) - Another company that is, in their view, under-appreciated by the market and can still grow operating margins in a tough environment. The company specialises in automotive loans, and has been impacted by the massive supply chain backlog for new and used cars.

But those headwinds, in Migotti's view, are starting to abate.

"We think the underlying quality of the business is under-appreciated by the market," Migotti said. "We actually think the downside is limited relative to where it was 12-18 months ago."

The company's share price soared recently despite reporting a double-digit fall in loans, revenue, and net income. Its revenue guidance for the second quarter is also far weaker than the update given just three months ago.

Yeti (NYSE: YETI) - Despite a difficult backdrop for consumer-exposed stocks, the team argues this is one under-appreciated business that could double its size in the next few years. It will all boil down to strong management, its geographic expansion plans, and product innovation. 

And two larger stocks...

In the small end of the market, having an information edge is a big advantage. Knowing which companies are on the precipice of making big waves in their industries through deep analysis of both fundamentals and macroeconomic landscape could be a big help to any investor. But in the larger end of town, that edge slips away given how much analysis is available on these companies.

So when the team was explaining its in Meta Platforms (NASDAQ: META), they referenced the need to maintain a different kind of edge - psychological.

"The stock pretty much became untouchable and it was essentially priced like it would never grow again," Stokes recalled. "But holding our nerve through what was a very difficult period in this stock was vital." 

Stokes said the fund is continuing to lighten its position in the Zuckerberg-led company (it owns less than half of what the stake it owned back in November 2022) and will continue to do so if the share price rallies.

One of its other large-cap positions is in UK supermarket chain Tesco (LON: TSCO). The fund reinvested in the company in late 2022 after it demonstrated an ability to regain market share from German chains like Aldi. As markets become more heated, the fund will pivot to stocks like Tesco in a bid to preserve capital.

As a last side note, the team also has a small exposure to Japanese stocks. In particular, the fund has had a long-term holding in technology giant Sony (TYO: 6758) as well as some other machinery-related companies.

If you want to catch the entire webinar, you can rewatch it here:

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