Amid one of the direst economic environments since World War 2, ASX small caps are living up to the spirit of Australian ingenuity. Through hard work and creativity, quality management teams are finding ways to survive and even thrive in adverse conditions. For investors, the question is which great businesses are still available at a reasonable price given the market rebound?
In this episode, Dean Fremder of Perpetual Investments and Simon Conn from Investors Mutual take a stand on the following stocks: 1) Nanosonics, one of Livewire's most-tipped small caps; 2) Service Stream, whose management remains upbeat on the company's earnings and dividend prospects; and 3) InvoCare, which in April undertook a placement to strengthen its balance sheet and support growth plans.
Dean and Simon also each bring along two under the radar quality small caps trading at attractive discounts to intrinsic value.
Notes: Watch, read or listen to the discussion below. This episode was filmed on 17 June 2020.
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Vishal Teckchandani: Welcome to Buy, Hold, Sell, brought to you by Livewire Markets. My name is Vishal Teckchandani, and today we're discussing quality small caps. These are companies with robust balance sheets. They're generating cash, but they do come at a price. The question is, is it one worth paying for? Joining me on the show today is Simon Conn from Investors Mutual and Dean Fremder from Perpetual. Dean, let's start with you, Nanosonics, one of Livewire readers' most tipped small caps. Are you with them? Are you against them? Buy, hold, sell?
Dean Fremder (Sell): Sell, unfortunately, I'm against them. It's an awesome business, and we'd love to own it, love the business model. Unfortunately, the valuation just escapes us. And ultimately, at today's prices, you're being asked to not only pay for the next 10 or 20 years worth of perfect execution in growing their current product, but you're actually also being asked to pay for perfect execution of their second product, that they haven't even announced to the market, what it is yet. So a great business, but we're not really excited about paying for 10 or 20 years worth of growth upfront, particularly, if we don't even know what they're going to be selling.
Vishal Teckchandani: Simon, it's got $82 million of cash on its balance sheet, nearly no debt, plays in the very central area of infection prevention. What do you reckon, buy, hold, sell?
Simon Conn (Sell): It's a sell. You're paying two billion dollars for $100 million dollars of run-rate revenue. Extremely, at 20 times revenue, it's a great business and I get the recurring revenue. But again, two billion dollars, you're paying a lot. And I know they've talked about the second product. I think they've started talking about the third product before they've even released the second product, which is just a bit of a warning sign for me, but the valuation's very rich.
Service Stream (ASX:SSM)
Vishal Teckchandani: Okay. Next stop, Service Stream Management, came out in May, reaffirmed that they'll generate record operating EBITDA and have committed to paying ongoing dividends. Buy, hold, sell?
Simon Conn (Hold): I think it's a hold. It's an okay business, but I'm always a bit wary of contractors, particularly, with a concentrated customer base. Your margins are a product of what your customers can tell you. Look, they've made good money over the NBN rollout, but we're now migrating to a different phase of the NBN. So look, it's a good management team, balance sheet's okay, but for a contractor, 15 times is about as much as you want to pay. So it's at a hold to a sell.
Vishal Teckchandani: Dean, SSM is on a 12 times PE ratio, circa 5% fully franked to yield. Share price has come off a bit, screaming bargain or Pandora's box?
Dean Fremder (Buy): It's a buy for us. It's a super-boring business, but we love that. Ultimately, it doesn't matter whether the economy is booming or in recession, if Sydney Water, one of their pipes leaks, they're going to get it fixed. So very resilient through what could be a tough economic environment ahead. To us, it's cheap. It's got a very good balance sheet, it's net cash of 5% fully franked yield roughly. Sensible management team with a good track record, and they'll buy some things to bolt onto their business, which we think it would be really attractive. So buy for us.
Vishal Teckchandani: Dean, death and taxes, two of life's unavoidables. InvoCare manages to specialise in one of them. Buy, hold, sell?
Dean Fremder (Hold): It's a hold for us. Clearly, a very defensive and attractive industry. You don't need to worry about whether your customers will turn up, which is a nice thing. So InvoCare, they dominate the space, clearly something with great long-term earnings potential. What keeps us a little bit at bay is, we're still waiting to see the returns from their big capex investment programme in recent years. You've seen some announced senior management turnover recently, and the stock's quite expensive still, so we'll sit on the sidelines for now.
Vishal Teckchandani: Okay. Simon, the company did raise more than $200 million recently to strengthen its balance sheet, pursue some potential growth optionality. Is there fun in funerals? Buy, hold, sell?
Simon Conn (Hold): Fun in funerals, well, at least you can go to a funeral now whereas for a couple of months, you couldn't, which I think was makes for huge uncertainty. But look, actually, I think I'm quite positive on the new management team. There's a new chairman who I know from previous other companies. There's a new CFO, just been announced today, who I have high regard for. Look at the low $10s, when you can get a 4% yield on a pretty solid balance sheet and a pretty recurring predictable business, I think it was a buy. Around the mid $11s, it's probably a hold. But if you can buy it in that low $10 price range, I think it's a good business. They have been spending a lot of catch up capex, but that will come to an end in 12, 18 months time. And I think when that comes through that business will start generating more cash going forward. Pretty defensive business, pretty boring, but pretty safe in these times.
SkyCity Entertainment Group (ASX:SKC)
Vishal Teckchandani: Alrighty. We did ask our guests to BYO one quality stock trading at a reasonable price. Simon, what have you got for me?
Simon Conn (Buy): We really do like SkyCity. They've been raising money in the current market, but very strong balance sheet. Apart from that, it really reflected the fact that their gaming activities in Auckland and in Adelaide were shut down for a period of time. But I think we're seeing increasingly as the economies open up, people are getting back to their normal habits and gaming is a pretty resilient business. So the main gaming floor is in Auckland and has traded very well since the level three and four restrictions have been wound back. So the business generates good cash, has a strong balance sheet, trades at a small premium to book value. And the balance sheet is obviously, stronger now since the capital raising. There's a lot of value in the asset, in the business. The online business now is starting to generate some earnings for them. Good management team. We quite like it in the mid-$2s.
QANTM Intellectual Property (ASX:QIP)
Vishal Teckchandani: Dean. What's the quality stock you're itching to tell the world?
Dean Fremder (Buy): Sure. For us, it's QANTM IP - QIP is the code at the smaller end of town. So they're the second-largest intellectual property law firm in Australia. And they've got a nice growing Asian business. And the great thing about intellectual property law is, it doesn't matter, again, if the economy is in good times or in bad times. Just because the economy might be slow, Google's not going to stop paying to reinforce that patent on its search algorithm. So really resilient earnings, trades on nine times PE. It's got a healthy balance sheet, 7.5% yield. It's a buy for us.
Vishal Teckchandani: Invest in quality small caps, find good value, and your returns may just go... quantum.
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