As any experienced microcap investor could tell you, investing in microcaps presents many unique challenges, not the least of which is finding good ideas for further research. While there is a plethora of data, analysis, and broker reports available for large, mid, and even small cap companies, investing in microcaps requires a decidedly more ‘hands on’ approach. Whether it be trawling through annual reports, diligently checking each ASX announcement every day, or attending meetings in person, there’s no escaping that investing in this part of the market requires some work. But those who put in the work, may be handsomely rewarded.

In today’s Collection, we hear from five different microcap managers about how they generate new investment ideas. They also discuss some of the unique risks to be aware of when investing at the smallest end of the market.

Responses come from Nick Guidera, Eley Griffiths Group; Harley Grosser, Capital H Management; Oscar Oberg, Wilson Asset Management; Scott Williams, Fiftyone Capital; and Shane Fitzgerald, Monash Investors.

There are many ways to generate fresh ideas

Nick Guidera , Eley Griffiths 

Uncovering the next A2 Milk or Afterpay early in the company's journey is the product of good industry research, understanding the key stakeholders and trends, both quantitative & qualitative fundamental analysis as well as an inherent openness to new business models, technology and concepts that challenge your historic beliefs. Good fortune can also not be discounted as timing can be everything.

Idea generation can take many forms hence many methods can be useful. We have discovered emerging companies through our examination of the supply chains of larger listed players. Take A2 Milk as an example, its key infant formula manufacturer Synlait was once a microcap with the market taking time to ascribe the appropriate value to its Chinese registered manufacturing capacity, concurrently the importance of DHA as a differentiated ingredient led us to discover Clover Corp.

Global trends spawn entrepreneurs the world over and typically they require access to capital. Great management teams articulate how their business models are taking advantage of a global trend. By taking the time to understand universal movements such as cloud computing and the stakeholders involved, ideas such as Rhipe - a Microsoft Azure & 365 partner emerge or Megaport with its software defined networking approach to data centre connectivity, are discovered.

With an investable universe of over 400 stocks, many of these conceptual or pre-revenue and a substantial number without formal analyst coverage, we often start with a screen of our universe against several current/historical financial metrics. Some which include revenue/earnings trajectories, the ability to generate operating cashflow, Return on Equity benchmarks and multiple valuation metrics. From the results we conduct a detailed critique of each business model.

Often overlooked is a company’s Annual Report. While the length can be daunting, direct insights from directors and management on how the business makes money, key opportunities and risks, and an audited set of accounts is one of the most effective ways to come up to speed on any listed business.

Unique risks among microcaps

Liquidity is often the most under-priced risk in any microcap portfolio. As an institutional investor with larger pools of capital to deploy, the ability to back management with a significant financial commitment, likewise, taking a decision to reallocate capital as markets change, requires significant discipline around managing to liquidity filters. By maintaining a focus on average daily turnover as part of any investment decision, it ensures we don’t put our investors capital at risk in a downturn, as retail investors can look to liquidate positions at deep discounts to realise cash.

Corporate Governance is also in its infancy in many microcaps with some boards under-resourced and many yet to transition from private to public life. Ensuring we understand the makeup of the board, the background of the Chairman and the board’s working relationship with the Managing Director/CEO, can be a very useful risk management tool. A greater understanding that strategic alignment runs from the top down, and determining who ultimately is in control of a business’s destiny, will assist in better investment outcomes.

Expectations, whether they be too great or too little, can also be the source of much joy and pain in microcap investing. With the absence of consensus in many microcaps, taking the time to evaluate how the market may be positioned for a particular outcome or result, can be a very effective tool in risk management. Adjusting position size to reflect risk outcomes, will ultimately reduce the downside should expectations not be met.

The early bird gets the worm

Harley Grosser, Capital H Management

My process is completely manual. Most microcaps that we are buying won’t show up on a filter or screen as interesting opportunities. By the time they do they’ve probably already re-rated to some degree, at which point they may still be great buys (and we might be buying more), but I’m trying to get there a bit earlier.

There aren’t that many listed microcap stocks in Australia. If this is your full-time job it is not that difficult to manually trawl through everything and start building a database of meeting/call notes, financials and discussions with management teams that, over time, becomes meaningful and allows you to move quickly if and when there is a catalyst to justify doing so.

Be optimistic, but realistic

The reliance on management is magnified to the extent that your thesis may be entirely reliant on one or two people. In microcaps, the CEO is often the founder and largest shareholder. This just requires you to do more work on the management teams.

By definition, a lot of microcaps aren’t yet at scale and so they are more exposed to cycles than large caps. Their good years can look great and the market will price them as if this will continue forever, which occasionally provides an opportunity to exit. And then they’ll have hiccups that the market will also price as permanent, which often provides opportunities to buy.

It is the really rare ones that can go from microcap to a business of scale and enter the ASX 300, then 200 and so on, but be aware that the vast majority won’t be able to do this. If you do happen to find one, don’t let it go!

If you approach microcaps with a realistic optimism, knowing the majority will never graduate to institutional grade, you will probably be better off in the long run.

Understanding the entire value chain is key

Oscar Oberg, Wilson Asset Management 

Investing in microcap companies provides significant opportunities and considerable risks. As a microcap fund manager, you must be rigorous and highly diligent in your process. At Wilson Asset Management, we go through every ASX announcement throughout the day, providing us with a greater awareness of the market in general and of the latest company developments. We also regularly use screening tools to filter for new ideas, such as screening for price movements or valuation metrics.

Meeting with companies, customers and suppliers in the listed and unlisted sections of the market also help us generate ideas. By doing so, we gain a better understanding of the value chain within an industry and are better placed to therefore identify new opportunities early.

Three important risks to consider

Generally, the smaller a company, the less diversified its business. This means that certain products, divisions or even geographical exposures can affect the performance of the entire company. We manage this risk through rigorous on-the-ground research, such as visiting the offshore divisions of the company and regularly cross-checking with customers and suppliers to test our investment thesis.

In the microcap space, share prices can change quickly which is partly driven by lower liquidity relative to the larger companies. We find that managing this involves having your finger on the pulse at all times through extensive research.

Another risk of microcap investing is that a lot of the products are not household names compared to the larger end of town. Consequently, this can involve more digging to verify the business model or the strength of the product. Ensuring management is aligned with minority shareholders is also crucial. This is either through management having material shareholdings in the business or having the right short-term and long-term incentives as part of their remuneration package.

Reading, meetings, and don’t forget Livewire

Scott Williams, Fiftyone Capital

Finding great ideas in microcap world for us normally starts with an introduction from someone within our network. We also follow a lot of other funds and read people’s views on platforms like Livewire, which is a great source for ideas and alternative views. Having a network where information is shared and published can be a great start.

Normally once you find a company or a theme you like, then you need to dig deeper. A good example is with the recent iron ore price rally, many small caps who once had un-economic projects, suddenly looked very attractive. But finding the right project, people and company to invest in can be a difficult task. It’s about having the foresight to see beyond the short-term price moves as sometimes these small companies have doubled, tripled or more. But when you look at the fundamentals, they can still be very good value.

Using iron ore as an example, as the big miners like BHP/RIO/FMG started to move on the iron ore price rise, there were other less known companies like CIA and FEX that we took small exposures in that obviously give you far more leverage to the thematic. Both companies  were introduced to us from our broker network at presentations we attended. As a fund, it can be sometimes difficult to buy such positions in a size that would generate good returns, but as you can see, the performance of these smaller companies in percentage terms since the start of the year far exceeds that of the bigger, more established players.

Don’t be drawn in by the “get rich quick” appeal

The biggest risk is the promotional nature of many of these smaller companies and the promoters doing so. Coming from a broking/corporate background we are always interested in knowing how a deal was put together, what the history is and who the people involved are.

Unless you are prepared to do extensive due diligence, speak at length to management, suppliers and or people connected to that company and then to understand the risk/rewards of the opportunity, it is an area of the market fraught with danger. Unfortunately, we see far more people attracted to the ‘get rich quick’ nature of small caps, without understanding what they own or why they own it and having no clear exit strategy.

Outsized opportunities come with higher risks

Shane Fitzgerald, Monash Investors Limited 

Microcaps are attractive due to the oversized returns that can be generated, however with this comes higher risks. It is relatively easy for a stock with a $100m market capitalisation to become $200m, however, it is actually very difficult for a $2bn market capitalisation stock to become $4bn. Conversely, it is relatively rare for a $2bn market capitalisation to become $1bn, but it is easy for a $100m market capitalisation to become $50m. The point is that volatility in the microcap space is much higher and that can lead to investment opportunities.

When it comes down to finding new microcap ideas, there is no substitute for hard work. Reading as many presentations / announcements / websites etc as you can. Attending as many presentations, management meetings, conferences as you can. It is only by seeing many different opportunities that you can gain some sense of those worth backing. We also fall back on our experience and the patterns of reoccurring behaviour we see all the time in the market to inform us of the opportunities worth further consideration.

Screens can be of some use as they can narrow the field. Ultimately, it is only the knowledge gained from in-depth research that allows informed decisions to be made.

Watch the gap!

There are many unique risks in investing in microcaps, and one of them is managing the life cycle of the investment. Often a microcap stock is an early stage business or concept stock, a business that is looking to develop a new market opportunity. During the early stages of its life cycle all there is to judge the stock on is the opportunity itself, hence it becomes all about the potential or blue-sky in the business. However, at some stage the business will start to execute, generate revenues, cashflow etc. When the “rubber first hits the road” there almost always is a disconnect between the blue-sky which has driven the share price and the early performance of the business. It is also common for the time it takes to gain meaningful traction to be much longer than expected or originally communicated by management. It is usually during this phase of the life cycle that the share price underperforms, as it simply can’t live up to the expectations the market has formed when it was all about the concept. In the final phase of the life cycle, the stock can either go on and execute successfully against the blue-sky and potentially become the next ASX100 stock, or at the other end of the spectrum fail to generate any meaningful traction and the share price crashes. Obviously, there are more in the latter camp.

The balance sheet is also a particular focus, as more often than not microcaps are not generating positive cashflow, and therefore the length of their runway is critically important. Once the runway shortens to less than 12 months, it all becomes about the balance sheet and the next capital raising. Everything else is irrelevant. Repeatedly we have seen microcaps announce what would normally be extremely well received pieces of information, but if there are questions over the balance sheet, then the share price will not react.

Liquidity is also a key risk. While it can be tough to get set in a microcap, it can be extremely challenging to exit as this will usually be as result of the investment case not playing out as expected and coincide with investor interest in the stock falling dramatically.

As with all risks associated with microcaps the best way to manage them is to keep the portfolio weight modest, to continue meeting with management and focus on any changes / modifications in the story. It is only over time that you can gain a good understanding of management and the performance of the business.

More from this series

• Part one: "6 unique microcaps under the radar (for now)".

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