Overlooked micro caps offer fertile hunting grounds

Microcaps are a big universe and screening tools help you sort through it, but they're blunt tools on their own. Luke Winchester from Merewether Capital believes that successful microcap investing also requires knowledge of business models, people and red flags. 
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Merewether Capital founder Luke Winchester has built a niche investing in Australia's huge microcap market, where he says the lower liquidity and sparse research give him an edge.

"You naturally have an inefficient market, I suppose, in microcaps," he says. "And it does provide that opportunity for investors if you're willing to put in the work.

"The other important thing is having conviction in that work because there's often no sell-side research or the companies themselves aren't very savvy with investor relations."

In this video, Winchester discusses the use of screening tools in stock selection and why he is cautious about it. He also covers the role of past performance and the red flags that tell him to when to stay away from particular companies.

Edited transcript

How would you describe your style and what do you see as your edge?

From a style point of view, I try to stay pretty agnostic. But I would skew, I guess, more towards value over growth.

And that comes more from being downside-focused rather than just purely upside-focused.

I'm always initially focused on what's my potential downside in investment. Then, if the business executes to the path you expect it to, the upside works itself out.

I think that skews me more to value over growth. But that said, if I'm comfortable with a growth company's downside outlook, I'm more than willing to pay up to capture that growth as well.

As far as an edge on the market, I play in the microcap space, which I think provides a natural edge in and of itself, liquidity being the major factor.

It's just that you are restricted. There's not as many funds playing in the space. It's mostly personal investors, not as much sell-side research, not as much investment chatter on forums, Livewire, Twitter, places like that.

You naturally have an inefficient market, I suppose, in microcaps. And it does provide that opportunity for investors if you're willing to put in the work.

The other important thing is having conviction in that work because there's often no sell-side research or the companies themselves aren't very savvy with investor relations.

You've got to have a lot of conviction in the work you've done rather than having other people to bounce that research off and borrow their conviction. So that's where my edge stems from.

And being in microcaps, it's very much an accumulated knowledge thing. I've been doing it now for the better part of 10 years.

You get to learn the businesses that should do well and the businesses that maybe won't. You get to know the people involved because they'll pop up again and again on boards and management teams, and even from an investor-based point of view.

There are so many microcaps. How do you find the stocks you think warrant deep research?

It is a very big universe. You'll often see very little overlap between microcap funds, given the opportunities you can have.

I want small businesses under that $200 to $250 million market cap. I'm looking for sustainable business models and usually a bit of growth. Good businesses, in a nutshell.

I estimate there are 500 to 600 businesses in that universe. It's multiples bigger than the ASX 200, where some larger funds play.

You have to be judicious about how you approach a universe like that. I use screening tools as an initial search. But they're a blunt tool.

You have to be careful with them because they will screen out ideas. And these are businesses with sometimes very fluctuating financials and also a lot of reverse takeovers and things like that.

Often the data itself won't be fantastic that flows through a screen. So the short answer to your question is, I do a lot of reading: ASX announcements every day, quarterly reporting season, opening up every 4C cashflow report.

It's the hard work you have to put in to build up that knowledge base so that when the time is right, you can be quick to move on it.

Most of my ideas are very rarely stumbling across a new company I've never looked at and spending a few weeks to get the conviction to buy it. It's usually a company I've looked at two or three years ago.

These businesses are often very early in their business cycles or their business lives. And you're just waiting for that timing to be right.

What red flags do you look for when you're researching a company?

It's a really good question. As an investor, you have to have a checklist or something like that where you are looking for those red flags.

The most obvious one is past performance. What has the business said in the past that they would do?

Did they achieve that? If they did, were they conservative in how they provided either guidance or communication to the market?

Did they miss? If they missed what they said they would do, were there valid reasons? And can you still justify that as an investor?

Beyond that, as a microcap investor, or even just an investor in general, you build up a knowledge base of business models, people and general things that are red flags to you.

You might see a person pop up who you know has a questionable track record or a business model you know another business has tried before and failed. That's where that knowledge base kicks in and you can screen out those ideas.

But like I said, the simplest one is to go back and see has the business achieved what it said it would do.

A lot of businesses provide positivity around their business and where they think they can go. And it's only natural to have a management team that is incentivised to drive that business.

But as the investor, you have to be the pessimist, I suppose, to their unbridled optimism sometimes.

Looking to invest in microcaps?

The Merewether Capital Inception Fund invests in small and microcap companies listed on the ASX, with the ability to invest in pre-IPO opportunities. It employs a long-only, high conviction strategy (10-25 positions) with a focus on profitable growing companies with skilled and aligned management teams. The Merewether Capital Inception Fund is open to wholesale investors only. Contact Merewether Capital here.

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