There’s always a bull market somewhere

Equity investors by nature tend to be pretty optimistic, but over the past few months even the permabulls appear to have lost a bit of steam.

While the NASDAQ has staged a breathtaking recovery from the lows of late March, here in Australia the ASX 200 has failed to sustain the same momentum. But you're probably aware of that. You’re also probably well aware of the latest rate hike from the RBA (that’s 3 now), the cost of fuel, high-inflation and uncertainty around the prospect of changes to the tax regime in next week’s Federal Budget.

So how about a dose of optimism? 

What if I told you that there was a part of the ASX where the future leaders reside, it’s less efficient so more opportunities exist and it offers exposure to a wide range of sectors giving you economic diversification.

We’re talking about the S&P Emerging Companies Index or the XEC, which tracks around 200 companies ranked between 350 and 600 on the ASX. The XEC is up 35% over the past 12 months - easily outpacing the ASX 200. 

Joel Fleming, Portfolio Manager of the UBS Micro Cap Fund, says that strong performance extends to longer-time frames and often catches people by surprise.

“Well, even historically it surprises people. I've done some presentations recently and even over a 10-year period, it has done better than most of the other components of the market.”

Fleming explains that unlike the top end of the market, where concentration across industries is extreme, the XEC offers a more diverse opportunity set. That means he is able to find derivatives and niche ways to play some of the bigger themes that are playing out in markets.

“I heard a really good saying, there's always a bull market somewhere in smaller microcaps.”

Joel has been investing in this part of the market since 2014 and the UBS Micro Cap Fund, which he manages, has delivered over 14% p.a. over that time.

In this episode of the Rules of Investing, Fleming guides us through the path less travelled on that ASX in the pursuit of future market leaders.

There’s no free lunch - especially in microcap stocks

Microcap investing isn’t for the faint of heart and Fleming is pretty blunt when it comes to the realities of navigating this end of the market - expect volatility. The same factors that create mispricing, such as less media and broker coverage, also means an added workload for investors looking to uncover ideas.

Fleming says he and his team conduct up to 2,000 meetings each year as part of their investment process. Some of those meetings will bear fruit, others he explains will be a note for future reference.

“We'll sit down with anyone for 45 minutes and hear their story … And that's the best part of this job, meeting people who are out there having a go. They're pursuing something, they're having a crack at solving problems and they're trying to build something.”

When it comes to portfolio construction Fleming’s approach is to manage position sizing according to the lifecycle of the business. Early stage, higher risk positions get a smaller weight and positions grow as confidence builds.

“We start with the balance sheet. We focus on companies that are sustainably profitable with good dividends, though profitability isn't an absolute prerequisite if we can see the path to it.”

“We also run a diversified portfolio across industries and life cycles. A great example was Pro Medicus (ASX:PME). We had a 2% position when it was sub-$1. By the time it was $10, it was 4.5% of the portfolio. Even though it was more expensive, our conviction was 10 times higher because the contracts were being won and the downside was de-risked.”

Three stocks you might never have heard of

To bring the idea of microcap investing to life, we asked Joel to pitch three companies that he has uncovered highlighting the diverse opportunities in microcaps.

1. GR Engineering (ASX: GNG)
Market cap: $170mn

“If you are building a gold plant in Western Australia, you are almost certainly talking to these guys.”

GR Engineering are a Perth-based "picks and shovels" play with a long history of delivering projects on time and above capacity. While the market often overlooks engineering firms, Fleming notes that GNG has historically traded on a very attractive 10x PE with an 8% fully franked yield. 

Beyond gold, they provide a derivative way to play the broader commodity cycle through their work in copper, nickel, and oil and gas maintenance.

2. Metals X (ASX:MLX)
Market Cap: $1.37bn

Tin might not sound as "spicy" as lithium, but it is an essential component of the circuit boards powering our world. Metals X operates a tin mine in Tasmania that is currently generating a "huge amount of cash" thanks to strong commodity prices. 

What makes this particularly interesting is their "lazy balance sheet" - they are sitting on significant cash reserves and deploying them into global optionality, including investments in tin projects in Spain and elsewhere in Tasmania.

3. ARTRYA (ASX: AYA)
Market Cap: $707mn

This is a software-driven play targeting a massive problem: coronary heart disease. ARTRYA has developed an AI tool that fits into hospital workflows to make diagnosis more efficient and productive. 

Unlike many medical tech companies that burn through cash on massive sales teams, ARTRYA is using a partner-led model to commercialise their FDA-approved product, offering a "neat solution" to a global health crisis.

A stock to own if markets shut for 5 years

When asked which single stock he would own if the market closed for five years, Fleming pointed to energy software business Energy One (ASX:EOL). Describing it as the "Bloomberg of energy trading,"

Energy One provides the technical tools needed to manage a modernising power grid. As energy markets move toward five-minute settlement increments, their software becomes a structural necessity for both the Australian and European markets.

“We’ve got two shots on goal. Australia is a relatively mature market but Europe is a very big opportunity. So we really like that on a five-year view.”

Watch the full interview on YouTube or listen to the podcast on all the major podcasting platforms.