Two inexpensive, defensive ASX small caps for your portfolio

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Keeping an open mind is always a good tip for investors no matter what sectors, regions, or asset classes you participate in. That advice is as, if not, probably more important when looking at the ASX small caps. There's no doubt that small caps are extremely popular - among the Livewire audience and beyond. But, with more than 2,000 of them in Australia alone, there is also no doubt that it's a humongous universe to sort through.

And few will grow from an ex-ASX 300 company into something much larger and more remarkable. 

So how do you get better at finding the winners? Firetrail Investments' Investment Director Kyle Macintyre argues you need to keep an open mind.

Being unconstrained is absolutely critical to adding value in small companies in Australia.



The one-in-four missed opportunity

Australian small-cap managers tend to have a bias towards "quality industrials" - but notably, this tends to exclude the resources space. As we've seen in 2022 so far, that exclusion has been to their peril. In fact, the only ASX IPOs of 2021 to come through relatively unscathed in the financial year to date have been resources stocks.

Kyle says that's an opportunity for investors to capitalise on, even if the fund managers and brokers won't.

"Over a quarter of the opportunity set is in resources," Kyle notes. "We look for opportunities in under-researched markets with material tailwinds - resources tick those boxes."

A deeper look under the ground

Commodities are often split into two buckets - the China-facing opportunity and the decarbonisation opportunity. Kyle and his team have a greater interest in the latter given they forecast rare earths demand will double over the next decade. The demand opportunity is even greater for lithium.

The only problem? There is nowhere near enough supply.

That means higher prices are coming for all the decarbonisation-associated resources. So how do you filter the good small caps from the great ones? Kyle says it's all about being picky.

"You need to invest in the high-quality producers, with operations and proven teams that can expand capacity profitably in order to capture the opportunity," Kyle says.

The overlooked opportunity: DDH1 (ASX:DDH)

One of the team's favourite ideas is DDH1 - an ASX-listed mining services and drilling company (comparable to such names as Base Resources). Listing in 2021, the company has a role in many new mines and expansions in Australia.

But the secret to DDH's potential is in its diversity. The company has fingers in a whole range of pies - including gold, iron ore, nickel, and copper production to name but a few.

"50% are benefitting from higher prices today while the other 50% is in these decarbonising materials where we think there are structural growth tailwinds," Kyle notes.

That makes demand a key tenet of the bull case. However, there is even more to it as the company continues to grow organically at a relatively attractive valuation.

The team's number-crunching suggests that if the company can pass on just half of the projected price rises, the balance sheet could see a 20% boost to earnings.

An idea for demographic tailwinds - Estia Health (ASX:EHE)

Just because Kyle has mentioned resources as a big boom area so far does not mean that there are no opportunities outside of the mining space. Migration is only coming back slowly into the economy and the population continues to age. In fact, it's been estimated that the number of aged care beds may need to double by 2032.

Enter Estia Health - a company that Kyle describes as an "inexpensive defensive" name that deals head-on with this challenge. Add on tailwinds from Budget funding and there could be as much as a $20 billion boost to the company's earnings.

Kyle also argues that Estia is a recovery play. High-frequency data shows that the post-pandemic return to normal should be a key boost for the company's earnings.

Finally - and pertaining to Kyle's whole thesis - the company is simply poorly covered among the brokers and research houses. 

Conclusion

Under the radar, receiving tailwinds, and getting ahead of the future. That's how Kyle Macintyre of Firetrail Investments looks at the ASX small-cap sector - and the opportunities within them. His two stock ideas are a reflection of this thesis and in turn, showcase why being unconstrained can lead to greater ideas - and a more open mind!

Discover more about high conviction investing

Firetrail is an investment management boutique that specialises in high conviction investing. They build concentrated portfolios of their best ideas, to generate outstanding long-term performance for their clients. Click here to find out more.

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