Undervalued ASX microcaps: The “fallen angels” that have US fundies frothing

Fallen angels, for a microcap investor, can be heaven-sent. They may also wreak havoc on your portfolio if they skip the crucial “turnaround” component and hit the deck. But the two people I spoke to for this article – Mark Tobin of Coffee Microcaps and Merewether Capital’s Luke Winchester – are convinced the potential upside is worth the risk. And they’re not alone. US fundies are also clamouring for a piece of the action. In this wire, they reveal five microcaps that may soar in the next couple of years – including the three that have US fundies frothing.
Glenn Freeman

Livewire Markets

Foreign fundies’ interest in local microcaps has been piqued, with three ASX companies recently presenting to a prominent US investing summit for the first time in several years. And with good reason, say Coffee Microcaps’ Mark Tobin and Merewether Capital’s Luke Winchester.

What's a micro-cap, you ask?

In Australia, a micro-cap stock is, generally speaking, any listed company that sits outside of the ASX 300. But the definition of a microcap varies widely between different countries and depending on who you talk to. Some regard an Australian micro-cap as any stock with a market capitalisation below $500 million. Others set the cut-off far lower.

But in the following, let’s assume they're stocks with market caps of somewhere between $100 million and $300 million. To be clear, we're not suggesting any retail investor go “all in” on micro caps or even allocate a meaningful proportion of their portfolio. They are a satellite exposure, at best – and as always, you should speak to a financial adviser before making any investment decision.

Fallen angels or devilishly bad?

You might also wonder about fallen angels and why you’d want them in your portfolio. (Hint: It may sound like it, but there’s no connection to a Dan Brown novel and no Opus Dei subplots).

“It’s a stock that’s neglected by the market, often underperforming for so long that many have given up,” says Luke Winchester, co-founder and portfolio manager of Merewether Capital.
“The turnaround can be explosive as the market cap begins to catch up to the level at which the business is now performing.”

The crucial aspect here is the “turnaround”. This is where a white knight rides in (such as an acquiring company, or new management) and fixes things. Or an external market event sets the company’s share price trajectory soaring once more. A recent example, as discussed here, is Prophecy International (ASX: PRO).

An Aussie microcap that could double from here

The call centre software firm’s share price went nowhere for around five years. From 50 cents in 2017, after muddling along amid poor management calls and questionable decisions, a new executive team entered. By April and May 2021, the share price rose to $1.50. At today’s open, PRO was trading at $1.57 a share.

Measuring without a yardstick

You should also be aware that there’s no reliable local benchmark for micro caps. Many use the Small Ords or a subset of this, such as the Small Industrials, as a benchmark, says Mark Tobin, who runs microcaps newsletter and webinar events business Coffee Microcaps. He calls out two local indices covering micro-caps:

  • S&P/ASX Emerging Companies (SPAXEC), and
  • MSCI Australia Micro Cap Index, which is the lesser-known of them.

The former includes up to 200 names, with around 180 currently, and the MSCI index has 500. But neither Winchester nor Tobin place much emphasis on them. For Tobin, this is mainly because the local indices are quite concentrated and don’t capture a reliable set of data about the sector. This is no fault of either S&P or MSCI, but because while every micro-cap company has a share price, they don’t all have earnings, particularly when they’re early-stage businesses.

The above also explains why it’s hard to get a handle on average valuations across ASX micro caps. Regardless of your view on price-to-earnings multiples, it’s a point of reference but isn’t very useful when weighing micro caps.

Probably the biggest issues is a dearth of sell-side research in the space. But it’s both a problem and an opportunity. It's why few people know about many of these companies, but it's also why you want to know about them – the road less travelled is where the best opportunities lie. The managers of such companies are crying out for research “but over the last four or five years we’ve seen a big drop off in coverage of microcaps,” Tobin says.

The above situation is changing gradually, partly because of the rise of paid-for research providers in the space. It may be something of a double-edged sword due to potential conflicts, but Tobin believes it’s better than nothing.

And coinciding with the declining volume of micro-cap research is rising interest from US fund managers, put off by nosebleed multiples and few under-researched opportunities in their much larger home market.

Aussies invade the MicroCapClub

A bellwether of this rising interest occurred a couple of months ago when a handful of Australian companies fronted the annual summit of the MicroCapClub. This is a US forum established by professional microcap investors Ian Cassell and Mike Schellinger around a decade ago.

“Three ASX microcap companies were on the agenda, but there years ago there wasn’t even one local company,” says Tobin.

“A few microcap funds from the US are starting to show up on the registers of these Australian companies.”

The three companies are:

  • RightCrowd (ASX: RCW) - which provides safety, security and compliance services, including wearable devices and contact tracing, for worksite employees and visitors.
  • Tinybeans (ASX: TNY) - a mobile and web-based social media platform targeting parents of young children.
  • Cogstate (ASX: CGS) - a neuroscience company focused on brain health.

Winchester’s watchlist

I also asked Merewether’s top stock picker for some of his most promising micro-cap stock ideas that he doesn’t already own. The following haven’t cracked the MicroCap Club (yet) or Winchester’s fund but they’re certainly blinking on his radar.

Spacetalk (ASX: SPA) is an ASX-technology company whose smartwatches targeted squarely at children have broken through in the UK market. With a market cap of around $30 million, the firm has inked several global distribution deals since it launched 10 years ago.

For Winchester, a major appeal is the company’s distribution model. Alongside traditional online retail and some in-store sales, the smartwatches – which require SIM cards that are most commonly found in mobile phones – are sold mainly via telcos Telstra in Australia and Vodafone in the UK.

“The upcoming quarter could be a big one for them,” he says.

Good for investors, bad for carpark cheats

Winchester also calls out Smart Parking (ASX: SPZ), which he regards as an example of a second-order COVID recovery play. SPZ’s fortune continues to rise as shopping malls fill up with cars again.

The company's first product was the red and green lights above the parking bays inside large retail parking areas, the lights telling you at a glance whether spaces are vacant or filled. From there, SPZ has further leveraged its expertise in sensors and data.

Smart Parking is currently generating revenue of between $8 million and $10 million, a range Winchester says could easily hit between $10 million and $15 million in the next couple of years.

The company’s biggest markets currently are the UK and New Zealand, where there are fewer barriers, including lower costs, in getting access to individual data based on number plate information. So far, regulatory issues have hampered progress in Australia, with individual numberplate data being closely held by most state governments, with the exception of Queensland. But South Australia and West Australia are likely to be the next Australian states to provide access. And internationally, the firm is also looking to launch in Germany.

How to invest in microcaps: Blessed be the loss-makers?

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Glenn Freeman
Content Editor
Livewire Markets

Glenn Freeman is a content editor at Livewire Markets. He has almost 20 years’ experience in financial services writing and editing. Glenn’s journalistic experience also spans energy and automotive, in both Australia and abroad – including the...

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