Criterion: Why the microcaps malaise has reached its ‘maximum pain point

• This week’s annual microcaps conference convened amid the worst conditions in the sector for a decade
• Under pressure on fees and costs, institutions have abandoned the small fry stocks
• Trashed valuations mean more opportunities for investors willing to invest time and shoe leather in their own due diligence

For the 20-plus companies presenting at the 15th Australian Microcap Investment Conference in Melbourne, rustling up investor interest was a harder task than in previous years.

It’s not as if the inquisitive audience wasn’t keenly engaged: it’s more a case of the sector swimming against the tide of structural and cyclical adversities.

In the year to October 1, only 23 of the S&P/ASX Small Ordinaries constituents have risen in value. Strip out the resource stocks and the numbers are even less flattering.

Microcaps are trading at the biggest discount to the large caps in ten years, Salter Brothers director of equities Gregg Taylor told the forum.

But he delivers more hope than the King’s Christmas message.

“History shows that if you invest at this point of the cycle, you are more likely to do well than not well.”

While the sector is variously delineated, Salter Brothers defines microcaps as those with a market cap between $50 million and $500 million.

No longer the ‘only show in town’

Small to mid-cap companies notoriously are impacted by high interest rates and inflation – but there’s more to the malaise.

Taylor notes that most institutions have abandoned the sector because their AI-driven ‘quant’ strategies favour dealing in billions – rather than millions – of dollars.

“Fees are under pressure, which calls for more AI and data-driven strategies,” he said.

“That doesn’t work so well with microcaps … and they’re retreating from the market.”

With the investors exiting, there’s even less research on the sector.

Few IPOs mean brokers have little incentive to invest in analysts.

Microcaps used to be a source of zing (or ‘alpha’) in otherwise staid portfolios. Indeed, more than one-third of presenting companies at this year’s jamboree were speculative biotechs.

But these days more options are available for the ‘funny money’, such as crypto global and exotic exchange-traded funds.

“There’s genuine competition for risk assets and that’s not going away,” Taylor said.

As for the evil Is – interest rates and inflation – the issue is not so much when they are likely to come down, but when they will peak. Or when they are anticipated to do so.

When that happens, opportunity abounds.

Trawling for bargains

Salter Brothers’ portfolio consists of around 30 companies. The tech sector accounts for about 40% of them and 12% are unlisted.

The fund does not invest in resource stocks.

Around 12% of the holdings are private.

“Only 1% of companies under $500 million are listed,” Taylor said.

He cites Alfabs Australia (ASX:AAL) which provides steel structures for infrastructure projects and the mining sector.

He says few people know about the profitable, $20 million market cap entity that listed three years ago.

Ai-Media Technologies (ASX:AIM) is better known.

Still, few investors appreciate the company’s pivot from a “body shop” hiring out voice-to-text translators, to an automated service with much better margins.

Regtech play WRKR (ASX:WRK) provides the “plumbing” for employers to remit employee super to the large super funds.

With the introduction of rules mandating real-time payment of super, the process has become an administrative pain for companies and – of course – a boon for WRKR.

Maximum pain point?

Run by veteran stock picker David Paradise, Paradise Investment Management has returned $700 million of its $3.3 billion Australian small caps fund to investors.

“The less money you have in small caps, the more likely you are to outperform in the future,” Paradise reportedly said.

Ouch!

Taylor says it’s hard to swim against a tide of exiting funds but believes good fundamentals ultimately will shine.

He notes that after the last two sharp downturns, the microcaps saw 100%-plus returns in the subsequent two years.

“I’m not guaranteeing that will happen again, but it feels like we are at that maximum point of pain”.

Lest investors get too zealous, Taylor counsels them not to invest everything at once, because good microcaps need funds to chase opportunities.

“I suggest leaving a bit in the tank until they do another raising.”

 This story does not constitute financial product advice. You should consider obtaining independent advice before making any financial decision.

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