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Microcap Investment

1:45pm to 2:15pm
MICROCAP
Seminar
This session highlighted ways in which to
more successfully find the hidden gems that can be
found among the micro-cap end of the market.
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Learnt where a fund manager specialising in them sees investment opportunities.


Developed a better understanding of how to value micro-cap companies
Leaned how to incorporate them into your portfolio, and
Saw some critical features to look for

DIVERSIFICATION, OPPORTUNITY AND PERFORMANCE


In mid 2014, the CBA was worth more than every ASX company outside of the
ASX200combined! Out of nearly 2,000 companies listed on the ASX the 13 largest had
a market cap greater than all other ASX-listed companies.
This extreme concentration leads many investors to miss those small and microcap
opportunities which can provide diversification, opportunity and performance to their
investment portfolio.

Diversification: An allocation to microcaps can


reduce the BlueChip risk factor of being
overexposed to the top 100 stocks.
Opportunity: Microcaps can be the fastest
growing companies on the sharemarket and
there is very little research undertaken on them and
Performance: Microcap companies offer some of the best opportunities for investors
where increases in revenue can result in a great impact on profit
Generally, most sharemarket investors with a time horizon beyond 5 years could
comfortably allocate 5-15% of their total shares allocation to Microcaps. Some investors
may be surprised to discover they have that much invested in one or two large cap
stocks alone.
Microcap investment manager Contango sees an FY15 outlook of solid but not stellar
growth of around 3% as the economy transitions from mining investment to non-mining
investment and consumption. In this environment the preference is for companies with
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I www.contango.com.au

Contango I Microcap Limited 16 July 2014

Microcap Investment

solid growth profiles and high free cash flow yields, while avoiding low growth
defensives and pure-yield type companies.
The small cap sector typically outperforms large caps when risk appetite is
strong. While that might not describe the current environment there are always select
opportunities particularly in well-managed, small industrial companies with strong EPS
growth prospects and solid balance sheets.
Investors may do well to remain cautious about small companies exposed to the mining
sector, particularly if they are early-stage or carrying high debt levels. In a stronger
growth environment, when bond yields and commodity prices are typically rising,
investors can look to increase their mining exposure. Until then find the right
combination of high quality companies with attractive valuations at the right point in
the business cycle.
FUNDAMENTAL MARKET VALUATIONS
From a fundamentals perspective the Contango MicroCap Limited portfolio of 69 ASX
listed microcap stocks is demonstrating
attractiveness on a both relative and
absolute basis.
DO YOUR OWN RESEARCH
With microcaps the information is
scarce and share prices volatile.
Research
and
discipline are the
core of microcap investing where knowing a company, understanding
its operations and its industry are critical.
Limited information arises from brokers who cant recover the cost of
producing research on them and media covering better known
companies. Good stories are eventually covered but in the early stages
of a companys development, information must be sought. Herein is
the opportunity with microcaps in that disciplined investors with
clearly defined processes can find good stocks to invest in.
KNOW THE COMPANY
Fundamental and Quantitative research will never go out of style. Understanding the
constructs of and the principles behind price/ earnings, EPS growth, balance sheets and
cash flows are non-negotiable. The same with discounted cash flows- you dont have to
be able to build a DCF model, but you have to understand them. For instance, if the price
of oil goes up 20% or gold is discovered you need to be able to calculate how that will
impact share price.
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Contango I Microcap Limited 16 July 2014

Microcap Investment

Investors also must be able to deconstruct a company. By that understand how it


operates and generates its profits, what its key advantages are, identify key risks in its
business model and understand the attractiveness of the sector it operates in and its life
cycle.
At each point of the cycle investors need to have a different understanding of cash flows
and profit expectations. The market ascribes different valuations to a company and its
assets depending on where it is in the cycle. For a mining company this goes from:
Exploration Feasibility Pre-Bankable Project Construction Construction
Production.
Likewise Gold companies are not all the same and dependant on their point in their life
cycle you must factor in a different Enterprise Value and Dollar Value to pay per ounce
of Resource held by the company. (ie dont pay as much for Inferred resources as you
would for Measured resources)
Similarly when determining companies Net Present Value (NPV) valuations will differ
dependent upon their point in the cycle. As such a Producer should be expected to trade
at a higher price than its NPV because it offers a greater leverage to commodity prices.
While investors often dont have the information fund managers can source there are
things they can do to better know a company which will add value to their investment
strategies. Essentially, investors who do their research can better determine what price
to pay, and best times to execute their trades.
DIY, LIC OR UNIT TRUST?
Microcaps can be accessed either directly by buying shares on the
ASX, or outsourced to a investment manager. Given sufficient time,
resources, skill and inclination most investors can create a
diversified portfolio of 20+ stocks robust enough to withstand
shocks to one or two stocks within.
However it is hard to do this continually, never mind sleep comfortably at night - as
investing in the share market carries risks and microcap companies can be extremely
volatile, where events such as an unexpected fall in revenue can have a significant
impact on the value of the company. Its no surprise that fund managers have teams of
5-10 people focussing full time on these companies.
There is no best way, or one size fits all way to invest in microcaps. One potential option
is to allocate 75% of ones micro exposure across 2 or 3 fund managers, and perhaps 5%
in each of five securities well known to the investor.
In many instances investors can only access specific fund managers via an LIC, which are
increasingly popular for their dividends and franking, as well as the transparency and
control they offer. Some LICs focussing on small & microcap stocks include Mirabooka,
OzGrowth, WAM Capital and Contango MicroCap.
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Contango I Microcap Limited 16 July 2014

Microcap Investment
GETTING INTO THE STOCK
When choosing stocks avoid reliance on stereotypes. Each company is unique and has a
price so dont invest in a company because of one
feature- such as it being a Rare Earths company.
Likewise dont not invest in it for the same reasons.
Look for a balance, avoid holding too many of the same
type of company and look for spread. At least 20
microcaps offers a diversified portfolio.
Know why you are investing in the company. Create a
folder for every investment you consider, build an
investment checklist and stick to it. Be rigid, disciplined
and methodical.
If you decide to invest in a stock write a paragraph detailing why you like it, why you
invested in it and at what point you will exit it. Have your trading strategies preplanned, relating to tactics for:
Getting set:
How will you accumulate your position? How might that impact share price?
Managing the investment:
What are your actions upon price falls and following negative or positive news?
Exit Strategies:
Is your eye always on the exit door? What happens as you near your target price?
SUMMARY
The sharemarket remains a medium to transfer wealth from the impatient to the patient.
There is a case to invest in Microcap companies however discipline, research and
patience is required. The lack of microcap research provides hands-on investors with the
opportunity to get ahead of the market and find quality investments at the right prices.
Microcaps can be both exhilarating and financially rewarding. Investors are reminded
that diversification is critical to ensure their portfolios are protected from those shock
events which even the best research cannot prepare for.
Astute investors who prudently allocate to MicroCap companies are well positioned to
capture the growth in these companies as they progress from micro into successful, well
known companies.
NOTE AND DISCLAIMER

This article is written as an introduction to market investing. It is NOT to be construed as providing financial advice or a statement on the
market. Microcaps are a volatile investment class and may not be suitable for your investment needs. Consult professional financial
advice before making any investment decisions. Forecasts in this article are predictive and based on numerous assumptions including
the forecast outlook for key variables and may be affected by various factors including inaccurate assumptions, risks and unforeseen
events. Accordingly, actual results may differ materially from those implied or forecasted. Contango Asset Management Limited (ABN 52
085 487 421) holds an Australian Financial Services License (AFSL #237119) restricting it to providing financial products and services to
wholesale clients only.

I www.contango.com.au

Contango I Microcap Limited 16 July 2014