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Microcap investing can deliver but requires work

Nicki Bourlioufas  |  07 Aug 2017Text size  Decrease  Increase  |  

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Microcaps are a very under-researched part of the market, opening opportunities for investors willing to do the challenging work to uncover undervalued businesses. But the greater risks of investing need to be closely managed, according to the experts.

 

Small and microcap portfolio manager with Perennial Value, Andrew Smith, says there are nearly 2000 microcap companies on the ASX but only 500 are covered by brokers. This lack of coverage creates price inefficiencies and opens up investment opportunities for those investors willing to do the numbers.

The effort can be worth it. The great draw of microcaps is that they can quickly grow, a lot more so than established large businesses, so investment returns can be greater.

"Microcaps are largely immature businesses in the early stages of growth so they are developing their markets and investors have a great opportunity to invest in the company in the early very early stages, much like a private equity investor, and ride any share price increase," says Ross Macmillan, a senior research analyst with Morningstar.

"People are hoping to pick up a microcap that will experience robust growth in the hope they will become a large business. Domino's Pizza (ASX: DMP) is a great example of the small business and who would have thought that it would grow into the business that it is today?" he says.

Macmillan also gives the example of Magellan Financial Group (ASX: MFG), which listed on the ASX at $1 a share back in 2006 and has recently traded as high as $29. "That's why people invest in microcaps--to take advantage of those great opportunities," Macmillan says.

According to Perennial's Smith, microcaps are very diverse group of companies operating in a range of industries. "This allows investors to access almost any sector in the economy rather than having to focus on banks and resources, just because they are large parts of the benchmark index."

In addition, the management and boards of microcaps usually own a sizable percentage of stock, "aligning their interests with fellow shareholders".

Like midcaps and small caps, microcaps are more often targets of takeover activity than large caps, which means their prices can jump on any takeover offer.

But there are big risks with microcaps, and rather than grow, their businesses may struggle or collapse since they are often still establishing their markets. "So that is why you really need to be keeping a close eye on the company and watch its management very closely," says Macmillan.

Other risks include greater share price volatility than ordinary shares and a lack of liquidity given the relatively small market for their shares.

To help do the sifting for investors, including extensive company visits and financial modelling, Perennial recently launched a micro-cap fund, the Microcap Opportunities [41568] portfolio, which invests in stocks with a market capitalisation of less than $500 million. Perennial Value's investment process begins with screening approximately 2000 stocks.

"Stocks are then eliminated based on factors such as expensive price/earnings ratios and high debt. Detailed modelling and research is then conducted on approximately 200 companies," Smith explains.

"To qualify for investment, stocks must have sustainable businesses (qualitative) and offer good value at the current share price (quantitative) ... Direct company and industry contacts are an integral part of the stock selection process.

"To manage this risk, we have a diverse portfolio of 50 stocks, half of which have no debt. We also do extensive research to understand the potential risks for a business before investing.

"We are also less focused on dividends at this end of the market as we want our companies to be reinvesting in growth initiatives, hence our investors are more attracted to the potential for capital growth."

Perennial charges a 1.2 per cent per annum base fee and 15 per cent of the net outperformance of the fund over the benchmark Small Ordinaries Index. This is only paid "if we outperform and deliver a positive absolute return that month".

Given these relatively high fees compared to other managed funds and exchange-traded funds, which track indices, investors also need to do their research on which microcap fund manager they choose. In recent times, for example, many small-cap fund managers have been underperforming their benchmarks.

"There is a lot of work in assessing microcaps, the financial earnings, and doing all of the analysis and company visits, so they tend to have higher annual management fees and quite often performance fees, so that can be an issue," says Morningstar's Macmillan.

Perennial's Smith says while the Perennial Value Microcap Opportunities Fund only started in February 2017, the six-month return to 31 July 2017 was 12.6 per cent (net of all fees) versus the benchmark return of 4.0 per cent.

"While the team was pleased with this start for the new product, investors should assess performance over a longer timeframe," he says.

"Given a portion of the Perennial Value Smaller Companies fund has always been in microcaps, investors can look to this fund for a longer track record--in this regard the fund has generated 5.9 per cent per annum of excess returns versus the benchmark over the last 10 years."

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Nicki Bourlioufas is a Morningstar contributor and owns shares in Magellan Financial Group. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.