MoneyTalks is Stockhead’s regular recap of the ASX stocks, sectors and trends that fund managers and analysts are looking at right now.

Today we hear from Adam Lund, an analyst and head of trading at Spheria Asset Management.

Spheria’s Australian Microcap Fund has achieved over 15% returns per annum since its inception in May 2016 and 80.6% in the 12 months to July 31, 2021 – net of fees. It also has a Global Microcap Fund that has returned close to 50% in that 12 month period.

Lund says he and his team just “stuck to our knitting”.

“We’re long only, bottom up, fundamental stock pickers. We focus on businesses that have proven business models, cash flow, sustainable margins and businesses with balance sheets that can fund through the cycle so they’re not reliant on the capital markets,” he told Stockhead.

“Cash flows are at the core of what we do here and we’re often looking for inflection points – we’re constantly trying to identify now forgotten businesses where the industry structure is positive.

“We’re style and sector agnostic and looking for the best relative opportunities where there’s compelling valuation support as opposed to chasing down value or growth. We’d rather just look for quality management teams to partner with and find the best relative opportunity.”

 

The opportunity in ASX microcaps

Lund says if you’re disciplined there’s opportunity in the ASX microcap space even if you don’t have a particularly high risk appetite.

“Microcaps offer opportunities where fundamentals aren’t often fully priced in because you have less analysts covering these stocks and less brokers with research out which creates dislocations in the market,” he said.

“You’re often buying businesses with high growth potential being less mature in the product development or technology and yet they’re somewhat undiscovered which creates the opportunity.

“Access to liquidity is key in micro caps. Excess frictional costs erode returns for investors however with advanced trading tools and systems we have found this to be our competitive advantage as market impact from other investors leads to greater dislocations from fundamentals in the market which creates the opportunities”

“We’re constantly looking for unloved companies going through some kind of inflection point – whether it be new management cleaning up the business or perhaps the market capitalising a short term hiccup.”

 

Michael Hill (ASX:MHJ)

Lund says this jewellery chain was once a market darling but now very much forgotten. Yet he is a particularly big fan of the company’s managing director Daniel Bracken.

“He came in a few years ago and is well regarded in retail management circles, regarded as a turnaround expert and that’s exactly what he is doing,” Lund said.

“It’s taking longer than expected in the COVID environment – with COVID restrictions they had to shut stores – but he’s come in and taken costs out of the business and implemented systems and workflows to improve the performance of the business.

“We’re seeing margin improvement with better brand collection sales. The business has strong returns, strong cash flow conversion and positive like for like sales growth and has a net cash balance sheet of $72m.

“It’s hard to believe before Bracken came in, MHJ didn’t even have a loyalty program.

“Not only is he driving sales and consolidating stores to only have the profitable stores but (he’s) stepped in and put initiatives like a loyalty program and got offshore strategy back on track.

“We believe it’s primed for strong sales coming out of lockdowns and will be a good re-opening trade.”

Michael Hill (ASX:MHJ) share price chart

 

Class (ASX:CL1)

This company delivers cloud-based software solutions for the wealth accounting market in Australia and Lund says it’s going through an inflection point too – again, a different boss.

Its managing director Andrew Russell stepped up in 2019 replacing CEO Kevin Bungard.

“We often find with microcaps that are looking to graduate into small caps, the founder needs to make way for a more experienced public company operator,” Lund said.

“And Andrew fits that bill, given he spent his career at Mortgage Choice (ASX:MOC) and REA Group (ASX:REA). He has a lot of experience in turning businesses around and engaging with investors and executing on strategies.

“That’s what we feel he’s doing – the market has been pretty underwhelmed by the lack of growth in the core super business but we see the cross selling opportunity to into other products it’s selling, being the trust and portfolios which they are beginning to commercialise.

“Not to mention they’ve made recent acquisitions – Nowinfinity and ReckonDocs which helps expand the product suite to sell to accountants, financial planners and lawyers.

“Class has good cash flow conversion, it has a Net cash balance sheet, always had strong returns and margins improving and we feel they’ll continue to improve as that cross-selling starts to play out with the expanding product suite.

“You’re buying a growth stock in a market that’s now expanding for an affordable multiple and we’re seeing a lot of valuation support in the stock and there is a real risk of consolidation within the industry. We think Class is on the radar of corporates and PE funds given its fundamentals are strong.”

Class (ASX:CL1) share price chart

 

Universal Store (ASX:UNI)

This company, a casual fashion retailer, listed in mid-November 2020 and has more than doubled since then.

Lund admits it’s not an inflection point investment per se but is nonetheless an exciting ASX microcap.

“It’s challenging for businesses once private, navigating the transition to public life and I think Universal managed it well despite headwinds and the current environment,” he said.

“With UNI, you’re partnering with management team in Alice [Barbery], who’s well aligned with shareholders as she has stock herself.

“You’ve got the store rollout, growth strategy ahead of you, a track record of cash conversion and returns, an omni-channel improving with online presence and label brands driving the margin expansion, you’ve got strong brand and customer loyalty.

“I think Universal know what they stand for, where they fit in to the market and they do it well.

“We think the stock is somewhat under-owned but given the [Five V Capital & BB Capital] sell-down it will change as it has swollen and will likely be an index candidate.”

Lund says this ASX microcap is an example of a so-called “re-opening trade” stock. And while COVID-19 was tough for many companies, some might ironically emerge from the pandemic in better shape.

“I think a lot of them have been forced to implement costs savings and coming out of this, some of these cost savings will be structural,” he said.

“A lot of businesses have they’ve been forced to invest in their online presence; you’ve got people at home at the moment bored, they’re online and buying up a storm. We’ve all seen the data coming from Aussie Post and some of these logistics companies have been literally run off their feet to meet the package demands with the spike in volumes.

“You’re going to have stores re-open and people want to get out, so buying in-store, and you’ve got online as well.”

Universal Store (ASX:UNI) share price chart

 

When brokers find an ASX microcap opportunity, others follow

What’s the big deal if an ASX microcap such as Universal Store becomes an index candidate?

Lund says it’s another inflection point in that it will lead to more exposure among brokers which will have a knock-on effect with retail investors. Some microcap fund managers are prohibited from buying stocks with market caps below a certain point.

“But as soon as the market cap graduates it gets on the radar and you see quite a significant spread or re-rate once they go through that microcap level,” Lund told Stockhead.

“There’s not much broker coverage on that one [Universal] either; in recent times that’s started to change and you’ve seen it turn a corner – obviously brokers want to partner with companies where there might be some ECM opportunities, the liquidity is there and there’s a decent inflection point playing out and that’s what we’re seeing now.

“Morgans was the only one covering it, Macquarie has come onboard and Barrenjoey is looking at it so it’s starting to turn up on more radar screens for micro and small cap radars. And I think once it goes into index it will leg up as the marginal buyers start to come in.”

 

Discipline counts

For the record, Spheria defines anything below $500 million as microcap in Australia (although it is also incubating a Global Micro Cap fund which defines microcap as anything below US$1 billion) and Lund says it’s therefore not always the case that they’re risky.

“They’re not small businesses and I think there’s been this kind of misperception of global microcaps that they’re very risky and there’s a lot of volatility. But if you have a disciplined investment approach you can invest in this space and have lower risk,” he said.

“Many perceive it as higher risk but it outperforms the market with less volatility. Micros have an important part to play in a portfolio when they’re undiscovered compared to high pick.

“You have to partner with quality management understanding drivers is more than numbers – it’s what management style will promote the growth of the business?”

Lund noted the high returns Spheria has made but says there’s one thing worth crowing about.

“I think the more important thing to understand is that the funds have outperformed but with a lower risk profile – both the standard deviation is lower and volatility of the funds is lower versus the index

“It’s been a difficult environment to navigate through and we’ve stuck to our process and remained disciplined. We’re not going and buying concept stocks that don’t have cash flow and that aren’t supported by fundamentals.

“We’d rather invest in businesses that have strong valuation support, cash flow and healthy balance sheets that can support through the cycle.

“That’s how we lower our risk. We have an active management strategy but our turnover is lower than most of our competitors. Given liquidity constraints in this space we’d rather have lower turnover and find the right businesses we can partner with for 5-10 years.”

The views, information, or opinions expressed in the interviews in this article are solely those of the interviewee and do not represent the views of Stockhead.

Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.

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