The ASX small cap boom - two pro investors discuss how to profit

ASX small cap stocks have led the market in the post-COVID economic recovery
Stockhead asked two small cap stock pickers about the macro forces driving that trend
The companies that can outperform in the months ahead

A closer analysis of the post-COVID ASX bull market shows small caps are outperforming the big end of town.

Despite rallying off its lows, the ASX200 still hasn’t reached its February peak since the selling frenzy in March.

Conversely, the ASX Emerging Companies Index (the benchmark gauge for microcaps) has surpassed its pre-COVID highs and surged more than 100 per cent from its March lows.

The broader forces behind the market rally – record fiscal support and central bank stimulus – are well known.

But we caught up with two professional ASX small cap investors to get their insights on some of the more nuanced catalysts that are pushing money flows into small caps.

Follow the money

Craig Scheef – managing director at investment fund Technical Investing – was quick to highlight the effectiveness of policy stimulus.

With more fiscal spending in the works globally, and interest rates expected to stay low for the medium term, it’s “not rocket science” to conclude that stocks will find support.

Additionally, he cited discussions with US-based strategists in recent weeks, who flagged the potential for an increased capital rotation out of bonds.

“The bond market is so much bigger than equities, and historically it’s been used as a diversification play. But that theme isn’t really playing out anymore,” Scheef said.

“So there’s a view that more money will come out of bonds over the next year or two, and move into equities.”

The combined result is “upside for stocks which means people are looking for higher risk or more beta, and to find it they tend to look at small to mid-size companies,” he said.

In addition, Scheef noted many smaller businesses had been better equipped to adapt to COVID-19 than larger firms.

“If you look at the change from COVID-19, so many businesses have had to pivot,” he said.

“Often, smaller companies can do that better and then also with the extra liquidity, they’ve been able to raise more capital and that’s had a positive impact on growth.”

Joshua Baker, investment analyst at Capital H Management, also noted an interesting dynamic around post-COVID capital flows.

“I think one thing we found in reporting season is that big ASX companies aren’t necessarily as reliable as dividend plays,” Baker said.

“High yield isn’t great in and of itself — you want decent yield that can grow.

“There’s probably been a bit of a tendency for investors to treat equities like a bond. Yes they might have a good yield, but the share price can also fall.

“Conversely, a lot of small companies showed they’re continuing to grow earnings.”

In addition, along with policy stimulus, the broader fallout from the health crisis has created an “unparalleled” investing environment, Baker said.

“Take the example of gaming stocks – they’re typically viewed as defensive. But it’s not defensive if you can’t let people into your casino,” he said.

“Then you’ve got the fact all air travel is banned. But that means billions of dollars get channelled somewhere else, which ties in with the ecommerce boom.”

“So in this environment you have to think about how money gets shifted and spent.”

ASX small cap picks

The portfolio at Technical Investing is primarily focused on software, but “the other area we’re starting to move money into is resources”, Scheef said.

He expects commodity prices will be supported by supply-side constraints as demand picks up. In the short term, “we think after this run the US dollar will trend back down again, and we should get higher gold prices as well.”

Among the small caps in Technical Investing’s portfolio is Vault Intelligence (ASX:VLT).

The workforce SaaS company is about to be taken over by Damstra Holdings (ASX:DTC) in a share-based deal that will leave DTC shareholders with 75 per cent of the merged entity.

“I think that merger will create an even stronger company, because Vault wanted to move into the US and Damstra already had a strong presence there,” Scheef said.

“So by merging the two you’re cutting money out of their cost structure and creating a lot of benefits.”

Another stock Scheef thinks has strong potential is Dubber Corp (ASX:DUB), — the cloud-based SaaS platform which provides call-recording software for commercial clients.

“They’re really playing off the work-from-home thematic. And they’ve already spent the money building a lot of the tech,” he said.

“That’s what you like to find — someone who’s done the capex and has their tech embedded into a telco network — once it’s in it’s hard to get out, so churn should be low and turnover high.”

Scheef said Dubber’s platform also had an AI capability to gauge the sentiment of conversations and measure customer satisfaction.

“There’s no company I think globally that has developed scale with a cloud-based call recording product over a complete telco network,” he said.

“So that’s a Melbourne-based company that’s taking on the world. They grew last quarter at 25 per cent and we think ongoing they should grow at similar rates.”

Over at Capital H, Baker discussed the firm’s position in education play Kip McGrath (ASX:KME).

The tutoring platform has historically provided face-to-face services via a franchisee model.

But in recent years it has rolled out a corporate model “to complement students that require tutoring in catchment areas outside of the franchise network”, Baker said.

That centralised network of tutors assisted the business once COVID-19 lockdowns were enforced and students had to study from home.

In a recent trading update, Kip flagged online tutoring as a key business opportunity, and said revenue growth from its corporate centre division was climbing at 400 per cent annually.

“With this model they’re not just taking a revenue share of the franchisee, they’re taking a full revenue ticket per class then earning same operating margin,” Baker said.

“So we think this transition is going to drive step change in topline growth, and also flow through to margins.”

Another company on Scheef’s radar is Linius (ASX:LNU), the video software platform which allows users to personalise video streams.

“Say you’ve had an interesting Zoom call, you can type key words and their tech can scan the recording and pull out the relevant segment,” he said.

“They’ve just raised $5m and I think it’s a pretty powerful concept. It hasn’t got much traction yet but it looks really interesting.”

Looking ahead, Scheef’s view is that the policy support measures in place should underpin growth in the medium term.

“We’re still pretty bullish. In terms of market cycles we think the pullback in March was a substantial pullback which has set the market up for the next bull leg,” he said.

“It’s in the first leg right now and there could be a couple more to come over the next couple of years.”