Managing downside risk while maintaining exposure to the upside is one of Luke Winchester’s core investing tenets.
And heading into year-end, the pro investor caught up with Stockhead to talk about how he applies that to ASX small caps, as well as the launch of his new fund – Merewether Capital.
Fund launch
Winchester recently struck out on his own after running the Emerging Companies portfolio at Oracle Investment Management.
While running his own shop had always been on the radar, the process was accelerated with help from Arc Funds (ASX:ARC) – a listed vehicle set up by Harley Grosser at Capital H Management.
One of ARC’s core propositions is to centralise the administrative tasks associated with running a fund (think lawyers, accountants and trustees) so portfolio managers can focus on their main job – picking winning stocks.
The fund also took an equity stake in Merewether, effectively acting as an “incubator” to bring forward Winchester’s timeline, he said.
After presiding over a small to mid-cap fund at Oracle, the Merewether launch gives Winchester an opportunity to focus on his first passion – ASX microcaps.
Smaller is better
“Merewether a true microcap fund,” Winchester says.
The term perhaps isn’t clearly defined, but Winchester starts in the sub-$200m market cap range.
“The lower the better – sub-$50m down to sub-$20m (market cap),” he said. And having that investment flexibility is an advantage.
“Being in the early days with low FUM (funds under management) we can be ultra-flexible. A lot of funds you’ve still got a bit of size so you’ve got to wait for capital raisings or block trades (to invest).”
“I can be very nimble. For example, some companies I speak with tell me ‘we have an illiquid stock’. And often it’s a case where we can help them find trading volume.”
“That would be a problem for a $50m or $100m fund, but where I am at sub-$10m (FUM), I can play on-market and soak up volume.”
“And if I get a thesis wrong and need to exit quickly I can do that too, so it’s good to have that flexibility.”
Finding opportunities
When it comes to microcaps, their small size and relative illiquidity is enough to scare plenty of fund managers off on-sight, Winchester says.
“I’ve never understood that argument because if you like a business, the liquidity issue is often a by-product of your fund and the way it’s set up rather than the stock itself,” he said.
So when investors say a stock is too risky or illiquid, “what they’re talking about is the share price”, he says.
“If you equate volatility with risk then yes these stocks are risky. But for a given stock that meets my criteria, volatility isn’t risk — it’s opportunity.”
“The only risk you take is permanent capital loss and there are things you can do to mitigate that,” Winchester said.
High debt levels are a clear red flag, and Winchester doesn’t do speculation – junior mining explorers, pre-clinical biotechs or pre-revenue tech stocks.
“If you’re speculating you can get blown up because there’s not always a sustainable business there,” he said.
“But if you look at ASX investors like Peter Johns (Westferry) or Harley (from Capital H), they buy good sustainable businesses – it’s just that they are small.”
And that’s the main game.
“If these companies were 10x bigger they’d be on much higher multiples,” Winchester says.
“So you’re getting just as good of a business model but you’re paying less for it, because it’s smaller and perceived to be riskier.”
So how does Winchester apply his strategy to ASX microcaps?
We discussed two companies in the Merewether portfolio where Winchester detailed how a pro investor thinks about microcap value.
Market cap: ~$38m
Most people are familiar with ‘nurse-call’ systems in hospitals – the hardware that allows patients to raise attendance alerts.
Those systems are Austco’s bread and butter (details to come), but Winchester described this investment as a prime example of how he manages downside risk at the microcap end.
For starters, AHC makes money.
“Even in FY21 which was pandemic-disrupted, they booked +$30m of revenue and $3.5m in net profits,” Winchester said.
“With a market cap in the high-$30m range it trades at a touch over 10x profits, and they’ve got +$8m cash in the bank.”
“So it really summarises my investment philosophy because all of that underpins my downside risk,” Winchester says.
“They’re a very stable business, they’ve been doing it for many years and the valuation of those profits is very reasonable. Then I ask – what can it give me on the upside?”
Historically, hospital network systems operated as a low-tech solution where price was the biggest differentiator.
But like many sectors, healthcare is open to tech disruption.
“In my view Austco were ahead of the curve in realising where healthcare was going,” Winchester says.
For nurse-call systems, that manifested in a shift away from price-based competition towards improved products and services.
Austco brought some new software to market to introduce what are more like smart devices that clients can tie into their hospital management system, he said.
Different alerts are sent to different staff as required. And Austco devices can be connected to bed sensors so alerts can be activated without a touch if it indicates someone’s fallen.
“The main thing they’ve done is realise healthcare is going to a connected solution – not separate systems,” Winchester said.
“In other words, — to make sure their solution was ready to plug into hospital networks and the beds themselves so that everything is able to operate on the same platforms.”
And on the upside, the company is building momentum after ~18 months of pandemic disruption, he said.
“The primary way COVID impacted the business was by making it harder to get on site and do their installations for nurse call systems, and upgrades etc,” Winchester said.
“So revenue has flattened out a bit, but at the same time they’re still winning new orders. If you look at their last couple of trading updates the previous order book was around $17m, then it climbed to $23m.”
“So they’ve built this order book in the background, and all of that revenue will come in over the next one to two years.”
Taking those operational and financial metrics into account, Winchester said AHC is still a company that many fund managers would skip over – largely due to its small size.
“But if you look under the hood, you can quickly see it’s a business that does ~$30m in annual revenues, it’s been around for years, it’s profitable and it’s still growing,” he says.
“Factoring in that upside from their expansion into software, for me it’s a much lower risk investment compared to what I see in far larger companies.”
Winchester has also given his seal of approval to the Austco management team – another crucial box to tick in microcap investing.
“With large caps, a company can often run itself in the sense that a poor CEO might not add much value, but they won’t kill the thing,” he says. “Whereas in microcaps a bad CEO can destroy the business.”
“So I really like Austco management team. Their CEO is based in the US which is a key region for them.”
“And more broadly I think COVID has masked a lot of the good things they’ve done over the past 18-24 months. They’ve managed to outsource manufacturing; they’ve brought in that software component and won a lot of new work.”
“Because of the pandemic we haven’t really seen that come through, but I think the opportunity is in front of them.”
Market cap: ~$70m
Headquartered in SA, the aerial mapping and imaging company listed on the ASX with a bang at the end of 2019, after raising $25m from investors at $1 per share.
Since then, it’s cooled off and currently trades at around 70c.
For Winchester, the stock at these levels represents a cheaper way to get exposure to 3D mapping and imaging compared to AMX’s larger peer, Nearmap (ASX:NEA).
And like AHC, it fits his thesis in terms of managing downside risk while maintaining exposure to the upside.
“This is a business that made money for a long time prior to listing. At around 15x EBITDA it’s not as cheap as Austco, but they have an underlying business based on aerial imaging in the Australian market which really underpins that valuation,” Winchester said.
And looking at the upside, the company has established an early foothold in the shift towards 3D imagery and mapping.
“The first time I spoke to them, I got the impression they’d done a lot of work on 3D over the years, where it was more a case of ‘build it and they will come’,” he said.
“They weren’t quite sure what the use case was, but it was a case of getting on the front foot and seeing what commercialises out of it.”
Now, 3D mapping is big business. As a recent example in the domestic market, the NSW government allocated ~$40m towards plans to build a 3D map of the whole state.
For Winchester, much of AMX’s upside is connected with the US market.
Returning to his discussions with management, he said the company’s edge stems in part from how it captures data.
“They use helicopters and specific techniques to capture data, but their main edge is with the tools they use to process that data – turning still images into a 3D map you can interact with,” Winchester said.
“Right now that’s the only service they’re providing in the US and they see it as a major growth driver,” he said.
It comes with more risk – AMX’s core Australian division booked around $5.5m of annual EBITDA, while the US business is still loss-making – but “the upside opportunity is significant”, Winchester says.
Within that upside framework is the emerging metaverse – the movement of resources and capital towards the development of more detailed virtual ‘worlds’ and landscapes (led most notably by Facebook’s rebrand to Meta).
In early October, AMX inked a US$250,000 deal to license its high-res 3D map of San Francisco to Lunaverse – a US company building a platform for users to interact in a virtual environment and earn rewards.
“My main take right now with the metaverse is that it’s so early no one can really say for sure what it will turn into,” Winchester says.
“But one thing I’ve grown certain of is there really is money is being spent here. And some of the businesses that AMX is talking to or partnering with have already raised millions in VC funding.”
“There’s capital moving into it, although where it ends up I don’t know. But Aerometrex is in a position with their 3D mapping to at least get an early foothold.”
On the management side, Winchester also flagged last week’s appointment of Steven Masters as Aerometrex’s new CEO.
“That was an interesting hire because he (Masters) has a lot of enterprise experience, which to me says they’re probably comfortable with the product and technical side of the business,” Winchester said.
“So now the goal is to bring in that execution in client management and business development to take you to the next level.”
In terms of competition risk, AMX does have a battle on its hands with Nearmap to build its subscription-based imaging and mapping business – a sector where NEA “is that 800-pound gorilla” with a major slice (around 90%) of the current market, Winchester said.
However, it’s another example of a stock where his investment metrics have been met.
Downside risk is managed through a profitable domestic business, while AMX has demonstrated the ability to build early deal-flow with its upside US opportunity.
And heading into 2022, the company offers a compelling valuation after racing higher from its $1 IPO price to more than $2.
Since then, the stock has trended lower to its current trading range between 70-80c.
“That’s what actually first attracted me to the business – the price,” Winchester says.
“Declines like that can put some people off, but what I ask is – is there still a business here? Or a concept that’s broken down?”
“When a speculative business breaks down, that’s what it looks like. But every now and then there’s a company like AMX which still has a strong operating model.”
And once you’ve done the work to form your investment thesis – be patient.
“Even if it bounces sideways or falls further I can stomach that. I’m not a market timer. But I’m willing to wait 6, 12, 18 months and as long the business executes how I think it will, then the share price will catch up,” Winchester said.
“In my view, this is a business that has kept executing. The updates are in line with my expectations and the 3D stuff continues to look promising. So it’s another example of an ASX microcap that meets my investment criteria.”