For small cap stock investors, the COVID-19 risk outlook is at an interesting juncture heading into June reporting season.

At current levels, the ASX Small Ords Index has bounced by an impressive 40 per cent from its March 23 low of 1,825 points (that still leaves it around 17 per cent below February highs above 3,000 points).

The catalyst for that rebound was a wave of stimulus from both central banks and governments. From here though, major economies globally are now grappling with the problem of how to reopen in a safe manner without sacrificing productivity.

The net result resembles a “tug of war” according to Chris Macdonald, principal advisor at broking and wealth management firm Morgans.

Stockhead caught up with Macdonald recently to get some insights on how he’s allocating capital in this environment.

Despite the uncertain risk outlook, Macdonald said he’s selectively adding to some ASX200 positions. He also highlighted three ASX small caps — Bubs (ASX:BUB), Althea Group (ASX:AGH) and Intelicare (ASX:ICR) — that still have positive growth metrics in a post-COVID world.

 

Macro potholes

Framing his investment view within that macroeconomic outlook, Macdonald said equity prices currently resembled the contrasting market forces.

“I think we’ve hit a bit of an equilibrium, starting with the unprecedented stimulus and a huge wall of cheap money flushing the system,” he said.

“Then on the flipside, you’ve got this huge economic black hole. How long will it take to fill in, and also what will the debt hangover be that comes with that?”

“So with markets at these levels, it feels like there’s a pretty even tug of war between the two.”

Macdonald said that left him cautious for the next six weeks through to the end of June reporting season, although he isn’t ruling out a second-half rally.

“There’s two things that have me cautious; one is that compared to the US, Australia has a pretty good handle on the real numbers around infection rates,” he explained.

“A lot of states in the US don’t really have that. So I think the next few weeks we’re likely to see a couple of pretty sharp spikes around the globe, albeit into hotter weather. But that may create some fear sentiment.

“The second reality, particularly in the US, is that analysts are going to have to try and model the impact of this quarter into those July earnings numbers. I don’t know how they’ll do it, but I’d expect to see some pretty sobering revisions in June, so that’s another potential wobble.”

Once the numbers are in though, it will at least remove an element of uncertainty from the market.

“Then hopefully we’ll see a more optimistic outlook, with quarterly numbers out of September almost growing exponentially off those July lows,” Macdonald said.

Within that framework, Macdonald picked three ASX small caps from three different sectors — infant formula, aged care and medicinal cannabis — that still have upside in the months ahead.

“What I’m looking for is companies that regardless of what happened in COVID-19, and what’s likely to happen in the slowdown, they still have good earnings prospects with top-line growth in customers and revenue. I want to tick that box first, then I’m happy to play risk,” McDonald says.

 

ASX small cap contenders

An early favourite of Mcdonald’s since it listed in January 2017, infant formula company Bubs was an early beneficiary of the COVID-19 crisis when it had to ramp up production to meet stockpiling demand.

Like for all infant formula players, there’s also the China opportunity, where Bubs has gained entry. Chinese demand is still growing at around 100 per cent per year but only represents “around 25 per cent of Bubs’ revenue”, Mcdonald said.

“The big shift for them this year is they became genuinely cashflow positive, so they’ve got that tailwind and they continue to win shelf space in the major grocers.”

Mcdonald also cited an expanded product range and the high valuations among competitors in the space. While Bubs shares have bounced sharply from their crisis lows, “I do think it can continue for those reasons”, he said.

“It’s a value-add high margin agricultural product. I’m still a fan and if we get a market pullback I’d be adding more to my positions.”

 

Aged care tech company Intelicare completed its IPO round through the teeth of the COVID-19 headwinds.

But it managed to close its $5.5m round and is likely to get some attention on debut next week, when it will become one of a small handful of companies to have listed since March.

The company’s core product is a software-as-a-service (SaaS) solution that tracks and monitors the movement of elderly residents in their home, with a mechanism to report unexpected changes to carers and family members.

“The reason I liked that business was that it’s a scalable technology that had a reason for being,” Mcdonald said. “It had a reason for being before COVID-19, but probably even more so because of it as well.”

“In my experience, anecdotally there’s very few stocks where you explain the model to someone and they quickly say yes, that makes sense.”

“And you want to buy these stocks when they’re genuinely pivoting from the trial stage to the commercialisation stage, and be there when revenue accelerates.”

Mcdonald said Intelicare had a number of pieces in place to help that topline growth, including some early wins in establishing its distribution network along with government subsidy support.

“If you look at machine learning and AI, we’ve seen the performance of Appen (ASX:APX) — learning from data and tailoring the solution for an individual — that’s how the next stage of tech is working.”

Intelicare is working with a similar model, using machine learning to provide a preventative health solution, in an aged care industry that has a “structural deficit of around 90,000 beds”, Mcdonald said.

“I think it’s an appealing product for families and the elderly who are often isolated in their homes. It’s a SaaS business that operates with a simple monthly fee, and they don’t really have any genuine competition in the market.”

Mcdonald’s third small cap pick, Althea Group, operates in Australia’s cannabis sector, which is coming off a brutal 2019 bear market.

But the local industry has seen some positive regulatory developments in recent weeks, including the potential legalisation of over-the-counter CBD sales.

“Cannabis stocks have had at least two phases, and the third phase is about sustainable value-add and earnings,” Mcdonald said.

“And that’s where I think Althea has a bit of a unique selling property. It’s dealing with patients for medical prescriptions, and they tend to be chronic ailments. So once they switch to a cannabis-based prescription, they tend to use that for months and years.”

“They’ve got good cash levels and their top-line numbers are growing rapidly here but they’ve also opened up in the UK and Germany, both of which are around three times the size of Australia.

“So it’s another company which fits my model — good balance sheet with about $15m in the bank, a good sticky recurring revenue business and monthly growth. Regardless of COVID-19, it’s still ticking those boxes in an uncertain world.”

 

Back on the macroeconomic front, Macdonald said the fact it’s a US election year may help bolster sentiment in the December half.

“Often that period in an election year turns out to be the best half out of the eight halves per cycle,” he said.

“The big unknown is a vaccine. My feeling is it probably won’t happen, but what we will do is have hospitals better equipped, with treatments to reduce severity.”

“So I’m optimistic in the second half, but in the meantime I’m being very selective in terms of the stocks that I’m buying due to the uncertainty.”

Read MoreCannabis StocksCOVID-19Software as a Service - SaaS

Featured Companies

You might be interested in