Morsels under the micro-scope

PORTFOLIO POINT: The micro-cap sector can be challenging for investors, so it’s important stocks tick the right investment boxes.

We know that good things can come in small packages; but sometimes even better things can come in even smaller packages.

As a specialist small-mid cap manager, I spend a good deal of our time trawling through stocks at the smaller end of the market capitalisation spectrum looking for the next “big” thing. These so called micro-caps (market capitalisation less than $200 million) can often prove a fertile source of stocks that will eventually become core holdings.

Some key characteristics that I look for when digging down into the depths of micro-cap land, include:

• Management. I prefer a CEO who I either know well or someone with a reputable track record. Regardless, I must have met management at least once, and often I have met with management several times, prior to investing.
• Growth. I want to see sustainable growth at the top line and also margin expansion as the enterprise achieves critical mass.
• Profitable and cash flow positive. I look for businesses that are both making money and generating cash – a subtle but important distinction.

So what am I seeing out there at the moment that fits the bill?

Silver Chef Limited (ASX: SIV). Market cap $131 million. I first invested in this provider of speciality asset finance to small-medium enterprises in March 2012. At the time, Silver Chef’s market cap was about $60 million and it was raising $10 million at $2.80/share to fund its burgeoning pool of rental assets. SIV provides long-term rental of commercial equipment to small businesses across Australia and New Zealand, with a focus on the hospitality industry. Since listing at $1 in 2005, SIV has achieved earnings per share CAGR of 20% and has paid final and interim dividends every six months (including right through the GFC). The growth and profitability boxes have both been firmly ticked on this one. And after becoming comfortable with SIV management, led by CEO Charles Gregory, I have been very satisfied with my investment, which is now breaking new ground at around $5/share.

Australian Power and Gas Company (ASX: APK). Market cap $95 million. APK is a fast growing electricity and gas retailer operating in Victoria, New South Wales and Queensland. The best measure of APK’s growth is its customer accounts which have gone from 54,000 in June 2008 to 341,000 in June 2012. This has led APK to take that important step in the evolution of any micro-cap in achieving critical mass and turning a profit (since 2010) and also paying dividends (maiden in 2011). I have met MD James Myatt at least once every six months (often more) over the three years I have owned APK and have always been impressed by his grasp of the key business drivers and his ability to clearly outline the business strategy to his investors.

Briety Limited (ASX: BYL). Market cap $33 million. Despite its size being right at the bottom end of the micro-cap spectrum, this mining services business is still able to demonstrate the three key attributes I look for when examining the minnow end of the market. Management is well regarded, with MD Peter McBain whipping the business into line and returning it to profitability since taking over the reins in November 2011. Analysts forecast the business to grow 25% in the current year and dividends to be at least maintained at 2.75cps (around a 9% yield). Currently trading around $0.30cps with net tangible assets north of $0.40cps and earnings per share of $0.085cps at 30 June, BYL is cheap in anyone’s language. It is trading at a discount to net tangible assets (mainly earth moving and mining equipment) and is on an historic PE of 3.5x (and 3x FY13 earnings).

I must also make an honourable mention of a stock that has recently popped up on my radar and which looks very interesting. Freedom Foods Group (ASX: FNP) has a market cap of $70 million, which includes a stake in the New Zealand listed A2 Corporation worth approximately $85 million. FNP has debt of $30 million, FY13 EBITDA estimated at $11 million and the business is growing at 20% per annum. FNP has three primary operating businesses:

• Freedom Foods – Specialty dietary foods production including gluten free, nut free and wheat free cereal based foods.
• Pactum – Rapidly expanding UHT production facility (for Asian export markets).
• Specialty Seafood – Brunswick Sardines and Paramount Salmon canned seafood product distribution.

The company is profitable, growing and, having met with the CEO Rory Macleod twice now in recent months, management seem to have a good handle on the business operations. Whilst the valuation of its stake in A2 Corporation (currently worth more than FNP’s entire market cap) and its relatively low stock liquidity makes this one a less straight forward investment, it is certainly screening well and worth watching over the coming 12 months.

Rob Calnon is portfolio manager at OC Funds Management Limited.