Often overlooked, micro caps are offering value

One of the weapons an individual has over institutions is time, and with real value emerging at the micro-cap end of the market, smaller stocks are an area worth holding on to.

A fund manager needs to report that it’s beating its benchmark index each quarter, but a private investor has the luxury of hunting for value then waiting for that value to be released. It can take years, but it’s worth it.

My family bought Bolnisi Gold for about 8¢ a share, and we spent about $70,000. About five years later, when the shares went well north of $3, this investment returned in the region of $1.5 million. Sure, we had various duds, but you only need one winner to transform your return.

Back to the value at the little end. A proxy for the micro-cap index is often thought to be the S&P/ASX Emerging Companies Index, the participants of which have an average market cap of about $100 million. This index is down about 25 per cent in the past 12 months, compared with the S&P/ASX 200, which, even after its correction of more than 9 per cent in the past month, is up almost 17 per cent.

Many small resource and industrial companies are trading at below their book value, which means that, in many cases, you could sell their assets, render the debt as worthless, and still make a profit on your shareholding.

In fiscal 2014 terms, the average price-to-earnings multiple for a small industrial company is 12.7 times, compared with about 14.6 times for a big-cap industrial.

But it’s not enough to be cheap. A key reason these companies are being sold down is liquidity. Investors have been pouring money into the big banks and Telstra, as well as companies that have demonstrated consistent double-digit growth, such as REA Group, which owns realestate.com.

The macro winds need to be blowing in the small and micro caps’ favour for this value to be released. But before this happens, it’s important to be positioned in the potential Bolnisi Golds of this world.

Andy Gracey runs Australian Ethical Investment’s small-cap portfolio. He says his portfolio has a defensive bias, with holdings including infrastructure companies and regional banks. But lately he’s been picking up micro caps, where he says value is emerging. He’s been buying hard-hit companies such as IT services provider ASG (ASX code ASZ) and some selected biotechnology companies.

‘‘People have definitely been focused on liquidity and safety in numbers lately. Small stocks are definitely unloved ... They get sold down to the point where there are genuine buying opportunities. Patience is the key, and knowing your stock.’’

Gracey names the health-related stocks of gene-therapy company Avita Medical (AVH), Alchemia (ACL), and Universal Biosensors (UBI) as some of his favourites being held by Australian Ethical.

Significantly, the majority of sales from these companies are off shore – in US dollars and euros – so they will be benefiting from a weaker Australian dollar.

Gracey knows that some of the smaller stocks can hurt his portfolio if things don’t go to plan, but he also knows that to produce outstanding returns in future, his fund can’t rely on stocks whose short-term returns are reliant on dividends. And nor can your super.

Richard Hemming edits the newsletter Under the Radar Report: Small Caps.