Three microcaps under the microscope

PORTFOLIO POINT: Microcap stocks offer good opportunities for retail investors willing to roam into smaller territory. Here’s three stocks that have recorded strong growth.

One of the advantages that retail investors enjoy over institutional investors is that they can more readily invest in smaller and less liquid issues.

While the larger fund managers may have a relatively limited set of companies into which they can deploy meaningful chunks of capital, enterprising small investors are free to roam, and roam they should.

Research indicates that their investment returns can be significantly enhanced by focusing some attention on the smaller end of the market.

The challenge for the enterprising retail investor is sifting through large numbers of lacklustre small companies to find the few that deserve their investment capital. Good broker research at the smaller end can be scarce, and the company names (as well as their products or services) may be unfamiliar.

I use proprietary software (e.g. Skaffold) to help me analyse and assess every company listed on the ASX. Each day my software models acquire and process large volumes of historical and forecast data to identify a relatively small number of companies that I think warrant closer study.

Before making any investment decisions I apply all of my human insight and judgement to the individual opportunities, and reject many of them. However, I know from experience and from extensive back-testing that the ideas generated by the models tend, on average, to be uncommonly good.

This week my models are at your disposal. I have turned my attention to the very small end of the market – companies with a market capitalisation of $50 million or less – to see whether I can identify some potential future stars.

Due to liquidity constraints these companies are challenging for me to pursue, but enterprising retail investors may find that focusing some attention on the following businesses is time well spent.

You might ask, why am I being so generous? The reality is that a fund with several hundred million dollars under management cannot employ even 2% of its assets without owning more than 10% of the issued capital of the company. That’s not to say I don’t or will not own them in the future.

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My Net Fone Ltd

My Net Fone Limited (ASX: MNF) provides internet-based voice-over-internet protocol (VoIP), data and video services to residential and business customers. The company is debt-free and generates good cash flows. It’s a business that benefits from scale, and having been loss-making up to 2008, MNF has more recently become profitable and demonstrated strong earnings growth. The share price has risen in response to this, but at its current size MNF seems to still offer considerable scope for further growth, and has the winds of structural change behind it.

Beyond International Ltd

Beyond International Limited (ASX: BYI) produces and distributes television movies and series for television, cinema and pay TV in Australia and overseas. Television production accounts for a large component of BYI’s earnings, and is focused on the production of factual series, sporting events, family/children’s programs and documentaries.

BYI’s financial performance shows positive long-trends across a range of key metrics including EPS, cash flow, balance sheet leverage and ROE, and the most recent full-year result included an impressive 66% improvement in EPS. Positive long-term trends in these measures are often an indicator of a strong underlying business, and a potentially rewarding long-term investment.

Supply Network Limited

Supply Network Limited (ASX: SNL) provides after sales service and parts for commercial vehicles (trucks and buses). For FY2012 it reported its fifth successive record profit, with EPS increasing by an impressive 48%. The business has minimal debt and a healthy ROE. There is one possible area of concern in that cash flow fell in FY12 – a result that was attributed to increasing inventory levels in support of sales growth. I would want to see this trend reversed in future periods, but aside from this SNL looks to fit the bill.

Summary

While they are diverse, these three businesses share some important common themes: all have solid balance sheets, high growth and sensible valuations. While there’s no guarantee that they will continue to perform at historical levels, these features mark them out as worthy candidates for your research time and attention.

Something to remember with smaller companies is that management can have a disproportionate influence. Experienced, stable, shareholder-oriented management (particularly with skin in the game) can be an important contributor to success. Pleasingly, the CEO of each of the three companies listed above has a meaningful shareholding interest in the business and, should you choose to become an owner, their interests are therefore better aligned with yours.

Two final points: Firstly, at the smaller end of the market, the risks can be greater, and investors need to consider carefully how much capital should be allocated to a single opportunity. Having said that, the rewards for identifying the right ones can be very substantial.  

Secondly, be careful not to extrapolate the returns you might make from investing in a handful of smaller companies to those you might make as a fund manager working with several hundred million dollars. It’s easy to make 50% on $100,000. While it’s certainly possible, it’s much, much harder to do it with a hundred million.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.