Separating the 'Haves' and 'Have Nots' in Small Caps?
The global sell-off in equities may have hit the small cap market hard ― particularly growth and technology stocks ― but for investors, the lure of the faster growth rates on offer in the sector remains.
With many small cap growth and technology stocks down more than 70 per cent from the November 2021 high, the market has seen companies that are unprofitable and burning cash perform the worst, driven by fears of a liquidity crunch if new equity cannot be raised.
The recent market sell-off has put a number of companies in the sights of corporate raiders. The most vulnerable companies sharing a similar profile of depressed share prices, an open register, solid financials and a potentially large market opportunity.
But without a crystal ball and being conscious that buying a particular stock on the hope of a takeout can often end in disappointment, we can look at how and why some businesses stand out from the crowd.
It pays to be highly selective
In this period you need to be highly selective and take at least a two to three-year view. If you are prepared to ride out the volatility, there is potentially a lot of money to be made. However, it’s not all about trying to find the next windfall gain, as these are rare, but more importantly it’s about being focused and disciplined when screening stocks.
The X factors that matter
There are around 2000 Australian small caps listed on the ASX.* So, examining the qualities and operations of each of these businesses to decide if it could ultimately provide long-term sustainable growth and competitive advantage is not simple, or a time-friendly process. However, there are certain factors that do guide the assessment of small cap stocks and how they might perform in a range of economic conditions, including:
- Having a unique business model with strong proprietary intellectual property
- Capital light funding structures
- Large addressable markets, which are preferably global
- A clear path to profits and positive free cash flow
- A strong management team, that can execute the growth strategy and respond to any threats.
We are currently seeing a number of attractive stocks in the sector that have many of these characteristics and will continue to assess their value in line with evolving conditions.
Even for the most seasoned investment specialists, picking the market bottom (or top) is difficult at best and is no different for the small cap sector. Investors should therefore speak to their adviser and look to accumulate positions over a reasonable period and complete their buying when upward trends have been firmly established.
*Rounded figure at June 2022
The information provided was prepared by Evans and Partners Pty Ltd (ABN 85 125 338 785, AFSL 318075) (“Evans and Partners”). Evans and Partners is a wholly owned subsidiary of E&P Financial Group Limited (ABN 54 609 913 457) (E&P Financial Group).
This communication is not intended to be a research report (as defined in ASIC Regulatory Guides 79 and 264). Any expressed or implicit opinion or recommendation about a named or readily identifiable investment product is merely a restatement, summary or extract of another research report that has already been broadly distributed.
The information may contain general advice or is factual information and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Where a particular financial product has been referred to, you should obtain a copy of the relevant product disclosure statement or offer document before making any decision in relation to the financial product. Past performance is not a reliable indicator of future performance.
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