Riding the Small-Cap Wave: Opportunities Amidst Market Volatility

As we close out the 2024 financial year, in Episode 32 of Stocks Neat, CIO Steve Johnson, and Portfolio Manager Alex Shevelev, do a deep dive into the state of small-cap stocks and the latest market movements. 

They discuss recent market volatility, spotlight resilient companies with strong recurring revenue, and share their stock-picking strategies. The episode also covers risk management approaches and provides insights on future market trends.

Tune in as they discuss current opportunities, from small-cap recovery to potential high-performing sectors. 

"The small-cap market has been a challenging space, but within it, there are high-quality businesses with strong recurring revenue and free cash flows, presenting significant opportunities for investors." 

Transcript

EPISODE 32

[INTRODUCTION]

[00:00:03] ANNOUNCER: Just a quick reminder, this podcast may contain general advice. But it doesn't take into account your personal circumstances, needs, or objectives. The scenarios and stocks mentioned in this podcast are for illustrative purposes only and do not constitute a recommendation to buy, hold, or sell any financial products. Read the relevant PDFs. Assess whether that information is appropriate for you. And consider speaking to a financial advisor before making investment decisions. Past performance is no indicator of future performance.

[INTERVIEW]

[00:00:39] SJ: Hello, and welcome to episode 32 of Stocks Neat. I'm Steve Johnson, Chief Investment Officer here at Forager Funds. And I've got a portfolio manager on our Australian shares fund, Alex Shevelev, sitting in the hot seat with me today. Hi, Alex. How are you? 

[00:00:53] AS: Hi, Steve. Hello, everybody. 

[00:00:55] SJ: We're just wrapping up the end of the financial year. And that's what today's podcast is going to be about. What's working out there? What's not? And what's ahead for the coming financial year in terms of where opportunities are? Neither of us have a whiskey. We're completely under the pump here at Forager at the moment and don't have time to be drinking whiskies. But I did host a whiskey club in my house on Saturday night. Catch up with a couple of friends once every 3 months or so and try a few new whiskies. And we had a sensational one. 

For anyone who's following along out there and wants to try something new, there's a Dalwhinnie 15-year whiskey on sale at the moment at Dan Murphy's. 99 bucks. They say it's normally 150. So, who knows what it normally retails for? But it's available for a very reasonable price at the moment. And one of the best whiskies I've had in a long time. It is apparently the highest geographically distillery in Scotland. Lots of very clear, fresh water. Tiny, tiny little bit of peat taste to it, but very, very drinkable whiskey. I reckon grab yourself a bottle of that while it's on special. But we won't be having any today. 

What's been happening in your world, Alex? 

[00:02:02] AS: Not a lot, Steve. Trying to manage school holidays in the lead-up to reporting season. 

[00:02:06] SJ: Father Sunday or Monday? 

[00:02:07] AS: That's right. 

[00:02:08] SJ: What did you get up to? 

[00:02:09] AS: That's a good thing to do. We went to a big, big jumping castle. Kids had a riot. It was very good. Very good.

[00:02:15] SJ: Sounds like a dream.

[00:02:16] AS: Yup. 

[00:02:19] SJ: End of the 2024 financial year. Now behind us. We've been sort of banging the drum for some time now about the case for a small-cap recovery. How did it shape up in the 2024 financial year? 

[00:02:31] AS: Well, I wouldn't say we got it for the whole year. We definitely had a stronger finish than we did start to the markets overall. And small Ords did underperform All Ords for the year by about 3%. I think the big story remains that, over the last 3 years, we're looking at 24 odd percent underperformance of the smalls versus the All Ords still. 

[00:02:54] SJ: That's cumulative. Not per annum. Yeah.

[00:02:56] AS: Correct. Cumulative. And we can see that. And I think we're seeing a lot of that in the stocks that we're looking at now and the stocks that we hold in the portfolio and the opportunity set that we've got in front of us. I think we saw a good reaction from some select stocks towards the tail end of FY 24.

[00:03:15] SJ: It felt a bit different this past year in that some stuff was working really, really, really well. I felt like there was a period of time there, particularly that post-2021 meltdown, where it sort of didn't matter what the business was doing. The share price was getting hammered. This past 12 months has felt like the performance, especially in small-cap land, has been much more divergent. It's not like nothing's working out there. We've had stocks do particularly well over the course of the year.

[00:03:39] AS: Yeah. I mean, Gentrack is an absolute great example of exactly that. There is demand out there from investors for the right sort of businesses. I mean, Gentrack, the underlying business model was always quite high-quality hidden by missteps of management and various issues in the UK for quite a while. But once people started to focus on that underlying core business model, the consistent upgrades from the new management team were very helpful as they scored some goals. And that idea that the stock can graduate from being quite small, quite illiquid where very few people can participate in that market given its illiquidity up to a situation where more can participate up to a billion dollar market cap and a whole heap of liquidity where even more people can participate has really shown itself, especially in the year with Gentrack, with a handful of others. RPMGlobal is a pretty good example as well in that context and a few others out there as well. 

[00:04:45] SJ: Even more recently, that Paragon Care, which we wrote quite an extended piece of in the March quarterly report. People can go back and have a read of that if they want. But it's now a billion-dollar or close to a billion-dollar market cap, I think that business. And there's been a lot of change there. But you can just see that process of, "Well, okay. This is now accessible to a significantly higher number of investors." And the management team's impressing people. And that one's very, very early days in terms of the numbers actually showing the benefits of the merger that's going on there. But it's not the gap between what people are finding appealing and what they're not. It's just enormous at the moment. 

[00:05:24] AS: And it's an interesting one for the inefficiencies that surround small-caps. Like That deal that they did was very – 

[00:05:32] SJ: This is Paragon Care you're talking about. Yeah.

[00:05:33] AS: Paragon Care's deal. The merger with CH2 completely changes the business, completely changes the scale, completely changes the shareholder register, the management teams turned over. Boards turned over. I think in the early stages of that, it just was not recognized. And there were people who were sitting there saying, "Okay, I've made a bit of money on this deal. The stock's up a little bit. I'm going to be a seller." And quite aggressive. 

[00:06:01] SJ: “I haven't had liquidity for 5 years. The second I get it, I'm going to take it.” Yeah.

[00:06:05] AS: And then there is a subsequent period where more people go to meet the management team, get their heads around the business, and are able to ascribe a more realistic value to that business over the subsequent six, potentially 12 months. It feels that process is still ongoing to some extent. 

[00:06:26] SJ: Yeah. I think if something like that happens at the large-cap end of town, 10 brokers write a report on it, everyone reads that broker report, it pretty quickly gets absorbed into, "Okay. This is what the business is today and what we think it's going to do in the future. And then it's a harder game about whether that's right or wrong." Whereas this was not complicated. But just not well covered. 

And the other thing I think is just a lot of scar tissue. Because the original Paragon Care business – for a bit of background for everyone here, this was a listed medical distribution company. It's called a merger. But, effectively, a company that is bigger than it is backdoor IPOing into it the owners of this CH2 company, which is a pharmaceutical distribution business will own 50% of the combined entity. So It's a completely different management team. The whole board of the old company is gone. And there's a new board come in place. But there's still scar tissue from people that have been invested in an underperforming company over a long period of time. And that's something I think we're all guilty of from time to time even just on a stock that you don't own hasn't performed well. You've done well from not owning it. It's very hard sometimes I think to change your mind when the facts change quite substantially.

[00:07:36] AS: And they can change quite quickly as well. That morning, there was quite a substantial change in what the future cash flows of this business were going to be. Yeah.

[00:07:44] SJ: Yeah. And we just had a fairly long debate about a company this morning that I've certainly got some preset opinions on that maybe need to be more flexible in the old red bubble, which we don't own at the moment, but is going through some change itself.

Interestingly, I think in the last year – and I guess it comes back to some things working out there, it was really the mining small-caps that dragged down the overall small-cap index. If you just looked at industrials, which is something we've talked about in the past, it was roughly in line with the All Ords index. Both of which were well under what we've seen globally from better quality businesses. But that mining drag on the small-cap index is also been something that – I mean, it comes and goes, but has been a drag over a fairly long period of time. 

If you look at that performance report, one stat that really struck me was that small Ords index has only done 4% per annum, this is including dividends, since we started our Australian fund back in 2009. It's a pretty woeful return. Is that what you get from investing in small-cap stocks in Australia? Is it just reflective of a bad 5-year period? Or is it actually not reflective of the universe and the value that you can get there? 

[00:08:54] AS: I think it's reflective of a few things. One is that that small-cap resource exposure has tended to underperform over long periods of time as a group. Of course, there have been highlights in that group and there have been low lights. But as a group, they've tended to perform quite – even when compared to the large-cap resources. 

We've obviously had the last couple of years where small-caps have dramatically underperformed All Ords as well. That's not helping. And then when we look at small industrials, the very nature of that index is that large swings, both positive performers and negative performers, are dramatically more positive and dramatically more negative than the stocks you'll find in the large indices. And at the core of it, it's that dispersion in returns that actually makes small-cap such a prospective place to go hunting for interesting stocks. 

[00:09:49] SJ: Those fund managers that are lucky enough to have that small Ords index as a benchmark to return against, there is a lot of crap in it that's pretty easy to avoid. Not profitable. Not cash generative, speculative mining, speculative medical sort of stuff. It does tend to drag things down. And I think if you just looked at a cohort of larger or better quality small-caps, it's probably performed a lot better than that over time. It's a bit of a weird thing, I think, for us. There probably is no genuinely appropriate index for what we do. And we try and provide it to people more for this is the tailwind or the headwind wind. Rather than this is what we're actually trying to beat every year. We're trying to generate double-digit returns over extended periods of time here from the businesses that we own. And we think that will outperform the returns from equity markets over time. But it's not us sitting here trying to just beat the index on a month-by-month basis.

[00:10:45] AS: And it's worth noting that small-cap index actually finishes with companies that are still reasonably sized and reasonably liquid. There is a vast group of stocks underneath that the micro-cap set that has even more variability than the small caps do and have historically had very large amounts of dispersion. Very big winners that have made their way through small Ords and then into the 100. And then companies that did very poorly as well. That, again, is a very prospective place. And we've got quite a lot of a portfolio that's more in that space. 

[00:11:19] SJ: And more than a few that went both ways.

[00:11:21] AS: Yes. 

[00:11:23] SJ: Up into the 100. And then all the way back down.

[BREAK]

[00:11:25] ANNOUNCER: Stay tuned. We'll be back in just a sec. Are you a long-term investor with a passion for unloved bargains? So are we. Forager Funds is a contemporary value fund manager with a proven track record for finding opportunities in unlikely places. Through our Australian and international shares funds, investors have access to small and mid-size investments not accessible to many fund managers in businesses that many investors likely haven't heard of. We have serious skin in the game too. Meaning, we invest right alongside our investors. 

For more information about our investments, visit foragerfunds.com. And if you like what you're hearing and what we're drinking, please like, subscribe, and pass it on. Thanks for tuning in. Now, back to the chat.

[INTERVIEW CONTINUED]

[00:12:08] SJ: We've seen some crazy moves in the US over the past sort of five trading days. We're recording this on the 17th of July. Back end of last week and then the first couple of days this week, a really dramatic reversal of small-cap underperformance over the past 12 months. The gap between the Russell 2000 and the S&P 500 over the past four trading days is 10%. The Russell has outperformed the S&P 500 index buy. It doesn't seem to be a lot of rhyme or reason to it all from my perspective. Either the sustained and dramatic outperformance of large-caps prior to it all, this reversal. Why it's happened? Or when it's happened? But what do you make of it all, Alex? 

[00:12:52] AS: Well, it's pretty wild over there. As you say, Steve, it's a different world. The liquidity is dramatic. I was having a conversation with Harvey about one of the smaller stocks international portfolio that market-cap-wise is quite a bit smaller than some of the stuff that we have in the Australian. But liquidity-wise trades a lot more than we're likely to see here. And I think one of the byproducts of that liquidity is quite quick adjustments to various changes in people's views. You do have positioning that starts one way and finishes another way. Very quick turnarounds on ETF-driven flows.

[00:13:29] SJ: Yeah. It's more thematic-driven than stock-specific. Obviously, around reporting season, you get stock-specific moves as well. But we're just seeing these wild swings on, "Okay, interest rates are going down. Pals come out and said interest rates are going to be down. And in small-cap land in Australia, it tends to be a lot more idiosyncratic. I think it's sort of the big moves happen around results or company announcements. And it takes time, like you said, for people to digest things. 

Over there, it seems even less about what is the company and how much profit does it make? And what is its factor that it's exposed to? And they get whacked and then recover dramatically on the back of that. One big thing in the past few days has been, okay, Trump's 70% likely to win the election according to the bookmakers. Sell everything that's going to be a loser because of that. And buy everything that's going to be a beneficiary. And we talked about in the reports about a company called Nextracker. Does solar farm equipment installation. Share prices down 20% over the past 4 days. As people have said, well, Trump's going to win the election. I mean, it probably does have an impact on business. But it's a fairly subtle shift in probabilities. And I think a fairly modest impact on the actual financials of the business as well. But those factors just work. Take your money out of the ETF that's exposed to all of the Trump things and all of the stocks get sold. 

[00:14:48] AS: It might be a byproduct of this happening on a more stock-by-stock basis in Australia. But we do see when these factor changes occur. But some of the larger stocks, the more liquid ones, go quicker in the direction that you would expect that factor to go. And some of the smaller stocks, they lag, can be quite dramatically. And it can cascade its way down from large, to small, to micro, which is quite handy, because you do then have somewhat of a lead from the larger stocks exposed to similar themes, if not factors. 

[00:15:17] SJ: To the extent, I have no idea whether this is the start of a more sustained period of better performance for small-cap stocks or not. But to the extent that it does happen, that is the difference here is the potential to recycle for at least a period of time out of stocks that do well initially into ones that take a bit longer for the market to find and recognize the opportunity that's there. 

Just in terms of the setup here, I saw a stat the other day, the concentration of the 10 largest stocks in the S&P 500. It's about 35%, 36% of the index of the S&P 500 at the moment. Just the market cap of those 10 companies. That is the largest that's been since 1929, the concentration of those huge businesses as a percentage of the market. 

I think there were good reasons, all of these trends, for things getting started. They are good businesses. They're growing quickly. They're global rather than just domestic US businesses. You can make an argument that they can be bigger than the big businesses were before. But once it starts working, people are doing well out of it. The index funds are doing better than active management. It becomes just self-fulfilling because it is what it is and the money has just kept piling into it over the past six months to the point where just the constraints of the size of the economy start to become very, very significant for that cohort of stocks. 

[00:16:38] SJ: Do you have a view on whether this is quick or slow? Or this is the start of some small-cap outperformance here? 

[00:16:45] AS: It feels, at least on the Australian small-cap side, like we've breathed a little bit of life into the space. That can – maybe not quite as violently as you talk about in the US. But it can breed its own success over time. You have the ability for businesses now to access capital, for example, whereas they didn't really necessarily have that option or potentially didn't have that willingness because prices were not what they were willing to raise capital at. That will spur some activity as well. That's very helpful. 

We're fighting, obviously, macro constraints to some extent in the small-cap side of things. But it feels like for particular businesses like we've spoken about already, for the likes of Gentrack, a lot of the stock-specific factors that are favorable are now actually getting a hearing and actually getting rewarded. Whereas even those positive stock-specific factors, 12 months ago, people were saying, "Well, that's all good and well." But small-caps – and now they're saying, "Well, that's great. We'll mark those stocks up." If you don't have some of those factors, you're still struggling a little bit. But that can also be opportunity. 

Yeah. I actually think it's a fairly ripe environment for just stock picking the opportunity set that's out there. And there's been a bit of disagreement in the – not disagreement, but differing opinions in the office about whether we even want this small-cap recovery to happen or not. Because I think, at the moment, like you said, there is stuff working. The performance of the funds has been good for the past two years. Been better than even those large-cap indexes. And the opportunity at the moment is to keep recycling those things that work into new ideas that are cheap because there's not widespread optimism in the space. 

And to the extent that it catches up through small-cap share prices going up broadly, then I think that makes that job more difficult. Whereas at the moment, I think the ability for us to keep adding value is very, very good. Maybe that's helped by it's not getting worse at the moment. Everything's not going down. But I think, at the moment, and you've seen this in the returns, it's been a relatively productive time. And you look at our portfolio today and we've added a lot of new stocks this year. And there's a lot of those that are way, way off there. 52-week highs.

[00:19:08] AS: I mean, for me, it comes back to that dispersion in smaller and micro-cap stocks. We can have an overall tailwind, which is helpful. Maybe that tailwind doesn't need to be extreme. But as long as we're able to recycle into pockets that are not working or individual stocks that are not working, I think we're going to be finding interesting and sufficient opportunities to deploy the capital that we take out of those that have been working and have moved through to our target prices and above.

[00:19:36] SJ: We won't talk too many of the new names right now. But what are some general pockets or areas where you're still seeing really good value out there in small-cap land? 

[00:19:46] AS: I've been generally really pleased to find some of the higher quality growing businesses that have done quite well for us over the last couple of years. Still, businesses with quite good recurring revenue at the smaller end of the market, quite ignored, but good characteristics with free cash flows that are high single digits. Or in some cases, low double digits just a year or two out without necessarily needing to make any heroic assumptions. 

There's enough of them out there at the moment for us to recycle a lot of capital into them. We've picked up four or so of those just this calendar year. All of the stocks in that bucket I feel are much like the Gentracks, the Catapults, the RPMGlobals. When there is a shift of attention to that part of the market, that graduation thematic can start to move them through smaller, illiquid. it's tough for us to get set. It's impossible for others to get set. To a situation where more people can buy it. And then onwards where even more can. So, there are a lot of those new businesses I think that have that capability to them by virtue of the strength and what we've bought business model-wise.

[00:21:08] SJ: Yeah. There are businesses I guess at an end of the spectrum where we're sitting there saying, "We're not really too worried about the external environment here. They've got nice predictable revenue streams." Often, there's a bit that needs to happen on the cost front, the scale. Benefits need to come through to profitability. There's stuff that still needs to happen. But it's not this business is in a state of turmoil. There is stuff though that I think is more economically exposed at the other end of the spectrum that's also interesting at the moment.

[00:21:36] AS: There is. And we've picked up also a couple in that space where, economically speaking, people are looking at the situation and going, "Well, this business has been ravaged by the environment that we've seen out there." And we think there is a way that they make their way through the difficult environments. Some of these stocks are off dramatically from prior highs. And it doesn't actually take much in that as we've seen a little bit recently on one of the smaller positions in that space. And it takes a little bit less negativity to pass through. Sometimes all it takes is just the conclusion of selling that had been out there and you get quite meaningful increases in price. 

And we've had quite a significant period of transitions over the last sort of while in small and micro-cap stocks. That is fund managers that have had money taken away. And they've been quasi-forced sellers or forced sellers but over longer periods of – and that's been difficult for some of the stocks to absorb, especially the ones with low liquidity, which has driven their prices dramatically lower, which has presented opportunities. 

We've been on the buying end of a couple of those situations. And sometimes they've been at prices that you would not have envisaged just a couple of weeks prior. But that's what was needed to clear the overhang of that particular line. 

[00:23:05] SJ: Yeah. It's a really interesting and sort of mixed cohort of stocks there. But some of them, we expect the profitability to get worse probably before it gets better as the economy continue to deteriorate. But I think, especially in that small, less liquid space, it's a real mistake to think you can sit here and wait for the environment to get better and then still buy the stock at a depressed price. Some of these businesses, I genuinely think if they navigate through this difficult economic period, they can be up four and five times. And the first 50 and 100% of that move can happen without a lot of liquidity. 

If you're us and you're sitting there trying to invest millions of dollars, it can be almost impossible after the news starts to get better. They're all positions that we can upsize and make larger and let grow into larger positions as we get confident that they are going to navigate the environment and get back to historical levels of profitability. But, yeah. I think the liquidity has been there over the past few months. And it's been a really good opportunity for us to get initial starter positions into some businesses. And I'm pretty optimistic about over longer-term time frame.

[00:24:08] AS: We shouldn't. I mean new has been quite perspective. But we do have quite a few stocks in the portfolio that haven't contributed much in FY 24 that are sort of in a stage where we feel the next 12 months would progress the market's understanding of that business. ReadyTech, for example, has been a big position throughout FY 24. It didn't contribute much to the year really. The business is in a position now where it's pushing through growth that might not be the mid-teens that had been expected of it some years back. But it's still quite consistent in the low double-digit range. And the ability to score some pretty large contracts on the enterprise side of things, really cement a business there that looks like a mini Tech One over time. And, again, it's nice recurring revenue. It's consistent cash-generating business with margins that have been high for quite some time. And the incremental revenue that is dropping through at high rates of free cash flow. 

[00:25:12] SJ: Yeah. And to that point, it's not even stocks that are down or haven't performed over the past year. I think one of the best opportunities – and we've talked it to death over the past three or four months. Or I certainly have. But catapult is a stock that's up close to 100% over the past 12 months. One that I think has a huge amount of upside in. And is only partway through that. Maybe it's not scar tissue, but a forgiveness phase for that business. A lot of people burnt by the previous share price retraction from $4 all the way down to 70 cents at one point. But they're really putting some runs on the board. And that business is a business that I think can grow for a very, very long time. 

[00:25:48] AS: I think more generally, we've come quite a long way from a couple of years ago where businesses have not only pushed free cash flow back to zero for some that had been loss-making just trying to grow – spending the free cash to grow. Sitting there going, "Okay, we are at scale. We've created scale in our business. We've got a nice recurring revenue base. We're going to focus on dropping quite a large portion of our incremental revenue down to incremental free cash flow." 

And I think that's a really important discipline for businesses to have internally. And it's actually a really important discipline to then communicate to investors to say this is what we're going to be doing. Hold us accountable for progressing along this particular path. At the end of that path, it might be 3, 4, 5 years down the line, we are going to be generating free cash flows that are very, very attractive. In the interim, we're flipping past free cash flow. We're moving to small amounts of cash flow. But you can see the incremental nature of those moves relative to our growth in revenue.

[00:26:55] SJ: That's the other problem. If the market just goes up on hold, All Ords change their minds again and go back to burning cash because they can raise the capital from the market. 

All right, Alex. That's the end of our podcast for today. If you want to hear more from Alex and the rest of the team, we've got our online roadshow coming up in a week's time. Get on the website, register for that, and tune in. We'll also be around the country in September. We'll have dates out for that soon for people to keep. 

Look, if you're sitting there thinking you can still afford to wait at the small-cap end of the market, I really think it's an important time to be thinking about your portfolio allocations. Get in touch with the sales team if you have any troubles adding to your investment. But this small-cap recovery, there's some real signs of it taking off in the US and some green shoots here in Australia as well. And both portfolios are very well-placed to take advantage of that. 

Thank you for tuning in. As always, any questions, send us an email or give us a call. Thank you.

[END]