Criterion: ‘Outstanding’ value is emerging in the small caps sector, but investors need to kiss a lot of frogs 

Yarra Capital Management says investor appetite for small caps is returning, spurred by the weak $A and takeover activity.

Selecting small cap star stocks involves kissing a lot of frogs and not ending up with too many toads. Pic via Getty

• A lower Australian dollar is likely to spur takeover activity in the small-caps sector

• Yarra Capital Management insists on meeting management and walking the shop floor in its selection process

• The firm likes stocks that service the mining, energy and data centre sectors

A confluence of factors including the weak Australian dollar has created “outstanding” opportunities in the small caps sector, according to Yarra Capital Management’s chief minnow whisperer.

One compelling reason is that the flailing Aussie dollar is likely to result in more takeovers – a trend that already has become apparent.

The other is that a weakening currency is linked to expectations of imminent interest rate cuts – another tailwind for the sector.

“The last couple of years have been tough for the sector generally,” says Yarra’s microcaps portfolio manager Joel Fleming.

“When rates go up, people avoid risk assets.

“Now there’s some outstanding value on offer, with some great companies doing great things.”

Merger mania takes hold 

Fleming says small caps already have been a “wonderful hunting ground” for mergers and acquisitions.

This week, online broker SelfWealth (ASX:SWF) was taken over by Syfe group after a three-way contest.

Smartpay has attracted a non-binding offer from Tyro Payments (ASX:TYR).

Mayne Pharma (ASX:MYX) is almost certain to be subsumed by US dermatology company Cosette, while Pointsbet (ASX:PBH) has fielded offers from Mixi Australia and Bluebet (ASX:BBT).

As Fleming puts it, there are “good, bad and indifferent” small caps, with the latter two categories outweighing the former.

Have a crack, not a croak

So how do astute investors identify the next Fortescue (ASX:FMG), Pro Medicus ProMedicus (ASX:PME) or Afterpay (subsumed by US payments giant Square, Block Inc (ASX:SQ2), for $39 billion in 2021)?

Within an hour he will know whether the company can achieve greatness by observing how happy and engaged employees appear to be.

“It’s about sitting down with management and working out what they want to achieve and whether they have the skills and balance sheet in place to go and have a crack,” he says.

“You need to kiss a lot of frogs.”

‘Agnostic’ approach

Yarra is agnostic in terms of sector or size, with its investments range from a $250 million market cap to as little as $50 million.

Fleming says this market sector is a great space for value sniffers, as it gets little or no analyst coverage. Usually, management is up for a chat.

As a result, discrepancies between a company’s valuation and its ‘real’ worth have not been exploited.

The firm embraces resource stocks, but will baulk at biotechs and explorers, which rely on a binary outcome such as a positive trial or drilling result.

The fund currently around $100 million under management across 50 stocks.

Yarra’s tips

Fleming cites Energy One (ASX:EOL) which provides software to the energy utilities – notably in Europe.

“As electricity networks evolve, it is creating opportunities as the market changes,” Fleming says.

A provider of software to the mining industry, RPM Global (ASX:RUL) has tie ups with some of the world biggest miners.

Fleming adds the company is more focused after selling its expert report (consulting) business for a tidy sum.

The data centre sector has run hard and Yarra was an early investor in NextDC (ASX:NXT) and Global Data Centre Group (ASX:GDC) , which held an investment in Airtrunk (acquired by Blackstone last year for $24 billion).

These days, Yarra prefers tangential exposures such as Southern Cross Electrical Engineering (ASX:SXE) , which provides electrical services to these digital repositories.

What’s more, the “picks and shovels” Southern Cross has a diversified exposure to other sectors needing in-demand sparkies.

We failed

Fundies are notorious for crowing about their successes and sweeping their failures under the Axminister carpet.

Fleming says his worst failure was investing in NextEd Group (ASX:NXD), which provided education for global students.

NextEd got caught out in the pandemic and then missed changes in government policies aimed at stemming migration. The stock has lost 97% of its value over the last five years.

Happily, Yarra’s portfolio princesses outnumber the warty toads.

Managed by Yarra, the UBS Microcaps Fund returned 21% in the yar to March and has yielded 12.7% since its inception in August 2014.

Over that time the ASX small-ordinaries index has returned 6%.

Originally published as Criterion: ‘Outstanding’ value is emerging in the small caps sector, but investors need to kiss a lot of frogs