The Market Disconnect Not Making Headlines

By Robert Miller | Portfolio Manager at NAOS Asset Management

When assessing the current landscape of the ASX, at present it is clear to see that there has been a significant shift of investor dollars towards a very select group of companies. Much has been made in the headlines about the WAAAX stocks (Wisetech, Altium, Afterpay, Appen & Xero). The share price performance of these companies has been exceptional, and in our opinion an element of FOMO (fear of missing out) exists which has driven these company valuations to multiples much higher than their comparable global peers.

Here we highlight how the demand for such businesses has had ramifications in the market and produced what we believe to be a disconnect between price and value that has developed over the past 2+ years. This disconnect exists between micro-caps and the wider market.

For the purpose of this article, we define a micro-cap as a company with a market capitalisation of less than $300m. To illustrate the disconnect between the performance of micro-caps vs the wider market, we have separated the domestic market (ex-resources) into two groups, those with a market capitalisation above $300m, and those below this threshold.

The chart below shows that since the recent lows of December 2018, companies with a market cap of less than $300m have returned approximately 4.6%; whereas companies with a market cap of greater than $300m returned almost 17%.

Source: Bloomberg

The reality of micro-cap investing

Micro-cap investing is not suited to all. In our opinion it is a much more inefficient part of the market that takes patience and tolerance to navigate successfully. In our experience, the growth and development of companies generally takes longer than originally anticipated. When a company achieves certain milestones or hits their targets, often it is not immediately reflected in the share price. There are also many other factors to consider such as liquidity, management expertise, capital requirements and investment time horizon, all of which require significant analysis in an area of the market which is not widely covered by analysts.

The opportunity of micro-cap investing

Micro-cap investing can also be an opportunity to obtain a meaningful position in a high-quality company before share price growth occurs. In our view, the holy grail of investing is finding a company with quality fundamentals that is growing its earnings before the wider market discovers it. Whilst these earnings continue to grow, its trading multiple expands, meaning investors are willing to pay a higher price for shares in this company. Many of the best ASX companies start out as micro-caps and have made those patient investors fortunes along the way.

Why has the current micro-cap disconnect happened?

In our opinion, this trade-off between ‘reality’ and ‘opportunity’ in micro-cap investing creates an area of the market that is cyclical in the court of public opinion. By that we mean that investing in listed micro-caps goes in and out of fashion based on how much emphasis investors are placing on each end of the reality/opportunity spectrum.

There have been recent examples of institutional investors losing mandates to invest in the micro-cap sector. When a mandate is lost a fund will have to return the deployed funds in a timely manner to the relevant mandate provider (e.g. an industry fund, non-for profit, charity, organisation, university, family office). This can result in large scale selling which is not correlated to the fundamentals of the underlying company.

As a result of the above movements by institutional investors, many retail investors follow suit by selling their shares as lower share prices often triggers further selling. Furthermore, leading into the end of a financial year, retail investors may look to manage their taxable income by undertaking tax loss selling on those positions which have underperformed during the financial year to offset their gains. Share prices then fall further, this time on very low volumes. This disconnect can become self-fulfilling. The result is an environment in micro-caps, like at present whereby very few investors want or have investment exposure and as a result liquidity disappears.

When does this disconnect end?

Whilst the current environment may not paint a rosy picture of micro-cap investing, we are firmly of the view that the public opinion pendulum will at some stage swing back to more normalised levels, meaning once again micro-cap investing will come into vogue. When will this disconnect end? Just like everyone else, we do not know.

What gives us confidence in our investment approach is the principle that despite short term disconnects between price and value, over the long-term, price should match value. This is particularly the case in micro-cap investing.

In his book ‘What Works on Wall Street’, Jim O’Shaughnessy analyses compound annual returns for a period of 50 years of US equities, segmented into the market capitalisation bucket. During this period, micro-cap stocks have outperformed large cap stocks by on average close to 3% p.a. The power of compounding means such that a difference of circa 3% p.a. means an outsized return of over at the end of that 50 years.

“The big money is not in the buying or the selling, but in the waiting.”  Charlie Munger

We believe this current period of disconnect for ASX micro-caps has further widened the inefficient playing field that is micro-cap investing. During this period of ‘waiting’ NAOS have been able to add to existing positions that meet our investment criteria. We can increase our ownership of quality businesses at low prices and also revisit companies we know well that have seen a significant earnings multiple reduction. Some have seen earnings multiples reduce for legitimate reasons that may be only short-term headwinds, others for reasons less relevant to the business fundamentals such as mandate or tax loss selling. These are the opportunities we like to see when making new long-term investments.

For those willing to spend the time doing the work on micro-caps, we believe there are compelling risk adjusted returns on offer. As the saying goes, good things can come to those who wait.

Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529 and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.