UBS Asset Management For professional / qualified / institutional investors only.
May 2020
Australian Equity Microcap Insights Opportunities abound in Microcap space As the economy moves into the post COVID-19 recovery phase, UBS Microcap Fund Portfolio Manager Joel Fleming expects microcap companies to be an important contributor to the recovery, Joel Fleming with many smaller firms driving high levels Portfolio Manager Yarra Capital Management of growth as they take advantage of the lasting changes caused by the pandemic.
There are a large number of common misconceptions Microcap recap about the contribution made by Australia’s smaller firms to Microcaps offer the largest investable universe by number the domestic economy. Some of Joels’s favourites include: on the ASX. With no ETF or passive products, a more constrained liquidity profile compared to large caps, and a • “Micro companies are largely in retail and service vast investable universe, Microcap investing is all about sectors and employ relatively few people in active management. comparison to larger firms” The index represents opportunity, with many examples of • “Micro and small companies tend to not be profitable. companies that have delivered on an idea and transitioned Profits in Australia are driven by large firms in the into the sphere of Australia’s Top 100 listed companies. mining, banks, supermarket and health care sectors” Think Afterpay, A2 Milk, Domino’s Pizza or TPG Telecom. • “Micro companies pay small dividends and have low While much of the universe will deliver poor returns, operating margins. Investing in the space is all about despite the hype and promise, the success stories can capital growth” deliver many multiples of an initial investment. • “Earnings growth for Micro companies are much more They touch every part of the economy, an important factor volatile than Large Caps” in the current period of change and disruption and the likely domestic driven recovery. There are 820 listed Though many people subscribe to the view that micro companies between $20-$250mn market cap (total market companies make only a token contribution to national cap $63bn) (Figure 2), and this already wide opportunity output and economic growth, the data tells a very different set is further enhanced by generally low investor and story. Micro firms – defined as having less than 5 media coverage. Compared to larger peers, it remains a employees – and their small company (less than 19 hugely inefficient part of the market. employees) counterparts employ 44% of the Australian workforce, contribute 48% of corporate profits and Since smaller companies tend to have a single focus on a generate 34% of Australia’s economic output. And, particular niche, they are often more dynamic and innovative. interestingly, the contribution of micro firms actually Clover Corporation, a provider of a key ingredient for the outstrips smalls in three of four key areas (refer Figure 1). manufacture of infant formula, is one example of many. Figure 1: Micro and Small Companies’ Share of the Figure 2: Microcap Universe By Market Cap Band Australiain Economy 400
60 350 300 50 250 7.9 40 200 17.2 30 150 12.6 100 20 16.1 39.8 27.0 50 10 21.7 12.7 0 0 Employment Wages Operating Profit Value Add
Micro Small
Source: YarraCM, ABS Source: YarraCM, ABS The COVID-19 impact Figure 3: ASX 200, Small Ords and Emerging While the market has recovered strongly from its March 23 Companies – Total Return CYTD (%) low point, we remain positive on the medium-term 10 opportunities that exist as a result of COVID-19. 0 Firstly, we believe growth will be a rare commodity as we adapt to a new normal and understand the impact on -10 unemployment and consumer spending and the wider implications for GDP growth. -20 Secondly, the economy will see structural change whether -30 it be increased digitisation or reshaped market structures -40 given the makeup of competition within sectors. This will provide both opportunities and threats for business. -50
Lastly, the outlook for yield also provides an interesting -60 backdrop with much debate around future payout ratios 31-Dec-19 31-Jan-20 29-Feb-20 31-Mar-20 30-Apr-20 and underlying levels of dividends. This is further ASX 200 Small Ords Emerging Companies supportive of capital growth, represented by businesses Source: FactSet, May 2020 that are growing strongly, being applied a premium. Outlook The rapid decline from the market peak (February 20) to the The strong outcomes to date on infection and the careful bottom (March 23) represented peak fear on the Australian re-opening of the economy have provided the market with health impact and resulting economic fallout. We saw an confidence as we re-emerge from hibernation: children are initial risk-off phase as investors moved away from heading back to school, shops are opening and many perceived higher risk, lower liquidity and more speculative aspects of normal life are emerging. positions. The ASX Emerging companies index best reflects Markets have recovered in recent weeks on an improving a Microcap subset and to illustrate this Index delivered a outlook as the economy emerges from lockdown and decline of 40.8% over February and March as compared to consumers seek a return to some sort of normality. the 29.7% fall in the Small Ordinaries (Figure 3). Updates from Baby Bunting, Clover Corporation and Initial concerns on supply chains were quickly replaced by Alliance Aviation have led to significant positive share price fears on solvency and liquidity as investors contemplated a movements, as the strength of their business models is potential zero revenue environment. Our approach was to affirmed and fears around recent trading have been shown test the investment thesis on every position in the portfolio to be unfounded. and re-test as the facts changed (e.g. launch of JobKeeper Our outlook is premised on a number of factors: and guidance on tenancy related matters). 1. Volatility will continue in the short-term Regular interaction with management teams has been Uncertainty around both the impact of the lockdown and critical, enabling us to model a company’s capacity to the shape of the recovery will inevitably give rise to absorb the shock. Understanding the true state of cost continued volatility in the short-term. While many bases and balance sheets has seldom been more important. businesses have performed well during this period – in While the initial sell off was indiscriminate, the rebound particular those with strong online offerings, gold miners has unsurprisingly favored those more liquid small and and companies providing essential services or products – microcap names. Over time, we can expect a move further there is still a large unknown around future employment, down the market cap and liquidity spectrum as investors consumer spending, and the speed at which the rest of the seek to add portfolio risk and leverage to the rebound. world will begin to open. Only then will we see the lasting Smaller companies that are able to tap into changing damage emerge. industry dynamics and carve out niches will be well placed 2. The casualty list will be long to outperform on the medium term. We expect that many businesses will not re-emerge from Given our hard market cap limits on initiating positions, the this period as government support withdraws and the market decline has increased our investable universe. Many economics no longer make sense. This may entail complete companies have been sold off aggressively, even though exits in some industries or a significant downsizing in their long term potential remains intact, enabling us to add operations. We see changes to competitive dynamics as a higher quality businesses to the portfolio. result, and this creates opportunity for those offering a better solution or experience for their customer base.
3 3. Great companies can still thrive The case for microcaps One thing that is unchanged is that the listed microcap While the decline in microcaps has been particularly sharp market is still willing to back a good idea. The market is through COVID-19, they have still outperformed large caps willing to fund and support great management teams over the past five years (whilst delivering a similar dividend seeking to build out their business plans. It remains an yield)1. important aspect of investing in the space and can provide And while COVID will have long lasting impacts and be the the initial entry into an opportunity with significant catalyst for much structural change across the economy, promise. small and nimble businesses with a sound financial base 4. The path back may not be linear and a sharp focus on their customer are well positioned to A re-emergence of COVID-19 – and thus another take advantage. hibernation of the domestic economy – is the greatest risk A lower-for-longer growth environment should see a at this time, though is not our base case. The path of the premium applied to businesses that are successfully global economy and our trading relationship with China delivering this rare attribute. This is also likely to be are areas which add to the uncertainty. reflected in M&A activity, as larger businesses seek growth Our base assumption is that with the opening of our at a time where this is difficult to deliver organically. domestic economy underway, many of our portfolio In conclusion we believe it is an opportune time to look at companies are well placed since they are domestically microcaps as part of a diversified portfolio. Our core focus focused, have lean cost bases and have built their on the quality of management, the quality of earnings and operating platforms on scalable technology. The changing the balance sheet has served us well during these times of competitive landscape will provide opportunities for and reinforces these attributes as key foundations of our growth as efficient, nimble companies grow their market investment process. share in a profitable way. This growth will be well rewarded by investors. 1 Source: YarraCM, performance of ASX200 vs MSCI Australian Micro Cap Index, 1 Dec 2014 – 1 May 2020
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