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.

Opportunities abound

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:

1. Having a unique business model with strong proprietary intellectual property
2. Capital light funding structures
3. Large addressable markets, which are preferably global
4. A clear path to profits and positive free cash flow
5. 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.

General considerations

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.