Volatility in small and micro-caps could be an opportunity. Here are 3 companies NovaPort likes

The following article was published by Sara Allen Livewire Markets, 1 June 2023.

Small and micro-cap companies are notoriously volatile, but NovaPort Capital’s Sinclair Currie argues a focus on quality is key to success.

You’d be hard-pressed to find an investor who doesn’t dream of finding that unicorn stock that rewards them with a huge upside. We’ve all heard the stories about those lucky investors who’ve made those elusive wins, but what if there was a formula that identified those stocks for you in volatile markets?

NovaPort Capital are that confident in their approach that a 50% upside return hurdle over three years forms part of their investment philosophy for investing in Australian small and micro-cap companies. So what does that approach look like and where is the investment manager seeing the opportunities right now?

I interviewed Sinclair Currie, portfolio manager for NovaPort Capital, to find out what he is expecting for markets, how to identify stocks with a 50% return upside and the stocks that he holds a high conviction on in the current market.

Volatile markets ahead

It’s no secret that small and micro-cap companies can be volatile to invest in. After all, their size and asset base leaves them vulnerable to market activities and events in a way that larger companies can better withstand.

Looking at the S&P/ASX Small Ordinaries in the last year provides a case in point.

As at 29 May 2023, the index is down 6.13% on the year and down 2.35% for the month… on a (very slight) positive, it is up 1.35% for YTD. 

Currie believes the volatility this year is linked to lower liquidity in the market.

“We believe the decline in liquidity seen this year is explained by elevated uncertainty about the direction of the economy and markets, which indicates low confidence in the 12-18 month outlook,” he says.

Investors shouldn’t take this as a signal to steer clear though.

“In our view, this creates opportunities for investors. However, the lagged and ongoing impact of tighter monetary policy on businesses means we have to carefully select which opportunities to back,” says Currie.

He suggests that investors focus on high quality and financial resilience to weather coming volatility. Volatility is not something to be feared, provided that the company “can be expected to maintain or grow its market share through cycles.”

Positioning and opportunities for the market

In anticipation of the environment NovaPort Capital sees, the portfolios are positioned with overweights in healthcare (to take advantage of income). The team are also taking advantage of selective opportunities for margin growth.

“The weaker market sentiment has created an opportunity for us to initiate exposures to quality growth companies, including Breville Group (ASX: BRG) and Netwealth (ASX: NWL),” Currie says.

Following on from the overweight towards healthcare, Currie sees specific opportunities from aged care reforms for small cap companies.

“Recent announcements of a new funding model and reformed pricing oversight has removed some of the overhang of uncertainty which had weighed on aged care operators. Further progress is required however we believe the shift in momentum is only just being appreciated by the market,” he says.

On the flip side, both micro and small cap portfolios are underweighted towards materials and energy with good reason. That is, the higher costs and risks involved in the early-stage explorers and development companies which are typically found in the S&P/ASX Small Ordinaries index.

“With respect to the battery materials sector in particular, we remain wary of the highly opaque pricing dynamics for these commodities in which demand and supply are both moving quickly in and out of balance,” Currie says.

How to find quality and sustainability in small and micro-caps (and that 50% upside return hurdle)

NovaPort Capital’s process aims to ‘buy companies, not stocks’. What it comes down to is a view on genuine belief in a company and deep understanding of it compared to the desire to trade quickly and regularly for returns.

“We invest investors’ money in companies where we have positively assessed the quality and sustainability of the business, the experience of the management team and the prospects for the strategy,” says Currie.

“In our experience, speculative bubbles percolate up through small caps and often leave investors with burnt fingers.”

Quality and sustainability are effectively interchangeable for Currie when it comes to identifying the right companies for the strategy.

“A sustainable business has customers which value its products (or services) and are less likely to search for alternatives. Quality businesses are sometimes exposed to the ups and downs of business cycles, however we should expect them to maintain market share throughout.

In small caps, management also has a significant bearing on quality. Their strategy must ensure the business addresses the fundamental current and future needs of all stakeholders. For example, Domain Holdings (ASX: DHG) business has many characteristics of a quality business, yet it is also exposed to the residential property cycle,” he says.

Domain is an example of how NovaPort Capital approaches researching and investing in companies with a potential 50% upside return hurdle.

“Sometimes we see opportunities because we are willing to take a three year view when the market is more focussed on the short term. For example, the current year earnings outlook for Domain Holdings is poor given presently weak listing volumes. However, we believe the share price will recover once real estate listing activity normalises, which we expect to occur within the next three years,” Currie says.

On the whole, aiming for the 50% return upside hurdle comes down to flexibility. Or as Currie puts it, to “maintain open minds to changes and new ideas, to try and understand the risks associated with each investment, and to carefully monitor investments to ensure they remain on track.”

That monitoring is critical.

NovaPort Capital will take the steps to sell companies that deviate from the outlook it holds, be it due to a change in strategy, shift in competitive dynamics, a regulatory change or even the identification of a more attractive opportunity.

Three high conviction small and micro-cap picks

While Currie also nominated Breville Group, Netwealth and Domain Group Holdings as companies NovaPort sees potential in (and has taken the opportunity to initiate positions in), there are three more companies Currie has high hopes for.

1. Aroa Biosurgery (ASX: ARX)

Market Capitalisation $341.39m

“Aroa Biosurgery is an ASX listed NZ based company has developed innovative products used for complex wound care and in abdominal surgery. Aroa’s products are well accepted by clinicians and has continued to generate impressive market penetration growth, supported by clinical data and experience.”

2. Capral Aluminium (ASX: CAA) 

Market capitalisation $127.44m

“Capral Aluminium has been transformed via rationalising costs and improving operational efficiency and customer service. Capral’s share price has recently weakened in sympathy with declining outlook for near housing starts. However with strong population growth and high demand for housing we expect a shallow and short construction cycle.”

3. IVE Group (ASX: IGL) 

Market capitalisation $331.57m

“We also expect IVE Group’s well credentialed management team to continue to deliver for shareholders, supported by consolidation in its printing and letterbox distribution businesses.”

Important Information

This material has been prepared by NovaPort Capital Pty Limited (NovaPort) (ABN 88 140 833 656). NovaPort  is the holder of an Australian Financial Services Licence AFSL AFSL 385 329 and is regulated under the laws of Australia. 

This document does not relate to any financial or investment product or service and does not constitute or form part of any offer to sell, or any solicitation of any offer to subscribe for interests, and the information provided is intended to be general in nature only.  This should not form the basis of, or be relied upon for the purpose of, any investment decision. This document is not available to retail investors as defined under local laws. 

This document has been prepared without taking into account any person’s objectives, financial situation or needs.  Any person receiving the information in this document should consider the appropriateness of the information, in light of their own objectives, financial situation or needs before acting.  The document has not been independently verified.  No reliance may be placed for any purpose on the document or its accuracy, fairness, correctness or completeness. Neither NovaPort nor any of its related bodies corporates, associates and employees shall have any liability whatsoever (in negligence or otherwise) for any loss howsoever arising from any use of the document or otherwise in connection with the presentation.