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Why Technology Makes ASX Small Cap Stocks Winning Investments?

Stuart Lucy

Stuart Lucy is an Investment Specialist at the Australian Stock Report, and has gained exposure to funds management and investment banking throughout his career. He draws on this experience to provide macroeconomic commentary and actionable investment insights to clients. Stuart is responsible for writing reports, is involved in delivering Macrovue webinars and provides general advice to our members on portfolio construction. Stuart currently holds RG146 General and Securities qualifications.

With the ASX 200 having barely changed over the past 12 years, you could be forgiven for thinking that the local market is not a great place to build wealth. You at least have to do a lot better than the average investor to make money, and, by definition, the average person can’t do that. This signals that most people will struggle to win off large stocks.

The problem with this argument, however, is that the ASX 200 is dominated by a handful of companies, most of which are in the financial or mining sectors. Many financial stocks have been poorly managed, have large market shares domestically and have been unsuccessful at expanding overseas. Mining is a cyclical industry in which large Aussie producers like BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO) and Fortescue Metals Group (ASX: FMG) are already world leaders. China is urbanising at the fastest rate in history, making it unlikely for demand to be much higher than it already is. While demand will most likely hold up, allowing investors to collect an income, it is unlikely to be as good an investment over the long term.

One factor that could increase small cap outperformance going forward is the average company now stays in the S&P500 for less than 15 years, as compared with 60 years a few decades ago. This means that people who buy the top 100 companies just because they are big are going to be tracking the performance of more and more companies that are headed for the dustbin, rather than profiting from the continual outperformance of previously untouchable blue-chip stocks.

ASX Small Cap Stocks 1
The average lifespan of a company is declining (Source: Innosight)

The accelerating pace of technological innovation means that existing companies need to become more agile. Barriers to entry in most industries are going down, and this will increase the number of smaller firms that are able to unseat larger competitors. Large banks like Westpac (ASX: WBC), The Commonwealth Bank (ASX: CBA), NAB (ASX: NAB) and ANZ (ASX: ANZ) are already investing heavily in tech to avoid becoming the next victims of the creative destruction shaping the world economy.

One thing that makes it much easier for small companies to innovate and scale is the cloud. Platform costs used to make it difficult for small tech companies to get their products and services off the ground. Cloud based computing reduces the costs of developing, marketing and scaling innovative tech-based solutions, which has resulted in an explosion of successful small cap tech companies.

Another benefit of small cap investing is the ability to profit from a less efficient market. Most very large companies are covered by numerous brokers and analysts, making it difficult to identify and profit from factors that are not already in the price. If only two brokers cover a stock, as is the case with a lot of the small caps on the ASX, it is much easier to identify and buy stocks at attractive prices. This is what attracts a lot of fund managers to small cap investing and is where Warren Buffett started his career.

How do I find small caps?

If you don’t hear about opportunities from others or constantly monitor the market, it can be difficult to know where to start when investing outside the top 100 names on the market. That’s because you may feel that you don’t know or trust the companies and would prefer to stick with what you know. This sort of thinking however is what got investors stuck in the largest names on the index, which was a losing strategy over the past 12 years.

One solution is to look around whenever you see a company to see if it’s a worthwhile investment. This strategy is advocated by Peter Lynch and may have helped identify Shaver Shop (ASX: SSG), a household name that has gone up over 45% this year.

Another way we often use is stock screens. These can look up every business within a matter of seconds and return the companies that meet pre-defined investment criteria. These may involve returns on equity, earnings growth, valuation multiples or a combination of a few of these. We make sure our stock screens are developed by a fund manager, because we want to be aligned with a screen that successful investors use in the market.

Just because a company meets a pre-defined set of criteria doesn’t mean that it is a great investment, but it is something that can provide investors with a place to start looking at opportunities. This is particularly useful in international markets, where there are far too many stocks for us to know them all.

One of the screens we use identifies companies with a quality dividend yield. One defining attribute of quality yield is the sustainability of their dividend income. Analysts are projecting a bearish picture for coal prices, with futures pointing to coal price declines. Nevertheless, even if these bearish forecasts do pan out, the company will still yield around 10%. While that alone is not enough to make an investment decision, it isn’t often that a company still yields 10% if pessimistic forecasts eventuate.

How we Use Stock Screens to Identify Companies with a Quality Yield ?

On HALO, our portfolio management and analytics tool, we have a monitor designed to identify companies with a quality yield. This helps identify companies which will not only provide you with a stable income stream, but also one that grows over time.

Given that the average Australian house cost well under a thousand pounds a century ago, it is imperative to make sure your income keeps up with inflation. Many dividend investors however think that it is fine for a company to now grow its dividends at all, and some even unquestioningly live with declines in dividend income that go on for years. We don’t, which is why our quality yield monitor will only return companies that have growing dividends.

It is also important however that if you are investing for yield, the company you are investing in has dividends which are better than average. While we do recommend keeping an open eye to global opportunities, the Australian market does have higher average dividends than most other global exchanges, primarily due to the tax advantages of paying out profits in the form of dividends. We ensure that all the dividend stocks we recommend have a yield of over 5%, which is 25% above the average for the index. While Australia is a dividend investor’s paradise, you still want to be doing better than average in terms of the income you will get today.

Since the monitor is designed by a top performing fund manager who has seen a few financial crises, it excludes any companies with a debt to equity ratio above 30%. This automatically rules out the big banks and has been included because companies with high levels of debt often go bust in recessions, leading to permanent loss of capital. Anyone who has been in the markets a while can tell you that permanent loss of capital is a much bigger problem than price risk or even dividend cuts, because the entire investment is lost forever. This is why we make sure that we focus on low debt companies; when well-managed, these businesses are unlikely to go bankrupt and are more likely to be able to maintain dividend payouts.

ASX Small Cap Stocks 2

Figure 1: Dividend cuts often come at the worst times (Source: Standard and Poor)

Another factor we consider is the return of equity of the business. Many investors turn a blind eye to this metric, losing large sums of hard-earned money in the process. Return on equity is the profit of the company divided by the amount of money the business invested to get those returns. This is often very different to the market capitalisation of the business and represents the efficiency by which management gets returns on the cash invested.

This is important because, if is too low, management is most likely not efficient at making money, or the business operates in a low-quality industry. Both these factors make dividends more unstable and increase the chance of a dividend cut. The problem with dividend cuts is that you often take a capital loss by moving the money elsewhere, which is why we make sure that all companies we invest in have a return of equity that is over 10%. This is a good indicator that the business is of a reasonable overall quality.

The last part of our monitor screens out businesses with a market capitalisation of less than a billion dollars. While not essential, it gives us businesses that investors are more likely to be aware of, as well as ones that are more liquid.

While this excludes some small caps, a company still has a lot more room to grow from a $1bn valuation than it does from a $50bn market cap in an industry it already dominates. This makes it a great tool to identify quality companies that are well on their growth trajectory. It is particularly good at identifying value mid-caps that are trading at attractive valuations and have the potential to end up as large caps.

Going out of the ASX 100 for Growth Stocks

One way to play stocks outside the ASX 100, is to invest in small caps that operate in cloud computing and 5G. These sectors have been top performers on the stock market, and present attractive small cap growth opportunities. Both factors are intertwined, with the development of 5G enabling more cloud computing than ever before. As discussed above, this will continue to be a game changer for small cap investing.

5G technology development is an innovative, lucrative and high margin business. It will enable networks to become much faster, allowing cloud computing software to be created for everything from autonomous cars to IoT devices. This will turbocharge growth in the cloud, as shown through projections for data centres demand to soar over the next few years.

 

ASX Small Cap Stocks 3
Figure 2: Data centre traffic projected to grow at 25% a year over 5 years (Credit: Cisco)

Companies will also build more advanced processors that can make the most of what 5G has to offer. Finally, you have telecommunications companies that are responsible for rolling out the 5G infrastructure, which will replace their existing 4G networks that will soon be obsolete.

Of these industries, developing network technology and technology that enables products is by far the best quality business to be in. The best 5G technology will help differentiate telco operators in a competitive market, giving the businesses that sell such technology a very high degree of pricing power.

Processors are another great business to enter, partially because 5G will enable the introduction of the internet of things. This development will increase demand for processors exponentially, since people will have dozens of computing devices at home instead of just a few, such as computers and smartphones. For industrial applications, increased automation will result in rising expenditure on devices requiring processors, although this expense will enable business to cut costs by a greater amount.

The technology will provide by far the least benefit to telcos. The main advantage they will have is being able to lift premium enterprise revenue, by allowing for the development of high-end packages for applications like gaming and autonomous cars. Most telco players, however, are not well positioned to take advantage of growth in the technology. This is because telco consumers expect continual network improvements without meaningful price increases, as they have been receiving for decades. This means that telco companies have a large bill for a 5G rollout, just to stay relevant in the eyes of consumers. With most operators rolling out 5G networks simultaneously, we do not anticipate major global market share shifts within telecommunications off 5G development.

Since 5G is such a transformative technology, it will affect multiple industries and winners won’t be evenly spread. This is why it of paramount importance not to just invest in any company exposed to the 5G trend, because some of them won’t go up just by being connected to the technology.

How do I get the Good 5G and Cloud Computing Businesses?

For an easy way to take advantage of price gains from companies that will make the most of 5G and cloud computing, we have a 5G Networks portfolio on our international investment platform, Macrovue. This portfolio, which attracts no management or performance fees, has given us over 32% in the past year.

This is because we not only find out how 5G will affect different companies and industries, to ensure we choose the right ones for future growth, we also look into hundreds of businesses to find the very best companies. Since it is such a transformative trend, it would be worth at least considering a few of them to tap into the revolutionary potential of what 5G has to offer.

  • Qualcomm (+32.65% LTM), one of the largest mobile chip makers globally and a company that is aggressively marketing its 8-series mobile platform chips customised for 5G enabled devices. The chipmaker also has several marketable connected car platforms that enable autonomous driving through 5G and is positioned to grow market share.
  • Skyworks (-0.39% LTM) sells semiconductor support applications that enable the internet of things to function. The firm’s technologies are applied across areas as diverse as avionics, biomedical products and collision avoidance systems in autonomous cars. With IoT enabled devices poised to grow to 75 billion by 2025, Skyworks is positioned to enjoy attractive growth for the foreseeable future.
  • Keysight (+63.82% LTM) produces communications solutions, electronic industrial solutions and ixia solutions, helping customers enhance network performance and security. Unlike other companies in this view, Keysight focuses on maintaining 10% EPS growth but with growing net margins which sit above 20% through improving overall business quality.

 


 

Disclaimer:

This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978)

(“ASR”). ASR is part of Amalgamated Australian Investment Group Limited (AAIG) (ABN: 81 140 208 288 Level 13, 130 Pitt Street, Sydney NSW 2000).

This article is provided for informational purpose only and does not purport to contain all matters relevant to any particular investment or financial instrument. Any market commentary in this communication is not intended to constitute “research” as defined by applicable regulations. Whilst information published on or accessed via this website is believed to be reliable, as far as permitted by law we make no representations as to its ongoing availability, accuracy or completeness. Any quotes or prices used herein are current at the time of preparation. This document and its contents are proprietary information and products of our firm and may not be reproduced or otherwise disseminated in whole or in part without our written consent unless required to by judicial or administrative proceeding. The ultimate decision to proceed with any transaction rests solely with you. We are not acting as your advisor in relation to any information contained herein. Any projections are estimates only and may not be realised in the future.

ASR has no position in any of the stocks mentioned.

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