This article was originally published on LivewireMarkets.com on April 29th, 2024

Want to learn how to identify undiscovered stocks before the rest of the market does? Of course, you do – what else are you going to talk about at your next dinner party… Or at the pub over a lukewarm beer… Or around the office coffee machine?

In this episode, Livewire’s Ally Selby was joined by LSN Capital’s Nick Sladen and Elston Asset Management’s Justin Woerner for a deep dive into how investors can do exactly that.

They share why investors, like you and I, may have an advantage in discovering mispriced stocks in the typically undercovered small and micro-cap arena, the screens they use to identify winning stocks, and one non-negotiable that every company that makes its way into their portfolios needs to possess.

They also outline the risks investors should be aware of when hunting for gems in this area of the market, and whether it’s worth investing in IPOs – because God knows, this anonymous writer has been burnt doing exactly that.

And just to help you level up your dinner party/office/pub chat, we also asked Woerner and Sladen to name an under-the-radar stock they are buying today. You’re welcome.

Note: This episode was recorded on Wednesday 24 April 2024. You can watch the video, listen to the podcast or read an edited transcript below.

Edited Transcript

Ally Selby: Hello and welcome to Livewire’s Buy Hold Sell. I’m Ally Selby. Time and time again, you tell us you want us to cover stocks that are under the market’s radar. So today, we’re going to be doing exactly that. We’ll be teaching you how to identify stocks that are under-covered and undiscovered in the market. And to do that, we’re joined by Nick Sladen from LSN Capital and Justin Woerner from Elston. As you guys may know, a lot of smaller micro-cap stocks aren’t really covered by a lot of analysts. Nick, I’m going to start with you. Does that give investors an advantage?

Thin coverage

Nick Sladen: Well, it’s the opportunity – I guess. As small-cap investors, it’s all about getting your hands dirty and understanding the business, understanding the industry and understanding where these businesses are going to grow and win market share from. So we spend an awful lot of time working that out, speaking to listed and unlisted competitors, and working out which businesses and industries are doing well, trying to identify businesses that are performing well and that are, ideally, not covered by many brokers. That’s the aim of the game.

Ally Selby: Nick said you need to be speaking with management teams, but I feel like retail investors can’t really do that. Do you have any other tips for why investors may have an advantage when it comes to small and micro-cap stocks?

Justin Woerner: I think it’s really just around what Nick was alluding to, in just trying to gain an information advantage. So if you look at the FactSet data, if you look at the top 50 businesses, on average, they’re covered by 14 sell-side analysts. Whereas if you look at businesses between say 300 and 500 [in the index], there’s an average of three analysts covering each business, and there’s 20% of those businesses that have no analyst coverage. So I think it’s like Nick was saying, really just turning over every stone that you can and trying to dig up as much information as you can to build that information advantage.

Screening for winners

Ally Selby: How do you go about finding those small-cap, micro-cap gems in the ASX? Are there any screens that you use? And if so, what are they?

Justin Woerner: Yeah, we do. We start off with a series of quality-based screens, so that gives us a ranked universe. From there, we’re really just trying to ascertain the underlying quality of the business. So we’ll assess the industry structure. We’ll look for competitive advantages. We make sure the business has the ability to generate a high level of return on equity (ROE) or return on invested capital (ROIC). So we’re really just trying to ascertain the quality of the business. And then, we’re very disciplined about quality in the portfolio. So then, we just really aim to hold the highest quality businesses.

Ally Selby: What does quality mean to you though?

Justin Woerner: So quality means a lot of things to a lot of different people. To us, it’s really about the business’s ability to weather any storm that comes its way. So whether you think about regulatory change, industry change, competitive change, we’re really looking for businesses that have strong value propositions, strong competitive advantages, a big moat around them to really be able to protect them from whatever comes their way.

Ally Selby: It’s all about quality for Justin. Nick, are there any screens that you use to filter the small-cap universe, and if so, what are they?

Nick Sladen: One of the things about small-cap investing is you can have access to many founder-led businesses, and that’s something that we really value extremely highly, whether it’s original founders or executives with significant skin in the game. So you’ve got really good alignment that you don’t get in some of the larger-cap stocks. We also like return on capital, as Justin said. We think as businesses mature, their ability to generate free cash flow is really attractive because ultimately, that means the business can self-fund its own growth, and then as they do mature, they can pay back shareholders in the forms of dividends and share buyback. So again, we really like those quality businesses that have those attributes.

The non-negotiable

Ally Selby: Nick, in your mind, is there one non-negotiable when it comes to a small or micro-cap stock making its way into your portfolio?

Nick Sladen: From our perspective, it’s a pathway to profitability and cash flow break-even. We’re not in 2020 and 2021 anymore, when money was free. We’ve had 13 interest rate increases. The cost of funds has gone up materially. Equity markets, in terms of secondary markets, are no longer there to support businesses for many, many years that are unprofitable. So we really think having that profile is really important in this current market environment. That’s something that we’re very particular and focused on at the moment.

Ally Selby: For Nick, it’s a path to profitability. What’s it for you? What’s your non-negotiable when it comes to a small or micro-cap stock making its way into your portfolio?

Justin Woerner: For us, Ally, it’s definitely balance sheet strength. So once again, we run what we think is a very evidence-based investment process. So we went back to the small odds. We had a look at 20 years of data. We identified just over 100 businesses that had failed during that period, and in about 75% of those occurrences, there was some kind of connection to having over-leveraged balance sheets. So not always the primary reason for the business to fail, but quite often that inability to service your debt, to refinance your debt was really the final nail in the coffin with regards to a lot of these businesses. So for us, we’ve really focused on balance sheet strength.

What are the risks?

Ally Selby: You talked about businesses blowing up before. What other risks do investors need to be aware of, and is liquidity still an issue like it was in 2022?

Justin Woerner: I’m not really sure about liquidity. I’m not sure whether it’s changed or not within our portfolio. I do know that, quite often, if we put liquidity into the market on one side, we quite often find liquidity on the other side. So we do tend to look at free float market cap as well as liquidity. But I think investing in small caps really comes back down to you are investing in more immature businesses. So, like Nick was saying before, cash flow is very important. The risk is really around the sustainability of that business model and the sustainability of the profitability.

Ally Selby: Over to you, Nick. What risks do you think investors need to be aware of?

Nick Sladen: I certainly agree with what Justin said on the individual stock basis level, but if you look at the market as a whole, 2022 and probably the first half or quarter of 2023, there was a considerable amount of pressure on small-cap stock prices as there was institutional redemptions being pushed out into the market, and there was margin calls from the number of interest rate rises that we were seeing. So that was a significant headwind for the small-cap market at that point in time. And what we’re now starting to see is asset consultants getting a little bit more positive, institutional capital coming back into the market, and that headwind for 2022 and early 2023 is actually becoming a tailwind for small-cap investing. And that’s something that gives us confidence that it’s going to be a really good environment for small-cap investing over the next couple of years.

Where are the IPOs?

Ally Selby: How about IPOs? We kind of saw just no IPOs over the last year. Do you think IPOs are back on the menu? And if so, are there any IPOs that you’re excited about in 2024?

Nick Sladen: They’re not back on the menu, but we desperately need IPOs, and we desperately need good companies. We’ve had five, six, seven, eight companies taken over. You’ve had Pacific Smiles, CSR, Adelaide Brighton, Boral, InvoCare. They’ve all been taken over at what I’d argue would be – on a three-year basis – probably pretty attractive prices for the purchases. So we’re losing good companies, and we need some more good companies to come back onto the market. But I’m not getting many IPO documents across my desk at all, so there are not many IPOs I can currently recommend. But we’re looking forward to them coming back because we need them to replace those stocks that have exited the ASX.

Ally Selby: I personally was burnt investing in an IPO. Do you recommend investors purvey this part of the market, or is it a little bit risky?

Justin Woerner: We would probably say ‘no’. We tend to steer away from IPOs. Do agree with Nick that it would be good to get a few more businesses onto the exchange. We’ve certainly had a few leave, but when it comes to IPOs, we’re long-term buy and hold investors. So we like to see a track record of audited financial accounts. IPOs tend to come to market, and they’ll have maybe a couple of years of pro forma-based accounts, and quite often, they’re dressed up for the sale. So we just think there’s too much uncertainty and too much risk around IPOs.

Undiscovered Stocks

Ally Selby: Really excited for this. I asked our guests to bring along one undiscovered stock today that they’re buying. Justin, I’m going to start with you first. What’s your undiscovered stock?

Clinuvel Pharmaceuticals (ASX: CUV)

Justin Woerner: For me, it’s Clinuvel – CUV is the ticker. It’s a pharmaceutical-based business. We don’t normally invest in pharma businesses, but we think this one’s a little special. So, long-term management, long term rational approach to strategy, a lot of cash on the balance sheet, just announced the buyback. They’re profitable as well. So they’ve got one approved product, which they’re rolling out across the USA and Europe. And then going forward, we see quite a lot of growth drivers for the business. On the drug side, they’ve got several other indications which are in varying stages of the approval process. And then on the consumer side, they’ve just recently released – and they’re going to continue to further develop – a cosmetics line, which is really focused on skin tanning, protection, and repair. So we think that could be quite meaningful for the business longer term as well.

Ally Selby: Over to you, Nick, your time in the hot seat. What’s your undiscovered stock for us today, and why are you backing it?

Coventry Group (ASX: CYG)

Nick Sladen: We really like Coventry Group. CYG is the code. The market cap is around $160 million, trades on a single-digit P/E, and supplies industrial fasteners to the building industry. So that’s screws, nuts, bolts, et cetera. And it also does some work in the mining sector as well in terms of supply and componentry there. They recently made an acquisition – just as recently as last week – of a competitor, Steel Masters, which is over 30% earnings accretive. So they’re putting their balance sheet to work. That business has got considerably higher margins than they’ve got, so there’s really good upside from the margin perspective in that business and we don’t think it’s reflected in the current price at the moment. We’ve got earnings per share growth of over 50% in FY24 and 30% in FY25. We think the outlook is really strong.

Ally Selby: Well, I hope you enjoyed that episode of Buy Hold Sell as much as I did. If you did, why not give it a like? Remember to subscribe to our YouTube channel. We’re adding so much great content just like this every single week.

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