This article was originally published on LivewireMarkets.com on April 8th, 2024

Among equity investors, 2024 is being touted as the year of the small cap. From Australia to the US, valuations are near the basement, earnings quality has been improving in many industries since the end of the free money era, and if you believe that rate cuts will tie in with a slow growth-esque (or at least, non-recessionary) environment, there is plenty of reason to be jumping on the bandwagon.

With this theme in mind, we’ve tasked a fund manager to share with us how he would invest $10,000 in new (hypothetical) capital. This time, it’s Gary Merkel, Portfolio Manager at Elston Asset Management. Merkel has picked three constituents of the ASX Small Ordinaries Index.

The rules are simple. Each participant answers a couple of quick-fire questions about their process and views on valuations. They then use $10,000 in (hypothetical) cash in up to three individual assets.

What’s your opinion on valuations in the markets that you cover?

Throughout calendar year 2022 and most of 2023, small caps had a very tough period relative to their mid and large-cap peers. The smaller part of the market more acutely felt investors’ concerns about the impacts of the monetary tightening cycle.

During this period, investors of the larger counterparts seemed to be more willing to look through the short-term headwinds. More recently, we have seen a rebound for small caps, coinciding with the rally in global markets and a better-than-expected reporting season.

While there aren’t as many bargains as there were six months ago, we still see attractive opportunities for long-term small-cap investors and, more broadly, valuations look reasonable.

What is your biggest hope and concern for markets moving forward?

There’s always short-term noise or concerns. Currently, interest rates, inflation, and global growth are the most vocal. As bottom-up investors, we try to look through the noise and focus on finding longer-term value. While we are not top-down investors, we are aware of the macro and take a conservative approach when forecasting macroeconomic influences on investments.

After a wild last four years, we hope for a little less volatility. We’re confident our businesses will sustain their competitive advantages and execute their strategic initiatives longer term, hopefully within a market with lower short-term volatility.

Explain your process for deciding which assets you’d pick for this experiment.

For this exercise, we took a 3-step process:

Firstly, businesses need to meet our quality requirements or, in other words, have longer-term durability. Quality businesses, for us, compete in large and growing addressable markets while benefiting from competitive advantages that look sustainable throughout the investment horizon.

Secondly, to diversify the portfolio, we looked to add businesses that derive revenues from different customer types and business activities.

Finally, all the businesses needed to be attractively priced on a five-year view.

Stock/Asset	Stock Code	Weighting
Nanosonics	(ASX: NAN)	34%
Nick Scali	(ASX: NCK)	33%
Megaport	(ASX: MP1)	33%

The case for Nanosonics (ASX: NAN)

Nanosonics ticks many boxes for us.

As the only automated ultrasound probe high-level disinfection system approved for the US market, its competitive advantage is obvious.

The business model has many appealing characteristics, including a high recurring revenue base, high gross margins, and a solid balance sheet. The business has been reinvesting heavily in new product development, which distorts current-year metrics but will provide the next leg of growth.

The business has been dealing with some cyclical issues. Like most of the world, the US hospital system is under budgetary pressure, impacting short-term growth for Nanosonics.

In the long term, the business has excellent prospects to grow revenues and increase margins as it matures. Ultimately, this is a quality business that we see as attractively priced for long-term investors. For the three stock portfolios, this will give investors exposure to a global healthcare customer base, linked to ultrasound scan volumes and increasing awareness of the necessity for high-level disinfection.

The case for Nick Scali (ASX: NCK)

Nick Scali is a high-quality domestic furniture retailer with a long track record of gaining market share in the large and fragmented furniture and homeware industry.

It operates a relatively simple but highly effective business model. To mitigate cash flow and inventory risk, they collect a deposit upfront, essentially covering the manufacturing and shipping costs and neutralising the inventory exposure most other retailers are plagued with.

We rate management very highly. As they have outpaced the industry, their buying power continues to improve, as seen in their industry-leading margins. With the inclusion of Plush into the Nick Scali business, there are still many years of rolling out stores to come, underpinning revenue and earnings growth and further market share gains. They have a solid balance sheet, hold little debt, and have an expanding commercial property portfolio held at cost, giving the business more than the necessary resources to fend off any sharp deterioration to the Australian consumer.

Nick Scali is a more mature business; investors can still expect capital growth but with a higher level of franked dividends compared to Nanosonics and Megaport. Again, this exposure is quite different from that of the other portfolio companies, providing investors with customer and revenue activity diversification.

The case for Megaport (ASX: MP1)

Megaport is a quality business that is supported by strong structural tailwinds. Rising network complexity and data consumption drive increased usage from its customers, which are influenced by broader thematics such as the rise of cloud computing and, more recently, AI.

Megaport has taken full advantage of its first mover advantage. The high costs of replicating Megaport’s global reach and the increasing offering depth will likely deter new entrants.

Similar to Nanosonics, this business has many appealing characteristics. It has a high recurring revenue model, produces strong gross margins, and is generating operating leverage from its largely fixed cost base. Once established, customers tend to be sticky and grow their usage and sales organically. Management has done a terrific job transitioning the business to a profitable growth model from a growth-orientated strategy.

Megaport has a long runway to grow. As they expand their offering, the revenue opportunity per customer increases materially. We expect to see margins increase as the recurring revenue base grows. Given the structural tailwinds and prospects to grow earnings, we think this business looks attractive for long-term investors.

This position provides exposure to a global customer base of enterprise customers linked to increasing data consumption and networking spending.