Three undervalued small caps

Much has been written about the boom in index investing and its effects on active funds managers. Less known is how growth in Exchange Traded Funds (ETFs) is hurting parts of the market, notably small-cap stocks that have less coverage than ever, creating opportunity.

I see two main investment implications of the trillion-dollar global ETF market. First, it’s killing underperforming active funds managers that charge high fees and deliver lower performance than comparable ETFs. Inevitably, that means more small-cap funds exiting this market.

Pressure on active funds management flows through to broking firms and research teams. Brokers have fewer small-cap analysts or less-experienced ones. The same is true in media; experienced journalists who specialise in small-cap stocks are rare.

The second implication of ETFs is index composition. As billions pour into global ETFs that replicate indices, making an index and staying in it is critical. ETFs buy and sell stocks indiscriminately, regardless of valuation. Companies in a key index benefit from ETF buying and suffer when they drop out of an index and ETFs have to sell en masse.

Most small- and micro-cap stocks outside the ASX 300 miss that index buying and a gigantic pool of investor capital is bypassing small-cap stocks. That’s good for eagle-eyed investors who hunt for quality, overlooked small caps.

Granted, there are many more landmines than goldmines in this part of the market and investors should always beware bullish comments based on small-cap generalisations. This is a stock picker’s market for experienced, risk-tolerant investors who assess every company on its merit. And who understand the dangers of owning micro-cap stocks with lower liquidity.

Here are 3 small- or micro-cap stocks that have caught my eye recently.

 1. IVE Group (IGL:ASX)

The communications group provides creative marketing services, digital campaigns, print production services, personalised marketing and data analytics. The goal is helping companies connect with current and prospective customers across a range of channels.

IVE grew revenue by 4.1% to $724.4 million in FY19 and underlying earnings (EBITDA) rose almost 10% to $80.4 million. The dividend rose and the Return on Funds Employed was a healthy 17%.

It was a good result in a challenging market. More companies are reducing their marketing, judging by gloomy outlook statements from media groups. Also, higher paper prices affected IVE’s printing operations and trimmed its gross profit margin.

IVE said it had several “meaningful” new client wins and contract extensions, and suffered no client losses. Improved cross-selling of IVE services also boosted revenue and is the key to a re-rating in the company’s share price.

IVE used to trade as four separate divisions: a messy structure that inhibited cross-selling across the business. The evolution of one IVE brand should help the company promote an integrated offering, lift cross-selling and get more sales hooks into clients.

IVE has grown revenue and earnings steadily for the past four years and outlined a positive outlook in the FY19 result: “Expected solid performance positions us well to generate strong free cashflow over the year ahead.” And, “working capital should return to normal levels.”

In spite of that progress, IVE is trading near its 52-week low of $1.96. The one-year total return (including dividends) is 5.7% and over three years is an annualised 7%. At $2.05, IVE is yielding 8% fully franked and on a trailing Price Earnings (PE) ratio of about 9.2 times.

The share price is going nowhere, even though the underlying earnings are growing. IVE has a reasonable amount of debt for a $304-million company, partly because of having to hold higher paper inventory this year due to supply issues.

IVE Group

Source: ASX

 2. Janison Education Group (JAN:ASX)

I wrote favourably about Janison in The Switzer Report in August 2019 in a story on education technology (edtech). Janison has rallied from 28 cents to 39 cents since that story.

To recap, Janison provides digital learning and assessment solutions. Janison Learning sells customised online learning platforms for companies and helps them manage compliance obligations around training. The Janison Insights business helps organisations centralise, streamline and digitise assessments. Both businesses operate in strong growth markets.

Annualised recurring revenue has grown from $8.1 million in 2016 to $12 million in 2019. Client numbers grew 60 per cent over FY19.

Like all good software-as-a-service companies, Janison has good margins and high customer-retention rates. The upshot is recurring revenues that snowball over time as more clients use its software and have high switching costs to leave.

Edtech is a potentially lucrative industry. As Janison notes in its FY19 results presentation, there will be another 500 million school and university students by 2025 in a $7.8 trillion market. The edtech market will more than double in size to an estimated $342 billion.

I’m always wary of micro-caps that promote gigantic industry forecasts. Novice investors are seduced by the future size of the market and overlook the challenges of selling into it – or the fierce global competition high-growth markets attract.

I’ll make an exception for Janison. Digitised compliance and testing is an obvious growth market. More rules mean greater compliance for companies and growth in student numbers means rising demand for online tests.

I’m told Janison has good technology and is progressing well. Software-as-a-service is a great business model when it works and the global education sector has many tailwinds. Yet Janison shares have been range-bound this year.

Janison Education Group

Source: ASX

3. Beston Global Food Company (BFC:ASX)

The micro-cap food company has had a tough time after seeking a minimum $100 million in an Initial Public Offering (IPO) on ASX in 2015. Beston’s 35-cent issued share hit 56 cents in early 2016, then steadily drifted lower, touching 8.7 cents this month.

A later-than-expected commissioning of the company’s mozzarella plant and a drought-induced drop in milk supply, and higher feed costs (again drought-related) led to $27-million loss in FY19 (a $5.2-million loss after adjusting for impairments and restructuring costs.)

For all the market negativity, Beston grew revenue by 77% to $84.8 million and has almost doubled sales each year since FY17. The company had almost no revenue on listing and looked like an agricultural start-up.

About 90% of the South Australian company’s revenues are in cheese, butter, cream and other dairy products. Its new state-of-the-art mozzarella plant provides scope to ramp up cheese products and increase its dairy range.

However, the key to Beston is capital-management initiatives. The company wants to free up capital to invest in new technology at its plants and boost margins and sales. It has identified 10 such projects with short payback periods.

Beston had $68 million in plant, property and equipment on its balance sheet at end-June 2019. Net assets were $80.1 million. At 9 cents, Beston is capitalised at $39 million and, like so many poorly performing floats, has been forgotten by the market.

If I ran Beston, I would do something with its four dairy farms (1,545 hectares) in South Australia to free up capital to invest in higher-growth businesses, bring in some needed cash and grow its promising track-and-trace counterfeiting technology. Food-traceability technology has huge potential as consumers want to trace food back to its source, for safety reasons.

My hunch is Beston would be better off privately owned, restructured, and brought back to the market in a few years. A private equity owner might do more with the company.

Like all thinly traded micro-caps, Beston suits speculators. This is not a stock for the risk averse. Emerging food stocks are tricky at the best of times, but Beston has considerable restructuring potential and assets that can be sold or spun out into other structures – and a share market that is paying no attention to the company’s turnaround strategy.

Beston Global Food Company

Source: ASX