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There is no universal definition as to what makes a ‘small cap’ stock, however there is no denying they do have certain characteristics that may help you reach your investing goal. Morningstar’s senior investment specialist Shani Jayamanne believes the asset class allows investors the opportunity to access investments that have higher risks and bigger rewards.
“Small cap stocks, both local and international allow you to change the risk and return dynamic for your individual situation. It also gives investors the opportunity to explore a market that is not as well researched or covered, allowing them a larger chance at finding mispriced securities,” she says.
Small cap stocks are found in the S&P/ASX300 index and generally have a market capitalisation of under $2 billion. This means that companies in the small caps category are worth less than $2 billion while large cap companies like BHP and Woolworths are worth over $10 billion.
There is a common misconception that small caps stocks are only for growth investors, but this is not true says Jayamanne.
“The same principles with large caps apply at the smaller end of town. You are able to find mispriced securities with strong fundamentals, you’re able to find companies with mediocre balance sheets but high growth potential, and all mixtures of both in between,” she says.
We used Morningstar’s stock screener to find three undervalued stocks in the growth, value and blend category for investors looking to dip their toes into the world of small caps. Whether you are interested in finding the next market darling, sniffing out a mispriced security or just looking to increase your risk to reward ratio, you’ve come to the right place.
EML payments is a financial technology company that builds infrastructure for customers to facilitate and accept payments via a prepaid card or in real time. The company has expanded globally and is used by consumers across 32 countries. The company primarily generates revenue by taking a small portion of payment transactions. EML (ASX:EML) reported earnings on Monday this week, announcing underlying net profit of $32 million which is relatively flat in comparison with last year. An underlying EBITDA for fiscal 2022 missed Morningstar expectations by 3%, coming in at $51 billion, down 4% from the previous year due to increased costs. However, Morningstar equity analyst Shaun Ler believes the growth company is currently undervalued, forecasting an increase in profitability in the future. “The firm is skilled at expanding the capabilities from one product across multiple applications, allowing it to build a diversified revenue stream,” he says. He believes EML’s ability to win new clients and expand the scope of their commercial relationships with existing clients will help the company grow revenue in the future. EML shares are currently trading at $1.00 as of Tuesday’s close, down 70% since the start of the year.
The online retailer is currently trading at a 70% discount to its Morningstar fair value of $11.70 after slipping into undervalued territory in April of last year. The company delivered fiscal 2022 results on Tuesday, announcing a 257% drop in EBIT over the year despite a 9.5% increase in gross profits. Pandemic winner Kogan’s (ASX:KGN) earnings have been declining since a peak in 2020 after a COVID sales surge began to normalise. However, director of equity research Matthew Hodge forecasts a bright future for Kogan as retailers begin to shift from brick-and-mortar stores to online hubs. “As an online pure play, Kogan is poised to benefit more than omnichannel retailers from the secular shift to e-commerce. We expect it to successfully retain its share in fast-growing Australian discretionary online retailing channel at around 2.5%,” he says. Equity analyst Johannes Faul believes the shift in consumer behaviour from shopping instore to a preference for shopping online will help the company bounce back from lower levels of sales in the post pandemic era. “We expect the structural shift of consumer spending to online to more than offset our weak near-term outlook for overall discretionary spending,” he says. Kogan shares closed at $3.55 after falling 5.8% after yearly results were announced on Tuesday morning.
Tyro payments is an Australian financial technology company which provides payment solutions and business banking products for merchants. Equity analyst Shaun Ler sees the technology company undervalued, as he expects the proactive, capital-light fintech to continue to gain market share in the near term. “We expect Tyro to win business from other generic EFTPOS terminals from partnering with larger retailers, extending its processing capabilities into other business lines like trade, accommodation and services, and creating new features to improve its terminal's capabilities,” says Ler. He forecasts revenue growth to overtake cost growth, allowing the company to achieve a net profit of 4 million by fiscal 2025. He believes the current market pricing is overly pessimistic with investors failing to consider Tyro’s (ASX:TYR) ability to increase market share and become profitable. The company will be reporting its fiscal 2022 results on 29 August, but Ler does not expect big changes. Tyro shares are currently swapping hands at $0.95 per share, 68% lower than Morningstar’s fair value of $3.00.
Nicola Chand is a wealth and finance journalist with Morningstar. Analysis as at 23 August 2022. This information has been provided by Morningstar Australasia (ABN: 95 090 665 544, AFSL 240892), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.