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Small Cap Investment Opportunities

By UBS (Victor Gomes)Market OverviewJun 27, 2017 12:33
Small Cap Investment Opportunities
By UBS (Victor Gomes)   |  Jun 27, 2017 12:33
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Originally published by UBS Asset Management

There are many sensible reasons for investing in Australian small caps. Access to earlier stage, higher growth businesses. A broader range of sector opportunities to pick from. An ability to more easily back future trends. The small caps technology sector ticks many of these boxes.

Whilst the rewards are potentially high, so too are the risks, especially for investors with short investment horizons.

Now to some stocks. If one is looking to back some very strong future trends, Nextdc Ltd (AX:NXT) has merit. As time goes on we will all consume ever-larger volumes of data on our mobile devices. Additionally most business software is moving to "software-as-a-service" (SaaS), delivered over the internet. This all translates to significant growth in demand for cloud based (a.k.a data centre) storage and processing. Nextdc has the largest footprint of vendor-neutral data centres in Australia. With strong recurring revenues, high returns on capital, and further capacity being added to its network we expect to see strong share price growth in the years ahead.

Technology One Ltd (AX:TNE) is another beneficiary of the SaaS revolution. It is a leading provider of SaaS based enterprise (ERP) software to the mid/large corporate and government sector. The founder (executive chairman) retains a large shareholding. This company has quite a unique track record of consistent earnings growth in the technology sector spanning almost 20 years of life as a listed company.

Wisetech Global Ltd (AX:WTC) also has a very large founder/CEO shareholder. In this case he owns more than 50%. Unlike TechOne, WiseTech is newer to the ASX having only listed in 2016. Nevertheless it has an equally long track record of strong profitable growth as a private company before listing. WiseTech's SaaS ERP software is a key enabler to the global freight forwarding and logistics industry (think "Amazon (NASDAQ:AMZN)" driven volume growth).

Both Technology One and Wisetech Global have strong management teams, deliver high returns on capital and have balance sheets with no debt (net cash).

Aconex provides customers with a collaboration based SaaS software for use in the construction and infrastructure industry.

All three SaaS software businesses are either regional (TechOne) or global leaders (WiseTech & Aconex) in their chosen field. The still-early stage of SaaS adoption by corporates should deliver this trio many years of good growth (subject to good management execution).

Another field of technology that Australia has historically done well in is medical devices (think ResMed Inc (NYSE:RMD) and Cochlear Ltd (AX:COH), both of which started as small caps). Whilst generally of higher risk again, this space also offers some promising small cap opportunities.

Two names with some merit are AirXpanders Inc (AX:AXP) (a "better mousetrap" tissue expander for use in post-mastectomy breast reconstruction) and Impedimed (a bioimpedence device used to measure body mass/fluid composition which is a precursor to many serious disease conditions). Both companies are very early stage and mostly "pre-revenue" so are commensurately much higher risk. We do forecast considerable revenues for this duo within our six year forecast period. Both have very large addressable markets and offer the promise of strong growth over many years.

So how to assess fair value for stocks in this sector? Technology stocks are generally high growth. For this reason they often trade on high price to earnings (PE) multiples. PEs will only look ahead 1–2 years. They won't capture any significant growth potential beyond two years.

A valuation based on cashflows that are forecast over a more reasonable (but not too long) period of say 5–6 years is a better compromise. To be sure, we expect the company share prices to see much more volatility than their underlying business over those six years.

Small Cap Investment Opportunities
Small Cap Investment Opportunities

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