Due diligence on micro-caps can’t be bypassed

15-Mar-2013

By Krystine Lumanta

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The complexity of micro-cap investments means self-directed investors cannot ignore adequate research, due diligence and an understanding of intrinsic value when it comes to directly investing in the sector.

“You cannot cut any corners in terms of the research; you have to do the hard yards,” Microequities Asset Management chief executive and chief investment officer Carlos Gil told financialobserver.

“The asset class is quite complex as the Australian Securities Exchange is roughly made up of 2300 publicly listed entities of which 1500 to 1600 are what we would deem to be micro-caps.

“Out of those 1500 to 1600, only about 500 entities would be profitable, so our real investment universe is between those 500 companies that are profitable.”

Gil said the significant disparity in the quality of underlying businesses and the reality was a problem for investors who had attempted to invest directly in the asset class.

“The reality is that not many micro-cap companies are genuine investment-grade companies; they’re just poor quality or they’re highly risky,” he said.

There were two issues the retail and self-managed superannuation fund (SMSF) investor had to take into account with micro-caps as they were not published in league tables and were an under-researched asset class, he said.

“The SMSF trustee needs to ask themself, ‘Do I have the time, resources and skillset to accurately assess the investment grade of these companies?’” he said.

“Secondly, we’ve got accessibility to the chief executives and chief financial officers, so it might be a little difficult for SMSF trustees to get in front of them.”

In addition, he said many investors tended to subscribe to the notion that the share price accurately reflected the intrinsic value of the business, which was a generic mistake made by investors in every asset class.

“We try to educate our investor base by stating that as a values-based fund manager we’re looking to find opportunities where the market values of the companies don’t reflect the intrinsic value and therefore don’t take our cues from market pricing,” he said.

“We believe that over the short to medium term, market pricing does not accurately reflect intrinsic value,” he said, adding self-directed investors needed to understand what intrinsic value was.

He said there was sometimes a disparity between the two and in the micro-cap asset class the disparity was accentuated due to the lack of research and the lack of institutional support.

Another issue micro-cap investors overlooked was that buying equities essentially meant becoming a de facto business partner, thus the longevity of the investment required and necessitated a long-term commitment, he said.

“If we come across any prospective investors, the first question we ask is what their investment horizon is,” he said.

“If they say one to two years, we advise them not to even go into equities directly because that is the wrong time horizon.”

In the past few years, investors have started to better understand micro-caps compared to originally regarding them as a speculative, high-risk asset class.

Gil said investors were attracted to micro-caps because of their faster growth rate against their large-cap counterparts.

“If companies are increasing their profitability by 15, 20, 30 per cent per annum, then obviously the underlying value of those businesses are also increasing by that amount, so there is tremendous shareholder wealth generation if you’re able to select those companies that do have a roadmap for growth,” he said.

It was common for high net worth individuals to outsource the management of their micro-cap exposure to managers, such as Microequities, as they did not feel confident enough dealing with the asset class, understood the asset class was complex and also lacked the time needed from a research perspective, he said.

Microequities planned to target institutional investors with its Deep Value Microcap and High Income Value Microcap funds as its key focus for 2013, he said.

“We’ve just started marketing ourselves to the institutional market, so we’re quietly confident that over the next six months we are going to bring a number of institutional investors on board,” he said.

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