Small-cap stocks often capture the curiosity of investors lured in by the prospect of untapped growth potential and a lower entry point.

They’re also providing some of the biggest bargains at the moment, with more stocks under Morningstar coverage screening as undervalued outside the top 100 companies on the ASX, as measured by market capitalisation.

In Australia, Morningstar defines the small-cap segment as comprising the bottom 10% of the Australian market by capitalisation. The largest 70% are classified as large-cap; the next 20% are mid-cap.

But small-caps can also come with increased risks and the possibility of disappointment if as-yet unproven companies fail to live up to the promise of growth.

To help wheedle the wheat from the chaff, we selected three quality stocks from the smaller end of Morningstar’s coverage universe, which are trading at a double-digit discount to their fair value estimate.

These companies have a market capitalisation under $750 million. Data is as of 14 March 2023.

Seven West Media (SWM)

  • Star rating: ★★★★
  • Fair Value: $0.60
  • Uncertainty rating: High 

Media conglomerate Seven West’s market cap comes in at just over $675 million, comparably small next to the $3.2-billion cap held by fellow ASX media competitor Nine Entertainment.

The company, which makes most of its revenue from its free-to-air television and video-on-demand units, recently posted a “commendable” half-year result, according to analyst Brian Han.

“Balance sheet repair in recent years has eliminated our previous concern regarding the group's financial position,” he said.

Looking forward, a softening advertising cycle may bring with it a slowdown in growth, but Han says Morningstar’s strong outlook for the company does not rely on “heroic assumptions”, forecasting a 14% drop in full year EBITDA in fiscal 2023.

“That is hardly enticing, but the stock is trading at just above three times our forward EBITDA estimates. The quality of that EBITDA base has improved markedly, thanks to digital-centric 7plus' growing earnings contributions,” he added.

That said, investors should also note the ‘High’ uncertainty rating attached to Morningstar’s fair value.

Han says Seven West appears well prepared for the advertising cycle slump, following on from an ad boom just over a year ago, but notes the sector cycles can be dramatic.

“The television advertising industry is a cyclical one, where revenue could swing wildly depending on economic conditions. As a largely fixed-cost business, the earnings leverage from this cyclical top line can be significant, both on the upside and the downside.”

Kogan (KGN)

  • Star rating: ★★★★★
  • Fair Value: $10.70
  • Uncertainty rating: Very High

Following the most recent half-year report from online retailer Kogan, analyst Johannes Faul sees “the first signs” of improvement in the company’s performance, following a period of heavy product discounting.

“Illustrating the extent of discounts, its third-party brands segment reported a net loss at the gross profit line, that is, on average, third-party products were sold below their costs,“Faul says.

“However, management expects improving third-party and exclusive brands contributions to group earnings, now that the bulk of the group’s excess inventory has been cleared.”

Faul says Kogan may be better positioned than some to stave off competition from larger competitors like Amazon, thanks to recently expanding to deliver bulky goods to Brisbane, Perth, and Adelaide.

“Although typically lower margin, we consider building a differentiated product offering around big-ticket items as a sound strategy.”

“As fulfilment of bulky goods can be challenging to automate and usually requires dedicated handling, Kogan is competing less with Amazon’s fulfilment expertise, and in categories with generally less online competition overall,” Faul adds.

Kogan shares are trading at around a 61% discount to Morningstar’s fair value estimate of $10.70.

MyState (MYS)

  • Star rating: ★★★★
  • Fair Value: $5.20
  • Uncertainty rating: Medium

As the collapse of US-based Silicon Valley Bank sends shockwaves through the global banking industry, Morningstar senior equity analyst Nathan Zaia says Australian banks won’t be materially affected.

“The full extent of the ripple effects will not be known for some time, but it seems premature to consider this a systemic issue,” Zaia says.

“We do not believe the conditions that allowed a run to happen on SVB exist for the Australian banks."

Zaia identifies two key differences.

"First is the concentration of SVB customer deposits, meaning it takes far fewer customers deciding to pull money out before creating a liquidity event," he says.

"Second, SVB had a large percentage of their assets held in investment securities, which were out of the money, in contrast to Australian banks which primarily invest in mortgages and corporate debt.”

One of Australia’s smaller banks—holding just 0.3% of the mortgage market—MyState may be overlooked by investors seeking banking exposure in favour of a one of the nation’s pillar institutions.

But following a “solid” recent report from the company, Zaia says the no-moat bank is back on track to meet a forecast net profit of $42 million.

“Net interest margin was admittedly much weaker than we'd forecast, but larger average loan balances provided a welcome offset,” he said.

Zaia adds that the ongoing RBA cash rate increases and the benefit of fixed rate loans maturing at higher rates should act as margin tailwinds, but cautioned that the new loans will, on average, likely be written at a lower margin and offset the benefits.

Despite these competing forces, Zaia says the longer-term outlook should see the banks margin pain ease.

“We assume loan growth slows to a low single digit by fiscal 2025, which should mean less of a need to price aggressively on customer deposits and small margin reprieve,” he says.

MyState shares closed on Monday at $3.72, a 30% discount to Morningstar’s fair value estimate of $5.20.