ASX small caps offering great value right now
Considering investing in small caps? See our top ASX picks.
Mentioned: Vanguard MSCI International SC ETF (VISM), PEXA Group Ltd (PXA), Perpetual ESG Australia ShareETF E (GIVE), DFA Australia Limited (DGSM), Perpetual Ltd (PPT)
Following on from my previous article Should you invest in small caps?, I explore two ASX players that currently offer great value.
How to invest in small caps
Whether you are investing in large or small cap companies, Morningstar’s approach to stock investing comes down to four consistent principles:
- Having an intimate knowledge of the company’s sustainable competitive advantages or moat.
- Determining the value of its shares.
- Understanding the inherent risk in the business as represented by the uncertainty rating.
- Only buying the stock when there’s a significant margin of safety in doing so.
Echoing the sentiments above, Morningstar emphasises the importance of owning high quality, competitively advantaged companies bought at reasonable prices.
I decided to run a screen to find the best ASX small caps using the below criteria:
- Market capitalisation under $2.5 billion
- 4 or 5 stars Morningstar Analyst Rating
- Narrow or wide moat
- Low or medium uncertainty
- Positive forecasted revenue growth
All the above criteria address the risks discussed in my previous article and attempt to negate the effects of them to find undervalued ASX players with value proposition.
Unsurprisingly, these rigid criteria excluded most small caps with only two companies meeting the requirements. Investors should be encouraged to adjust their screening criteria based on personal goals and investing strategy.
Perpetual Limited PPT ★★★★
- Fair Value Estimate: $24.50
- Moat Rating: Narrow
- Share Price: $21.16 (as at 21/11/24)
- Price to Fair Value: 0.86 (Undervalued)
- Uncertainty Rating: Medium
Headquartered in Sydney, Perpetual Limited (“Perpetual”) engages in asset management, wealth operations, corporate trusts and various other financial services.
The firm has found itself in the spotlight after a ~17% drop in shares year to date, echoing an overall 45% decline over the past five years. Perpetual’s name has been embroiled in leadership issues, poor capital allocation and an unfavourable business environment.
Source: Morningstar. Note: Share price data as of 21 November 2024.
Despite a difficult environment for active fund managers, Morningstar attributes poor capital allocation decisions have also destroyed shareholder value and led to share price depreciation. The company is widely considered to have overpaid for its largest purchase to date, Pendal, whose funds and products are very similar to ones that Perpetual was already offering.
In May, it announced that private equity shop KKR will buy its Corporate Trust and Wealth Management businesses, leaving Perpetual as a pure-play asset manager. Whilst the ~$2.2 billion consideration seems reasonable on paper; the ultimate proceeds are still up for discussion.
Whilst external conditions remain favourable for flows into risk assets, most asset managers we cover lack the performance required to attract significant inflows therefore we expect them to continue losing market share to industry super funds and exchange-traded funds.
Perpetual is in reasonable financial health with ~$680 million debt at June 2024 and a modest gearing ratio of 28%, below its stated target 30%. This should improve further as Perpetual deleverages. We expect the gross debt to EBITDA ratio to reduce to 1.2x by fiscal 2026 (from 1.7x in June 2024). The interest coverage ratio (EBIT/interest expense) should also recover to nearly 9x by fiscal 2028 (from 6x in fiscal 2024).
Perpetual receives a Standard Capital Allocation Rating emphasising its focus on reviving growth through acquisitions. However, we believe many of these are reactive manoeuvres that hinder it from getting ahead of lower-cost passive or algorithm-driven index funds and ETFs as well as more established active managers. We believe that attempts to broaden their product portfolio, distribution and geographic reach will not suffice to help attract more funds under management or maintain fee margins.
For further insights into Perpetual, our most recent edition of Ask the Analyst with my colleague Joseph Taylor and analyst Shaun Ler dives further into the future of Perpetual amidst a tough few years for active fund managers.
PEXA Group Limited PXA ★★★★
- Fair Value Estimate: $17.25
- Moat Rating: Wide
- Share Price: $12.32 (as at 19/11/24)
- Price to Fair Value: 0.71 (Undervalued)
- Uncertainty Rating: Medium
Pexa Group Limited (“Pexa”) digital property exchange and data insights business. The company assists layers, conveyances and financial institutions to lodge documents with Land Registries and complete financial settlements electronically.
The company’s share price has risen ~17% this year, enjoying a highly supportive environment of elevated property sales and an increase in distressed selling with further value to be found. Morningstar prescribes Pexa a fair value estimate of $17.25 representing a ~29% discount to the current share price. The market is likely undervaluing Pexa due to the negative value of their expansion into the UK, which we think is excessive and has a 25% probability of successful market entry.
Source: Morningstar. Note: Share price data as of 21 November 2024.
The moat-worthy Australian business is primarily supported by network effects and switching costs. With backing from Australia’s largest banks, that co-owned it and a legal mandate from state governments to move to e-conveyancing, Pexa became Australia’s first electronic lodgement network operator, setting the foundation for digital property transactions.
The company enjoys a virtual monopoly with ~99% market share of digital transactions and close to 90% market share of total transactions. Given widespread adoption of Pexa’s platform by stakeholders, we expect the remaining market share to eventually move to Pexa.
Our fair value estimate implies a 33x earnings multiple for fiscal 2025 estimates which may appear high, however, believe it does not represent the true value of the business as the company is currently investing invest heavily.
We view Pexa’s balance sheet as sound with net debt sitting under $300 million at June 2024. This is offset by ~$300 million in a Settlement Trust Account on which they collect interest. The firm is also free cash flow positive with its strong Australian exchange business limiting downside risk.
Compounded annual revenue growth has been projected at 12% over the next decade. The Australian business is near saturation therefore we forecast the company to grow pricing mostly in line with CPI. Pexa’s UK expansion will be the key driver of nearly all growth.
Alternative small cap investing
Whichever conclusion you drew from my previous article about whether you should invest in small caps, we can appreciate that the single stock risk is high. Further, the question of whether the time it takes to actively manage and research a portfolio of small caps may not be for the average investor. A collective investment vehicle like an exchange traded fund might be preferable.
I screened for gold medallist rated small cap ETFs and found the below three results:
For the purpose of this article, I will be covering Vanguard MSCI International Small Companies Index ETF with the lowest investment management fee of the group at 0.32%.
Vanguard MSCI International Small Companies Index ETF VISM
The global small cap market is fraught with many incoherent risks that foster inefficiencies and has led to a wide range of outcomes. VISM provides an unbeatable cost value proposition over active and passive peers alike, and it has highly efficient access to the developed market small cap stocks via a diversified index.
The index is composed of majority US stocks accounting for ~62% of the MSCI World ex Australia Small Cap Index. The benchmark also has significant stakes in healthcare, industrials and technology with only a modest allocation to basic materials providing diversification for Australian investors.
Given the great risk in small cap investing, Morningstar does not expect these companies to form core positions in any portfolio. Each investment should be foregrounded by your individual goals and risk appetite.
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