When it comes to investing in ASX shares, most investors tend to stick with the famous names. If you select a random ASX investor, chances are they will have at least one of the four major banks in their ASX share portfolios, for example. Or perhaps BHP Group Ltd (ASX: BHP). Or Telstra Corporation Ltd (ASX: TLS) or Woolworths Group Ltd (ASX: WOW). But chances are they won't have a single ASX microcap share.
Shares outside the S&P/ASX 200 Index (ASX: XJO) tend to have market capitalisations of less than $1 billion. But an ASX microcap is normally a company with a market cap of less than $300 million. So well outside most ASX investors' universe.
That's usually because the companies are less well-known and data on them is limited compared to larger ASX companies. And, well, small-cap and microcap shares simply tend to have a reputation as poor investments, often dismissed as 'penny stocks'.
Experts: what to look for in an ASX microcap
But if you can successfully invest in the microcap space, the rewards can be lucrative. It's a lot easier for a $100 million company to double in size than a $5 billion one, after all.
So what does one look for in a potentially successful ASX microcap investment?
In a recent interview with Livewire, two fund managers expand on that very question. Here's some of what Dean Fergie of Cyan Investment Management, and Luke Winchester, of Merewether Capital, had to say:
"A lot of the companies in my portfolio don't yet have earnings, so first and foremost, we look at the revenue they're producing," says Fergie. "Many earnings numbers can be fudged. For example, you see "underlying earnings" mentioned frequently in half-yearly results, which I think aren't very useful…. [In a nutshell, we] look at the revenue and then subtract the costs."
Art and science…
"The art and science lie in judging whether microcaps are either over-earning or under-earning," Winchester adds. "If an early stage or growing business is tipping a big chunk of its revenue into development or expansion initiatives, it's probably under-earning."
Fergie agrees, saying, "We sometimes see businesses that are driving top-line sales that are also spending the same amount on marketing. If you're spending $100 to get $90 of revenue, that doesn't work for long."
Winchester says his team doesn't avoid unprofitable microcaps, but he treats them with extreme caution:
"We get taught that risk and volatility are the same things, but they really aren't," he stated. "When you invest in a loss-making business, you assume that capital will always be available. But it obviously won't be."
So what to avoid? Winchester cites "companies in the EV metals and clean-tech spheres". He says, "To me, they feel like the themes that come up every couple of years, and they're crowded as a result."
So there you have it, two ASX expert investors on how to successfully navigate the world of ASX microcap investing. While it may remain a space that many ASX investors feel uncomfortable with, these two investors have clearly made it work for them.
