'Forgotten gem': 2 mid-cap ASX shares this fundie loves

When interest rates are rising steeply, cash flow is paramount. Here's a pair of stocks that are self-sufficient this way.

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In volatile times such as 2022, cash flow is king.

Rising interest rates means borrowing money becomes more expensive. So, naturally, if you can generate capital from within the business, it makes for a smoother path ahead.

Spheria Opportunities Fund portfolio manager Marcus Burns told a conference recently that his fund seeks mid- and small-cap ASX shares that precisely fit this bill.

"We do believe balance sheets are really important."

The era of near-zero interest rates encouraged a grow-at-all-costs mentality that produced many false idols.

"For a period of time no one really cared about debt because it was so cheap," he said.

"And all the pundits tell [businesses] to invest heavily, gear up the business… That's great in theory until you have to raise money, because [now] debt's risen in terms of cost."

As examples, Burns presented two of his fund's holdings that he has high hopes for.

Usually expensive market leader selling for cheap right now

Online real estate classifieds site provider REA Group Limited (ASX: REA) is one that Burns admitted he's bought and sold in the past, and has recently rebought.

The portfolio manager pointed out REA's "very good history" of cash flow management.

"Something like 96% cash flow conversion, which is extremely strong," he said.

"Everyone knows the business is a market leader. The only negative about the stock is that it does get expensive occasionally."

The share price has cooled off 27% year-to-date.

"We've added it back into the portfolio at a decent weight."

Burns is not the only fan of REA shares.

"Combined with its strong pricing power and new acquisitions and revenue streams, the company has been tipped to continue growing at a solid rate for many years to come by the team at Goldman Sachs," reported The Motley Fool's James Mickleboro last week.

"In light of this, the broker currently has a buy rating and $164.00 price target on REA's shares."

That's an upside in excess of 30% from the current level.

REA Group is due to report its preliminary numbers on Friday.

Showed tremendous resilience through the pandemic

Burns' team bought into jewellery retailer Michael Hill International Ltd (ASX: MHJ) after a change in management.

"CEO Daniel Bracken came across about two years ago and he's executed an incredible internal turnaround," said Burns.

"Loyalty programs, putting much more online, got rid of high-low pricing… which has given a big fillip to the revenue growth."

And of course, Michael Hill's cash flow has been exceptional in recent times.

"Their cash flow conversion is very strong, particularly in [financial year] 2021 when massive amounts of free cash were generated by the management team, despite the fact that 23 or 24 of the trading days were closed," said Burns.

"So they weren't a COVID beneficiary at all… so it traded very well during that period."

The Michael Hill share price has dropped about 28% so far this year, but Burns feels like "the forgotten gem" is well set for future growth.

"Balance sheet's net cash of to the tune of almost $100 million, trades at about 4 times EBIT," said Burns.

"So even though we're going through a potential consumer downturn, and people are worried about spending, [the shares are] still trading on extremely low levels despite the fact that [the business is] trading very strongly."

Michael Hill is scheduled to report its preliminary numbers on 22 August.

Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has recommended REA Group Limited. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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