3 battered small-cap ASX shares we're still backing: expert

Smaller businesses saw their valuations tumble in a troubled year like 2022, but will likely rocket up higher and faster when the market recovers.

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It's been a rough year for investors of small-cap ASX shares.

"All types of investing require nerve and courage. But perhaps none more so than small-cap stocks," said Ophir analysts in a memo to investors this month.

"When an economic downturn hits, small caps tend to fall first and farthest."

In volatile and uncertain times, the value of smaller companies sinks much more dramatically than larger companies for multiple reasons.

"Small caps also tend to be more sensitive to changes in the economy. They are less able to diversify their operations and are less likely to have the large cash reserves needed to withstand difficult trading conditions."

They can also get caught up in a liquidity spiral. In a falling market, institutional investors often sell out of smaller holdings first to avoid getting trapped in an illiquid position.

"They then also stop buying, pushing prices down further and faster on even lower levels of liquidity," read Ophir's investment strategy memo.

"And while small-cap managers might see even cheaper stocks, many are unwilling to enter the market so prices in small-cap stocks keep falling at a faster rate."

But the reward for hanging onto the small fish is that, on the other side, they rally much faster than large caps.

"Historically, in the 12 months after the US small-cap index has bottomed around a recession, they have returned an incredible 70% on average – that's 11% higher than large caps," read the Ophir memo. 

"The small-cap rebound is also quick. Most of the additional return benefit versus large caps has happened in the first three months."

So remembering this, here are three small-cap ASX shares that the Cyan C3G Fund is holding onto despite being absolutely hammered last month:

Rock solid investments for the inevitable small-cap recovery

The Mighty Craft Ltd (ASX: MCL) share price tumbled more than 21% in September, but the Cyan team is not worried.

"The alcohol industry globally is dominated by a handful of powerful players, but the domestic industry has been growing strongly in recent years," read Cyan's memo to clients.

"We think it's a sector worth being exposed to and Mighty Craft is our preferred business model, whereby they acquire and accelerate growing beer and spirits brands through provision of capital, distribution and retail and wholesale points of presence."

The nature of the industry means Mighty Craft could become an attractive takeover target.

"Inevitably the successful domestic businesses or alcohol brands are acquired as they obtain, or are on a clear path to obtaining, reasonable market share."

Melbourne video games developer Playside Studios Ltd (ASX: PLY) is another small-cap Cyan analysts are backing, despite a 14.3% drop in valuation last month.

"This gaming business continues to impress with the execution of its growth strategy through a business model based on work-for-hire, original IP development and new initiatives like a third party publishing division," read the memo from Cyan.

"In short, an exceptional team with a strong and growing business in a strong and growing industry."

The heavy discounting in its shares means it's another potential takeover subject.

"We believe Playside can deliver great returns to shareholders independently or as an M&A target in time (hopefully both)," said the Cyan portfolio managers. 

"We see this as a unique opportunity to get exposure to these dynamics in the ASX listed space."

The Cyan team has been a longtime fan of hospital software maker Alcidion Group Ltd (ASX: ALC).

And that hasn't changed despite a 12.1% drop in share price in September.

"Alcidion is building a strong position in the digitisation of hospital management systems, both administrative and clinical, in Australia and the much larger UK market."

The business raked in $34 million in revenue for the 2022 financial year. Its June quarter revenue was 46% up year on year.

"The company has worked hard to become one of the leading providers and the timing looks perfect to scale the business significantly over the next two years as governments drive the push towards technology in healthcare in a post-COVID environment."

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 positions in and has recommended Alcidion Group Ltd. The Motley Fool Australia has recommended Alcidion Group Ltd. 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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