3 small-cap ASX shares that drove fund up 35% while the market plunged

Ask A Fund Manager: 1851 Capital's Martin Hickson tells how his small and micro-cap portfolio managed to provide positive returns despite a turbulent 2022.

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Ask A Fund Manager

The Motley Fool chats with the best in the industry so that you can get an insight into how the professionals think. In this edition, 1851 Capital portfolio manager Martin Hickson names three ASX shares investors should buy that drove strong returns for his fund.

Investment style

The Motley Fool: How would you describe your fund to a potential client?

Martin Hickson: I'm Martin Hickson, portfolio manager at 1851 Capital, a reasonably newly established business and fund. 

We launched the fund back in February 2020. Both Chris Stott, who's my partner in the business, worked together previously at Wilson Asset Management for a decade together before setting up this business. 

Our style is we're a long-only small and micro-cap fund manager. We've got restricted capacity. We soft-closed the fund at $400 million back in August last year. From the launch, that was always the plan, to soft-close the fund once we got to that level. It's our belief that as you grow your funds under management past a certain point, it starts to inhibit performance, so that's why we've restricted the capacity of the fund. 

We invest in companies ex-S&P/ASX 100 Index (ASX: XTO) industrial companies, ASX-listed only. There's no pre-IPO or overseas companies, [no] unlisted assets. Our style is we're looking for growth companies with attractive valuations and a catalyst that can re-rate the share price.

MF: This year's been a tough time for smaller caps, hasn't it? How do you see things at the moment, and where do you see them going?

MH: Yeah, it has been a volatile time. The area of the market that we invest in, the small industrials, since we launched the fund just under three years ago, our area of the market's actually down by 15% over the first 33 months of launching the fund. [But] the fund's done okay. As of the end of October… from memory, it's up around 35%. 

It's been a tough 12 months, and it's been a very volatile almost three years for markets. Since we've launched the fund, we've been through two bear markets now, and a potential recession coming. We've been through the COVID pandemic, obviously a war, so there's a lot that's occurred in the first three years of the fund.

Hottest ASX shares

MF: What are the three best stock buys right now?

MH: The three stocks that I'll talk about, they're all companies that we own within the portfolio and at the smaller end of the overall market.

The first one is a company called IPD Group Ltd (ASX: IPG). A reasonably new entrant to the ASX, so listed back in December last year. It's been a strong performer. The share price has more than doubled over the last 12 months. 

What they do is they're an electrical equipment distributor and services company. If you go into a big apartment building or an office, you look at the electricity distribution room, and you see all the equipment in there, a lot of the equipment has likely come from a company like IPD Group. So power distribution, power monitoring, industrial control products.

It's been a very successful position for us. Despite the strong performance in the share price, it still trades at an attractive valuation — so they're 15 times price-to-earnings ratio, so quite cheap, below what the overall market's trading at. Their earnings are growing at over 20%. So very, very strong growth, but still trading at that cheap price. 

They extended their agreement with ABB Ltd. ABB is one of the largest electrical equipment manufacturers globally, with 30% market share. [IPD is] distributing all of those products in Australia on behalf of ABB.

The other thing we like about it is that they've got a growing EV business. They sell the equipment to install EV chargers in both residential homes but also in EV charging stations. They're one of the only ways to get exposure to that growing electronic vehicle thematic in the industrial space. There's obviously lithium, but this is one of the only ways to play it on the ASX in the industrial space. 

That's one that's performed strongly for us, but we still think there is further upside to that company.

Thirdly, they've got a strong balance sheet. They've got $25 million of net cash on the balance sheet, and that provides flexibility to potentially deploy that cash into acquisition opportunities.

MF: Fantastic performance, isn't it? It's not an energy company or a mining company, but it's more than doubled this year when everything else has flopped.

MH: Yeah, that's right. It's doubled in a period where the overall market's down just over 20%, so a lot of good tailwinds for that business.

MF: Great, your next stock to buy right now?

MH: Next one's a company called Atturra Ltd (ASX: ATA). They're an IT services company.

Similar to IPG, really. There's a lot of similar characteristics. They also listed around 12 months ago. We participated in the [initial public offering] IPO. It trades at a price-to-earnings ratio of 15 times, earnings rate 20% as well. And again, [a] very strong balance sheet — $30 million net cash on the balance sheet, similar to IPG. It gives them flexibility to potentially deploy that cash into accretive acquisitions. 

They've also given earnings guidance to the market back in August of $15 to $16 million of EBIT. We think that looks conservative. We think their earnings are growing at a very fast rate, but again, it's still trading at quite a reasonable multiple.

MF: You would think listing at the end of last year would be absolutely terrible timing, but both those companies have done really well.

MH: Yeah. If you look at the overall list of companies that IPOed in the second half of last calendar year, in that December half, there aren't many of them that have performed strongly. A lot of them are well underwater, but both IPD Group and Atturra have bucked the trend. They're up significantly since their IPO. 

Even in any market, in the micro-cap and small-cap space, there are always opportunities to find these gems that grow irrespective of what's happening in the overall economy.

MF: And your third pick, I think, is a bit more of a mature player?

MH: Yeah, the third is Capitol Health Ltd (ASX: CAJ). They're a radiology company. There's a couple of reasons why I like it. 

Firstly, their earnings are recovering post the COVID disruptions of the last couple of years. Their business is primarily in Victoria, so they were significantly impacted by the lockdowns there over the last few years, so they've seen a tailwind for their earnings this financial year. 

Justin Walter, the CEO there, who's been CEO for three years, has changed the business a lot since he joined. He's taken significant costs out of the business, he's improved the culture of the organisation, and also, in August this year, they acquired one of their competitors in Victoria, a business called Future Medical Imaging Group. That was an accretive acquisition for them, and it really reinforced that dominant position in the Victorian radiology market.

The other attraction is that it trades on a low EBITDA multiple of 7.5 times. We've seen, over the last couple of years, there have been private transactions where companies have been taken over at EBITDA multiples of 12 to 13 times. So based on those numbers, Capitol Health is trading a lot cheaper than a lot of those private companies were taken over at. That gives it very strong valuation support.

MF: The health industry is also defensive, isn't it, when an economic downturn is coming?

MH: Yeah, that's right, so better earnings streams … Like you say, quite defensive, given they operate in the healthcare space.

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 no position in any of the stocks mentioned. 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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