This $70 million ASX company just pulled off a $40 million deal: fundie

Ask A Fund Manager: Capital H Management's Harley Grosser reveals a pair of small-cap shares ready to take a massive leap.

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Capital H Management founder and chief executive Harley Grosser

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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, Capital H Management portfolio manager Harley Grosser tells us the two hottest small-cap ASX shares to buy right now.

Investment style

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

Harley Grosser: Our team manages the Capital H Inception Fund, which is a value-focused, bottom-up stock picker specialising in small and microcap ASX-listed stocks

What we try to do is find situations where the upside is large and the downside's relatively small. It tends to be in the smaller companies where you can find those, so that's where we focus. 

The final one is we only buy businesses that we think we understand and at prices that we think are well below what we think they're worth.

MF: The last 12 months for small caps haven't been great. Where do you think the market is now and where do you think it's heading?

HG: My honest answer on where the market's going is that I don't know, and we don't spend much time trying to figure that out. 

As you mentioned, it has been a difficult market for small caps. So what we do know is there's a whole lot more value in Aussie small caps now than there was 12 months ago. We've been pretty much buying some stocks every day for the last six months or so. We spend our time just sifting through everything and trying to find one or two good ideas a year, really. 

Over the really long term, markets will move higher but in the short term, they can do anything. So we just try to block out the noise and focus on finding good opportunities.

MF: Would it be fair to say you buy stocks with a reasonable investment horizon?

HG: Yeah, we want to be invested in the business as long as the company's executing and the valuation stays reasonable. So the longer that is, the better. When we're buying a stock, we're buying it on what we think is [its] earnings in 12 or 18 months, not what it's earning today or yesterday. 

We're happy to take advantage of the short-term ups and downs, but we try to take a long-term focus on the actual investment.

Hottest ASX shares

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

HG: One is Environmental Group Ltd (ASX: EGL), which we've been in for a while. It's a provider of integrated waste management and environmental solutions. 

They've had a really good 12 months at an operational level but as you mentioned, most small-cap stocks are down. So they've upgraded a few times over the last year through FY22, and we think there's good prospects of earnings momentum continuing into FY24, given their deal pipeline. 

It's a really well-run business. It's run by someone who the market knows well, and it's in the right space with billions of dollars going to be spent on waste and environmental solutions in coming years, regardless of inflation, or recession risk, or base collapsing. It's a little bit recession-proof there. 

What we think will get the market excited in the new term is their opportunity in PFAS [chemical pollutants], which looks like it's starting to come together. So I think it's probably just one that investors should keep an eye on because we think it's close to an inflection point, potentially.

MF: These small caps, they can go down a fair magnitude, but when the market picks up again, they go up significantly compared to the larger stocks, don't they?

HG: For sure. And when they do go up, they go up very quickly, and often on relatively low volume. So it's hard to buy them when they're moving. You've got to take a view, get set, and hope your work proves you're correct. 

We're not trying to be too smart and trade each year around the edges. We just held the position, and if the stock goes nuts, we'll of course manage the position and sell what we need to, but it's a long-term hold for us. And the management's executing, so we can't really fault them.

MF: Great, and your other ASX share to buy?

HG: Final one is Sequoia Financial Group Ltd (ASX: SEQ). They're a financial services group. They've just announced they've agreed to sell 80% of one of their businesses for $40 million of cash. 

The stock's trading on a silly valuation of three times EV [enterprise value] to EBIT [earnings before interest and tax]. The catch there is that the market doesn't yet fully believe the sale will complete, at least based on what the share price is. 

But the buyer is coming out saying publicly that they've got the funding, so we just got to wait and see.

We think it's an investment with relatively little downside. If the deal doesn't complete, we don't lose much. If it does complete, then it looks really, really cheap. We'll probably make a good return. 

The first key date there would be the 20th of March for investors to watch. Pencil that date in because that's when the first payment of about $10 million comes in. And we think as each payment comes in, there's three payments totalling $40 million, then the stock will re-rate. 

It's not without risk there. The deal might not complete, but we think it's a reasonable chance it does and the stock looks cheap on that basis.

MF: That's a pretty huge transaction for a company with a current market cap of only $72 million.

HG: Oh, massive. I mean if it does complete, they've got $45 million of cash, they'll still be doing say $8,  $9 million of operating EBITDA a year. 

I think the market was shocked, in a good way, by what price they got for Morrison's. But because the structure of the deal is cash payments over a relatively long time, the market's not going to price it in until the cash's actually in the account, which is fair enough.

Motley Fool contributor Tony Yoo has positions in Environmental Group. 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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