Investing in ASX small-cap shares can unlock great returns for investors. But there's also the possibility of finding some duds. In this article, we explore a small-cap fund manager's take on the factors that could help deliver outperformance.
It's much easier for a business with a market capitalisation of $500 million to grow to $1 billion than for a company to grow from $50 billion to $100 billion. That's a major reason why small businesses have more growth potential than larger businesses – they have longer growth runways.
The Ausbil Australian SmallCap Fund investment team has outlined some elements to look for when choosing which stocks to invest in. Two companies that fit the bill for Ausbil are Imdex Limited (ASX: IMD) and Lifestyle Communities Ltd (ASX: LIC).
Liquidity and profitable
The team aims to invest in "outstanding" ASX-listed businesses that are "liquid and profitable" while they are undiscovered, under-researched and under-owned. Identifying these companies early is "key to capitalising on their growth prospects".
Being profitable is a simple concept – it means making more revenue than the company is spending. I'd suggest it's easier to evaluate a company if it's making a profit. It also means that the business isn't burning through its cash.
Liquidity in this investing context means the investment team can "enter, exit and position size" its holdings to "minimise market impact and further mitigate liquidity risk".
If a small-cap ASX share isn't liquid – if there isn't much volume of shares traded each day – then it can be hard for a fund to buy the number of shares it wants to buy at a good price.
Low liquidity can also mean it's hard for a fund to exit a position at a good price if there aren't many buyers.
Even if a fund that owns shares isn't buying or selling, low liquidity during a market crash can see the fund's returns sink if other investors sell out and push the share price down heavily to get a sale.
Sustainability
The sustainability of the business model and the appropriateness of its capital structure are particularly important to the Ausbil investment team.
They look for "quality companies that have strong balance sheets, a high return on invested capital, affordable valuations", and a board and management that they can back.
A high return on invested capital (ROIC) demonstrates that the business is making a good profit on money that's invested in the business on things like heavy machinery, manufacturing, new software and so on.
The valuation of the ASX small-cap share needs to make sense to invest, and they want to see that the leadership team are capable and effective.
ESG
The Ausbil team said it incorporated ESG (environmental, social and governance) considerations into its investment decisions for small-cap ASX shares. This helped to "further reduce quantifiable and unquantifiable investment risks".
Readers can find examples of ESG investing in our Motley Fool guide. But, in a nutshell – environmental considerations are about doing the right things for the planet. The social element is about doing the right thing for people, and governance is about the right things by the company and shareholders.
