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June 2019 Fund Update – Price vs Value dichotomy in the Microcap and small cap equity markets

  • July 1, 2019

The Australian microcap and small cap equity markets have bifurcated, or to use biblical parlance the seas have split into two realms with very different market valuations. At one realm you have very fast-growing companies some of which are profitable, and others yet to make a profit, many of them speculative and high risk. This segment of companies has market values that are inflated, unjustifiable and some are simply in pure bubble territory. At the other realm of the market we have profitable modest growth companies, whose market values have either not risen or have retracted over the past 12 to 24 months. Some of these companies are at extreme low, GFC-like market values and we happen to own a lot of these companies.

Why are we seeing two realms of market valuations?

The dichotomy in market values has become quite extreme and is being driven by investment flows into valuation indiscriminate index funds (further fuelling valuations of overpriced companies) and the closure of many active fund manager businesses (Adam Smith Funds Management, Sigma Funds Management,  KIS Capital, Janus Henderson) which has accentuated further pricing dislocation and driven undervalued companies further down. The valuation gap between these two realms has become quite extreme.

A bipolar small cap & microcap market value world

5 small cap tech companies Enterprise Value

5 of Microequities investee companies Enterprise Value

* Forward market consensus revenue & earnings

Deep Value Fund and Pure Microcap Value Fund heavily undervalued

Our Deep Value Fund and Pure Microcap Fund have delivered negative market-based returns over the past 18 months despite overall earnings growth across the portfolios of these funds. There is a large segment of companies inside the funds that are at GFC-like market valuations. The pricing dislocation and undervaluation is not just significant but, in some cases, extreme.

Value investing in microcaps and small caps is a conviction business where the true compass is not the market values but the intrinsic values. The difference between the two is that the latter is always driven by the fundamental earnings of the business and these seldom change on a month to month basis. Market values, however, are attained from more abstract sources like sentiment, investment fashions, portfolio rotation, short term views and investment flow dynamics. Value investing does not guarantee year on year positive returns but our method of buying growing businesses and buying them at undervalued prices has delivered strong long-term returns. We believe the severe undervalued pricing across a large segment of the portfolio is laying the seeds of strong returns to come in future periods.

Do you see the opportunity?

For those investors who make decisions based on the frailties of market values alone, there is little in our 18-month performance of our Pure Microcap Fund and Deep Value Fund to be encouraged about. For those investors that understand that fundamental intrinsic value eventually breaks through the follies of speculation and value-indiscriminate investment, perhaps the tables above will excite you about our future. Our growing companies will not stay undervalued for ever, just ask GBST which this month received 3 upgraded take over offers from listed competitor Bravura Solutions. Bravura is an informed buyer, if ever there was one, and understands the gap in the value between its scrip and GBST.

Carlos Gil

Carlos is the founder and current CEO of Microequities. He has worked in stockbroking, funds management, and investment research for over 15 years, and has been an individual investor in Australian Microcaps since he was 18 years old. Carlos has held various senior management positions in Europe, including roles as Head of International Securities at BM Securities, and at Banesto Bank (Santander Group). On his return to Australia, he established Microequities with a single minded vision: to provide quality investment research on Australian Microcap companies. After being Head of Investment Research for five years, he became Chief Investment Officer of Microequities Asset Management in 2008. Carlos is a fervent supporter of Australian Microcap companies and the virtues of long term value investing. Carlos holds a Bachelor of Economics from Sydney University and a Master in Applied Finance and Investment Analysis from the Financial Services Institute of Australia (Finsia).

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