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If you haven’t got a healthy appetite for risk, you just might want to pass on microcap stocks – the moniker for stocks with a market value of less than $250 million. As microcaps are generally newer companies – some newly listed on the exchange – it’s hard for investors to get reliable information about the prospects of such companies. Furthermore, the analysts who follow the stocks of more established companies and provide ratings and opinions rarely pay much attention to stocks in the microcap space.

Thus, most investors on a fixed income probably want to steer clear of microcap stocks, but if you’re a younger investor with enough extra income to make some mistakes, microcaps can be an important part of a diversified portfolio. One way of decreasing the risk is to place your microcap investment in the hands of a microcap fund manager such as Macquarie. For a minimum investment of $20,000, the Macquarie Australian Microcap fund returned 39.15% year-to-date through March 31, 2011, and 21.21% per year for the three-year period before March 31, 2011. Macquarie has been one of the most successful of the small group of funds that specializes in microcap stocks. However, most of the other funds in the space, such as BT’s Wholesale MicroCap Opportunities and Contango’s Microcap Fund, have also outperformed the market in recent years.

The “holy grail” of microcap investors is the “ten-bagger” – a stock which increases in price by a factor of 10. Such stocks are rarely found among larger companies. Instead, it’s at the other end of the market spectrum – among micro-cap companies – that ten-baggers are most readily discovered. However, for every ten-bagger you find, you may well find nine shares which ultimately lose every penny invested in them. Thus, even if you’re a wild-eyed speculator rather than an investor with a long-term growth perspective, taking a diversified approach to microcaps makes sense. “Three or even 10 stocks is too small” for the size of your microcap portfolio, says Macquarie’s portfolio manager Neil Carter. “We have 60 or 70 stocks and our average position size is 1.5 per cent.”

In addition to spreading the risk over a diversified portfolio, there’s another advantage to investing in microcaps through a professional fund manager – improved access to information. “Companies planning to list or make a share placement tend to have a broker and they come to us,” says Contango Microcap fund manager Boyd Peters. “We visit a lot of companies and speak to management and their suppliers.” That’s something that most individual investors are unlikely to be able to do. Of course, such informational superiority is a selling point for any fund manager – but it’s even more significant where microcaps are concerned, given the extremely limited amount of research available to the general public about such stocks.

Among the top holdings in the Macquarie Australian Microcap portfolio are Carabella Resources (CLR), Hansen Technologies (HSN) and NextDC (NXT).

Carabella (CLR)

 

Chart: Share price over the year to 17/06/2011 versus ASX200 (XJO)

In March, TheBull’s Tony Featherstone covered Carabella and other start-up coal companies in “6 Recent Coal IPOs to Watch.” He pointed out that the latest Queensland coal float, Carabella Resources, had had a flying start, its 40-cent shares rallying to $2.04 at that point since listing in December. Featherstone highlighted three attractive aspects of Queensland coal floats: location, particularly the Bowen Basin, Australia’s largest coal reserve; a strong global demand for coal; and a tendency toward low valuation. “The key question for prospective investors in Carabella is valuation,” Featherstone noted. “After accounting for restricted securities (which the ASX deems cannot be traded for one or two years), Carabella’s market capitalisation is well over $200 million, a fair bite for an early-stage explorer.”

However Featherstone cautioned, “Prospective investors might wait for some heat to come from the share price before considering Carabella.” Indeed, by the time Featherstone wrote a follow-up article in April, Carabella was up to $2.56 – but on its way down, having peaked in March at over $2.90. It seems to have settled down somewhat, currently trading at $1.80 with little recent movement.

Hansen Technologies (HSN)

 

Chart: Share price over the year to 17/06/2011 versus ASX200 (XJO)

We also covered billing software company Hansen Technologies in TheBull last month, listing it as one of the most favoured value plays of Elio D’Amato, CEO of Lincoln Indicators. Hansen provides billing and customer support software and smart metering solutions to the utilities and telecom industries. “The decision by the utility billing software and services provider to acquire US billing software developer NirvanaSoft late last year is expected to double its customer base for energy billing in North America, and lift revenue from the region by 50 per cent,” we reported. “Trading on a P/E of 11.8x, HSN delivered full year 2010 EPS growth of 35.7 per cent, and currently trades on a 25 per cent discount to D’Amato’s $1.08 price target.”

At the end of May, Hansen upgraded its forecast for FY11. It is now expecting a pre-tax profit of around $17 million. The result, if achieved, would be a 20 per cent improvement on the previous year. CEO Andrew Hansen said the company’s international revenues had been impacted by the strong Australian dollar, but that it had been able to curtail the overall impact on operating performance. He added that a number of factors could influence the actual performance for the quarter, but that “we are confident in forecasting a profitability for this fiscal year that will materially exceed the prior year.”

NextDC

 

Chart: Share price over the year to 17/06/2011 versus ASX200 (XJO)

In April, we reported that Nick Harris, Senior Analyst with RBS Morgans Ltd, had targeted NextDC, a start-up ‘vendor neutral’ data-centre (DC) which listed on the ASX late last year, at a share price of $194. At that time, it was trading at a 20% discount to Harris’s target. Harris said that he expected the recent hiring of sales resources across Brisbane, Sydney and Melbourne to lead to customer wins in the foreseeable future. He also expected recently-hired experienced DC sales staff to be an important catalyst for the stock – leading to increased investor confidence and proof of market demand. His target price was based on the Brisbane facility being operational in June, followed by Melbourne in November, and then the Sydney facility becoming operational early in 2012.

Shortly after Harris issued his opinion, NextDC announced that it had massively oversubscribed its $5 million share purchase plan, offered to existing shareholders. The data centre operator received $15 million in applications, and decided to accept the $10 million of excess applications in full and apply them to “additional growth opportunities,” especially those outside Brisbane, Melbourne and Sydney. It then wasted no time in reaching a conditional agreement to buy vacant land in Perth for a 3000 square metre data centre.

‘Perth is a strategic location for NextDC and after a comprehensive evaluation of a number of alternative sites in Perth, we have selected this site due to its location and access to significant power and other infrastructure that we trust will be validated through the formal due diligence process to be conducted over the next two months,’ said CEO Bevan Slattery. NextDC is now trading at $1.69, a 13% discount to Harris’s target share price.

Winners and Losers

Macquarie’s Carter doesn’t expect every stock he buys to be a ten-bagger. “If you end up with more winners than losers then you will do pretty well,” Carter says. He’s averaged six winners for every four losers. And his stocks pay dividends – the fund has a forecast dividend yield of 4.3%, the same as the S&P/ASX20 index of top-20 stocks. Macquarie Australian Microcap has an Standard & Poor’s “new fund” rating of three stars, issued late last year. Other stocks in the Macquarie Australian Microcap portfolio include Entek Energy (ETE), Auzex Resources (AZX), MSF Sugar (MSF), and Northern Star Resources (NST).

>>Back to the newsletter to view other articles – June 19th 2011

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