Why Should Investors Look at Small-Cap Stocks?

Summary

• Small-cap stocks are among the hardest hit businesses during risk-off periods. With new business models, small companies have a less resilient business that is also sensitive to changes in economic conditions.
• Investors like to find quality and scalable opportunities that small-cap stocks may offer. Growth-seeking investors look for such businesses during the early stages to capture the growth.
• RPMGlobal and Objective Corporation, two small-cap IT sector players, have recently announced new acquisitions, boosting their offerings.

Companies with relatively new business usually fall in the small-cap category, but it could be other way around as well. Stocks are categorised based on respective market capitalisation, which is a combination of worth of the business and investor expectations.

So, when market expectations are very high, the stock may command a higher market capitalisation even if it is a relatively new or unproven business model. Consider the dotcom bubble early in this century, there were so many loss-making .com companies in stock markets with relatively higher market capitalisation than an established and profitable business.

If investor expectations are not favourable, even a company with profitable business, assets and growth prospects may not command an appropriate market capitalisation. Moreover, the business could be underappreciated by the market.

With new business models, small-cap companies have a greater risk than the large and established enterprises having more predictable business future. Small companies are also less resilient in nature, and a crisis like COVID 19 could wipe out these businesses.

It becomes imperative for investors to look at companies with resilient business models that can withstand deterioration in business conditions, even when they are looking at small-cap stocks. Since the stakes are higher in small businesses, the returns are also of a larger scale.

During risk-off periods like March 2020, investors look for businesses with a defined history of sustainable growth and profits, which is usually available with large companies or companies with proven business models and profitability.

Risk-off periods bring small businesses to their knees, and sell-offs are relatively more intense compared to large businesses. Small-cap companies usually do not have a diversified revenue stream and are focused on a few revenue sources.

Leverage in the business is critical to delivering strong shareholder returns. For some businesses, it is the model that requires debt funding like an infrastructure development company. Debt levels suppress the shareholder returns through interest payments and repayment of loans.

Profitability and returns of the business are also critical factors in assessing the capital allocation decision of the firm. Sometimes a small investment produces higher than expected results, but a large investment could also deliver adverse outcomes.

Capital allocations by management make or break the long-term prospects of the company. Investors assess these decisions by evaluating the results of previous investment and value addition to the firm worth.

But it is equally important to look beyond first-order consequences of the upcoming investment decisions of the company. It is favourable for investors when they find fault lines in the investment decisions that may impact the business over future.

When investors intend to capture growth of a business, it is highly perceived that investing in small businesses is the way to approach because such companies have more scalability, growth prospects and potential to become a large-cap company.

ASX Small-Cap Stocks

ASX has a large number of small businesses from Australia as well as other countries. Small and new businesses have preferred ASX to list their company may be due to an abundance of growth-seeking investors with deep pockets.

Let’s look at a few of small-cap stocks listed on ASX.

RPMGlobal Holdings Limited (ASX:RUL)

RPMGlobal is a software and services company, catering to the mining industry. It offers mining software solutions, in addition to mining advisory, technical consulting and mine planning services.

Recently, the company announced acquisition of Revolution Mining Software, entering a share purchase agreement for 100% shares of the Sudbury, Canada based mine scheduling optimisation software solution provider.

The privately held target business has been selling its product for the past six years. Revolution’s Schedule Optimisation Tool (SOT)^TM is used by tier one miners across the world.

RPMGlobal would also acquire other software solutions by Revolution that include Attain^TM and SurfaceSOT^TM. The transaction improves the scheduling solutions provided by the company. All employees would be onboarded to the company and will continue to add value to the customers through innovative solutions.

The company would pay CAD $500k upfront through its cash reserves, earn-out for two years based on the sales performance of the business, and working capital adjustments post three months of completion. It expects to complete the transaction by 31 July 2020.

On 10 July 2020, RUL last traded at $0.990, down by 1% from the previous close.

Objective Corporation Limited (ASX:OCL)

Objective Corporation is a tech business, specifically an enterprise software solution company. It primarily serves public bodies, governments, ministries, and financial services. OCL, which has a presence in five countries with over 1k customers, invested more than 20% revenue in research & development in FY2019.

Earlier this month, the company acquired Itree, a Government RegTech solution specialist. Enterprise value of the transaction was $18.5 million (net of cash). Itree has evolved into a leading cloud-based regulation software provider for government agencies and regulated industries across ANZ.

The acquisition update by OCL highlighted that both companies have complementary services and were founded in Wollongong, Australia. The target company has been recognised in 2020 RegTech Awards.

The acquisition builds on the company’s industry solutions strategy. One of Itree’s solution was developed under the Government’s Business Research and Innovation Initiative.

All employees of the acquired business would join the company, including Chief Executive. Itree is a profitable business, and the transaction would be funded through cash reserves. It is expected that the acquisition would be EPS accretive and cash flow positive.

In May, the New Zealand Commerce Commission (NZCC) commenced investigation into the acquisition of Master Business Systems (MBS) by Objective Corporation, noting potential anticompetitive concerns. The commission is yet to reach on conclusion of the breach of laws.

OCL stated that the company is committed to its customers and NZ community, and it has received strong support from the stakeholders of MBS.

On 10 July 2020, OCL last traded at $9.160, up by 1.552% from the previous close.