Joel Fleming, Microcap Portfolio Manager, looks the August reporting season in the micro cap equities space, where COVID-19 is bringing opportunities for many companies given the many changes that appear likely to be permanent.
Reporting season was very different this year, with face-to-face management meetings replaced with video calls (“I think you’re on mute”) a tiresomely repetitive theme.
Last reporting season and in the early throes of COVID-19 we were worried about supply chain impacts, before the full force of lockdowns and the rapid slowing of the economy saw these concerns move to company liquidity and solvency.
Extraordinary government intervention (JobKeeper, early withdrawal of super and rental abatement) supported businesses in hiatus, but have combined to cloud the medium-term outlook. As we emerge from the August reporting period, one where the majority of companies chose not to provide forward guidance, investors in the microcap space face significant challenges understanding which businesses will prove enduring to both survive and then thrive as these support measures are withdrawn.
We observed a few key themes from the recent results period. In particular:
1. Cashflow is still king
Cashflow is core to our investment process. It is the lifeblood of business, providing optionality to invest (incl. via acquisition), undertake capital management, and ultimately keeps the lights on. It is also more difficult to manipulate than earnings which are subject to non-cash estimates.
Most companies reported debt positions and cashflow above expectations. Markets tend to capitalize the most recent data point and we caution against extrapolating recent trends into future cash requirements. Indeed, a number of unsustainable drivers were apparent, including:
- Working capital benefiting from lower levels of ordering (inventory) and a slowing of supplier payments;
- JobKeeper and changes to rental arrangements providing short-term relief to the cost base.
Metal detection company Codan is one portfolio company that has surprised on the upside through COVID, with the business generating significant cash and having a balance sheet that provides optionality for acquisition or capital management.
2. Fuse lit under discretionary retail
Discretionary retail was a real standout after being the hardest hit sector into the March lows as investors worried about the health of the consumer and how physical retailers could meet rent and employee obligations on much lower revenues.
In addition to the unsustainable boost from rental abatement and JobKeeper (refer above), discretionary retail has seen an enormous sales boost from JobKeeper and early super withdrawals (both stronger than forecast). Just how much of this boost was a ‘pull forward’ of demand and how much represents shifting consumption patterns will become clear over time.
Despite skyrocketing share prices, the uncertain revenue outlooks (at best) and normalising cost bases means we remain focused on those retailers with defendable offerings, improving competitive positions and the online capability necessary to provide consumers a satisfying experience wherever (and whenever) they shop. Temple and Webster and Baby Bunting are two retailers in the portfolio with big ticks against these boxes.
3. Online acceleration accelerates!
For years we have all observed the increased digitization of the world around us. Online shopping has continued to grow strongly, with COVID accelerating these trends as people work and school from home and transact widely despite being confined to their homes.
Consumer facing businesses with no quality online offering were in trouble prior to the pandemic. Coming out the other side it is likely lights out for many of them, with thriving e-commerce platforms the most obvious beneficiary from the COVID disruption.
The businesses that can step change their economics as they draw new customers in the post-COVID normal will be well placed to outperform. Through its Mathletics software, 3P Learning is one company benefitting from the digital transformation of our lives. The bid from IXL at a 25% premium highlights the potential to scale the business globally, and we don’t discount more interest in the stock.
As long term investors, we look for businesses benefiting from structural change and with significant growth runways ahead. COVID-19 represents an opportunity for many companies given the many changes we believe will be permanent. Our $250m market cap threshold provides the ability to be early investors in the next generation of ASX success stories.