If you’re looking for some free ASX small-cap share ideas to stick on your watchlist, you’ve come to the right place. Below, I’ll briefly explain why it’s worth watching shares of Afterpay Touch Group Ltd (ASX: APT), Gentrack Group Ltd (ASX: GTK) and Redbubble Ltd (ASX: RBL)…
I also explain why we don’t own these shares already.
Why Small Caps?
In a world of record-low interest rates, credit excesses and full valuations in blue-chip stocks, I think it’s now more important than ever for savvy investors to carefully consider adding growth shares to their portfolio for the long-run (5+ years). A long investment timeframe like this can help you, the investor, look past the high amounts of uncertainty and volatility which often plague shares of small companies in the short run.
Basically, there are three primary reasons why non-bank aligned analysts such as myself choose to spend most of our time researching small caps:
1. They’re under-researched.
Relative to larger companies, small companies get less coverage from analysts because big institutions and fund managers are too large to buy them.
Don’t believe me?
According to The Wall Street Journal, right now there are 14 analysts covering Commonwealth Bank (ASX: CBA) shares (a $138 billion company), just seven covering mid-caps like Bapcor Ltd (ASX: BAP) (a $1.9 billion company) and five analysts covering Gentrack – a larger small-cap company worth around $500 million.
This lack of research creates an informational advantage for investors — an edge we look to exploit for Rask Invest.
2. Growth.
Put simply, Australia isn’t that big of a market so I think investors are better off buying the top quality companies when they’re sub-$500 million businesses rather than waiting for them to enter the ASX 200 or when they’re $2 billion-plus businesses. By the time they reach the big leagues, these companies are often forced to look overseas (which is risky and expensive) or move into other products and services.
3. Diversity.
The largest companies on the Australian share market are often heavily focused or dependent upon the financial services, banking or resources sectors. If you want fast-growth technology shares, industrials or up-and-coming brand-name companies, your time may be better spent looking outside the top 200 or 300 companies.
3 Small-Cap ASX Shares To Watch
1. Gentrack Group.
Gentrack provides billing and other types of software for essential service organisations such as energy providers, water utilities and airports. It has offices in New Zealand, Australia, the UK, Singapore, USA and Europe. It provides services for over 220 utility and airport sites in more than 30 countries. One of its main customers is Sydney Airport Holdings Ltd (ASX: SYD).
Gentrack has had a rough trot getting traction into the UK market as it hopes to capitalise on the fragmentation in the market at a time when the Brexit vote is consuming political and economic attention. What I really like about the business is the mission-critical, sticky nature of its software. It’s very hard (or not worth the risk) for an energy and airport customer to ‘rip out’ its software when Gentrack ups the price 5% in a year. Over time this should afford it pricing power and scalability. For this reason, Gentrack is on my watchlist.
2. Redbubble
Redbubble was founded in 2006. It owns and operates Redbubble.com and TeePublic.com, two global online market places where over one million independent artists can sell their designs on products like apparel, stationery, bags, wall art and so on. For example, we bought artistic pictures of Warren Buffett, Bill Gates and others to hang on the wall of The Rask Group’s office. Redbubble allows customers to shop through a wide range of options rather than just going to one art gallery at a time.
I didn’t much like Redbubble’s decision to use acquisitions to grow. At Rask Invest we almost always prefer companies to grow organically because it tends to be cleaner and — most importantly — reinforces the idea that management believes in their core product and strategy. Admittedly, the acquisition of TeePublic bolted on a large audience which is important as Redbubble seeks to take on Etsy Inc (NASDAQ: ETSY) and Amazon.Com Inc’s (ASX: AMZN) Homemade. One final risk to consider is that Redbubble seems to be at the mercy of web traffic and changes to internet search algorithms. In recent times, changes to some search engines has pulled the handbrake on Redbubble’s growth.
What we do like about Redbubble is the flywheel of cashflow it generates from sales and the potential for it to scale profitably and quickly — two things many Aussie tech stocks can’t seem to do at one time. What I mean is, given that Redbubble takes payments from its users upfront, orders the products from ‘fulfillers’ (manufacturers) and sends the artist payment a few weeks later, Redbubble should be able to effectively fund its growth using other peoples’ money and effort.
Companies such as Amazon have proven this cashflow flywheel can delight long-term shareholders who are happy to let their company compound its operations at a vicious rate.
3. Afterpay
Afterpay is not much of a small-cap these days but it’s so growth-focused and volatile it may as well be. Afterpay is the owner of the popular “buy now, pay later” app. It has over five million registered users worldwide.
The company is now trying to emulate its outstanding success in Australia by expanding its reach into the UK, using the ‘Clearpay’ brand name, and into the USA, where it has signed major social influencers to endorse its service.
What we/I struggle to comes to terms with is forecasting Afterpay’s net transaction losses and understanding what happens to margins within its core credit business beyond the next three-to-five years. Will the product lose its appeal with retailers who foot the bill? Or will its other services pick up the slack if margins fall away? We can’t answer this ‘central question’ but we’re working on it…
What we like about Afterpay is its cashflow flywheel and the oh-so juicy returns it can achieve from the incremental capital piped into its short-term lending model. Then there’s its impressive UK and US growth ambitions, optionality to expand the Afterpay platform beyond its current product suite and its high-quality management team.
What Now?
We don’t own any of the shares above for the Rask Invest model portfolio but soon enough we could. Regular readers will know we’ve profiled Afterpay quite a few times and will continue to do so as the thesis develops.
As always, we remain intensely focused on finding companies with first-rate products/services, high quality and aligned management, large addressable markets and competitive advantages — then we’ll buy them when they’re trading at a reasonable valuation.
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Disclosure: At the time of publishing, Owen does not have a financial interest in any of the companies mentioned.
