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A fresh approach to value investing in
undiscovered, quality businesses.

Asymmetric Risk-Reward Investing in Nano-caps 

 

In this article, Chris Steptoe discusses asymmetric risk-reward investing in relation to small ASX listed companies. We hope it gives you some insight into the way we think about stock selection and one of the ways we can provide exposure to interesting, high return opportunities, where we consider the odds of success to be in our favour. 

 

An asymmetrical risk-reward is the concept of taking a risk that will produce a return that far surpasses the risk taken. As an investor, that essentially means buying into a company where the potential gains in its share price are many times more than the potential decline in the share price.  

 

In business, not everything goes to plan. Sometimes the plan will fail. But sometimes it will just take longer than expected or the plan needs to be tweaked. In these cases, if the company is listed, by the time these businesses start to get things right, shareholder interest is often at an all-time low and valuations can be very attractive. This is one type of setup that we are looking for in our investment screening. 

 

There are many loss-making stocks on the ASX that have been beaten up and are now worth many multiples less that than when they first listed. These are typically story stocks. Often, they have great products and/or blue-sky potential, but management have failed to execute to market expectations. Whilst these companies may have been growing, the growth may not have been at the rate demanded by the market. In many cases, original investors have been burnt as they have sunk further in subsequent discounted capital raisings as the company requires cash to survive. Shareholder value has been destroyed and sentiment is very poor, but there is still a growing, operating business behind the awful looking share price chart. While the passing of time may not have benefited a company’s share price, time enables a growing company to increase its scale, cut costs, diversify its customer base, re-invest in its intellectual property and refine its strategy if necessary, and become a more robust and resilient business.   Here lies the opportunity. 

 

So, what do we look for when seeking out these opportunities? 

  1. Cashflow positive or funded through to cashflow positive. We don’t want to see the value destruction of further capital raisings. Therefore, we want to be confident that the company won’t be coming back to shareholders for more cash. We will participate in a capital raise if we think there is a good chance that it will be the last.
  2. Strong upside in valuation. We are focussed on cash flows, and want our discounted cash flow model to show a large margin of safety relative to the share price. Often, we will also look for peer valuation to provide a target upside scenario. 
  3. Quality business model. Like all our companies, we want to see a durable business model we can understand. We want to see a business that has a demonstrable track record of growth, and strong visibility that the growth will continue.   
  4. Insider buying. While not mandatory, we want directors and/or management to consider the current share price is trading at a large discount and have them buying recently 
  5. Catalyst for a rerate. We want to see a catalyst for a rerate in the next 12 months. This could simply be turning cashflow positive or some other event. 

So how do we think about the downside? We often come across companies where management have disappointed in their previous guidance, so we really focus on understanding if their guidance is realistic based on revenue and expense trends. This usually means focusing on the quarterly 4c cash flow and market update announcements. 

 

Many of the companies we look at might be trading at under $10m market cap. Often ASX shell companies (a company which has divested its operating business) have market caps of around $3m. Let’s say our company has a market cap of $10m, then we might consider the absolute downside in the event of business failure (and divestment of the business) to be a loss of 70%. However, as mentioned above, we are looking at opportunities that have a proven track record of growth, that are either cash flow positive or close to it, and are reputable, robust, proven companies, where we assess the likelihood of business failure to be remote.  Other downside scenarios may be based on tangible assets on the balance sheet.   

 

Below, we provide three examples of the Asymmetric Risk-Reward strategy in action at DMXAM. 

 

A success story – Tinybeans Group (TNY)  

 

Having followed the progress of TNY for some time, and after constructive engagement with management, we acquired a small position in TNY at the start of the April at 35c. On our forecasts it was significantly undervalued for a very fast-growing business that was rapidly becoming a significant (3 million plus users) global social media platform. It had been heavily sold off since its IPO at $1 two years ago yet was now in a far stronger position. User numbers had tripled since the IPO, and the company was consistently reporting triple digit revenue growth. As a result, at a $10m enterprise value, we viewed the downside as limited, and the upside as significant.  

Since our initial entry, the company has signed a milestone advertising contract with Lego. While not that meaningful in dollar terms, Lego is high profile and provides credibility. The announcement certainly excited the market and was the catalyst that drove the price higher (currently $1.20). With such low liquidity, violent moves up and down are not uncommon in this space. 

The current market cap of ~$40m is still low relative to many other fast growing, market leading, ASX businesses with a global addressable market and substantial ‘blue sky’. Our position here is now ‘free-carried’ and we still see material upside if growth continues resulting in TNY becoming a significant global family platform. 

 

Turnaround in Action  - CV Check (CV1)  

 

CV1 provides background screening (identity, credentials, employment history checks) on individuals which is particularly relevant for employers. It embeds its technology in its customer’s HR software, enabling its corporate customers to conveniently undertake (at scale and from one source) many reference checks, identity checks, criminal checks, psychometric tests etc for new employees.  

CV1 was beaten up as their B2C strategy struggled to be profitable with its share price dropping from over 70c to under 5c.  However, during this time of poor performance the company embark on a B2B strategy and reduce costs in the B2C business. We were attracted to the high-quality revenues of the B2B business and that they were near-term cashflow break-even.  This business-to-business revenue line is growing organically at ~30% annually. This is a company that can scale revenue very quickly, with high gross margins (60%) and significant operating leverage. It has the potential to be valued at many times higher than its current capitalisation (as seen by peer XF1 with a market cap close to $100m). A great asymmetric risk reward payoff. 

We were invited to take part in the placement for 5.75c back in November 2018 valuing the company with an Enterprise Value of around $13m. Management also took a significant portion of that placement.  We added to the position after they became cashflow breakeven at around 7.5c. CV1 now trades at around 20c. While the returns to data are pleasing, we still see significant upside potential with a market cap at $50m. 

 

One of our recent investments – Chant West Holdings Limited (CWL) 

 

CWL is a leading provider of research, consulting and software services to the superannuation and financial planning industries. CWL’s clients include the majority of Australia’s leading superannuation funds, institutional wealth managers and financial planning dealer groups, and approximately 90% of its revenue is high quality subscription, annuity style, revenue. 

Following the Royal Commission, CWL is seeing growth in demand for independent research data and software to compare super fund products. The opportunity is to expand the product suite to it’s customers so their data can be embedded in their customer’s own systems. While the two previous examples were loss-making when we invested, CWL is profitable, but has a checked history.  

In the nine months to 31 March 2019, CWL has recorded a 20% increase in cash receipts to $7.4m. Operating cash flow for the nine months (before R&D payments and tax refunds) stood at $1.3m – an impressive achievement for a company with an enterprise value of less than $4m. Again, with such a low enterprise value, we view the downside as limited, and the upside as significant. 

We have entered the register at between 6- 6.5c over April and May.  We look forward to the full year result which should prove to be a catalyst for share price appreciation  

 

Portfolio Approach 

 

We consider these types of opportunities to be earlier stage and therefore lower conviction than our core portfolio positions (which generally have a track record of profits and dividends). As a result, they don’t hold the same weighting in the portfolio.  To ensure risk is spread across multiple positions, we hold several of the type of opportunities highlighted above. This way, we should not see a failure of an individual position have a large impact on our capital. As we did with CV Check, if the investment thesis plays out, we are prepared to increase the weighting of a position.  

We see the potential upside from the DMXAM approach to asymmetric risk-reward as one of key our pillars of providing exposure to compelling investment opportunities that have the potential to generate above average returns to our clients