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How to find ‘hidden gems’ in the small-cap space

Graham Kelly

As canny investors know, there are no short-cuts to finding the share market’s “hidden gems”, those small-cap stocks that can provide double or even triple digit returns. It’s requires diligent research, a willingness to take a long-term investment view, and discipline – the capacity to ignore market noise. But the most important factor is being prepared to do your homework.

The top end of the market, those stocks in the S&P/ASX 200, are largely well covered by the broking analysts; they continually update their financial models on which they base their “buy”, “sell” or “hold” recommendations to their institutional or high net worth clients.

By contrast, few brokers or analysts cover the small caps. There’s simply little financial incentive to do so – with a major consequence. It means low-cap stocks with strong investment stories often go under the radar, providing investors with the opportunity to pick up under-valued stocks at attractive prices. When that happens, the leverage potential can be exciting.

Finding such stocks rarely happens over a beer at a neighbour’s barbeque; sustained investment success only comes when an investor does the necessary research. The balance sheet, cash flow, market opportunities, and management and board experience; these are just some of the factors that need to come under the microscope.

Certainly, there’s no shortage of market opportunities with between 80 per cent and 90 per cent of companies listed on the ASX falling outside the province of large caps. So, what to look for?

Unlike their large cap counterparts, most small caps have a straightforward business model, irrespective of what market sector they occupy. Not only that, the management and board want to engage the investor community; they often have skin in the game, are passionate about their product/service, are happy to share their story, and, in many instances, personally know their shareholders. [It’s also the realisation that mainstream media, like the brokers, is mostly focussed on the top end of town, explaining why social media is becoming increasingly important to small caps.]

A company such as Noxopharm, an Australian drug development company, is a good example. Dr Graham Kelly, the chief executive, regularly updates the market via social media and investor road shows in Australia and Asia about its primary goal – to develop drugs to address the problem of drug and radiation resistance in cancer cells, a major hurdle facing improved survival prospects for cancer patients.

In a timeline outlined in Noxopharm’s latest presentation, its key messages are:

  • End 2017: some current clinical studies to provide preliminary proof-of-concept data for likely indications (cancer type and treatment) for ensuing registration studies (for marketing approval);
  • Aims to have implemented one or two registration studies by the end of 2018;
  • Company aims to be generating a commercial return by 2022;
  • A successful outcome is a major share of the $100 billion oncology drug market;
  • Realistic potential to come a standard-of-care drug in most cancer patients.

What this messaging underlines is the need for investors to be patient, with a commercial return still five years away.

To date, it seems its shareholders appreciate that bringing an anti-cancer drug to market is a lengthy process (for anti-cancer drugs it’s generally eight-plus years), with Noxopharm’s share price trading yesterday at 38c, a 90 per cent premium to the issue price of 20c when the company listed 12 months ago. [The 2017 Deloitte IPO report, A game of snakes and ladders, shows IPOs delivered returns of nearly 12 per cent on a weighted basis for the year to 31 December 2016, outperforming the All Ords that closed up 7 per cent for the year.]

Noxopharm also fits other investor guidelines for a small-cap play. Cancer research is in one of those sweet spots that biotech analysts and investors like for the potential upside. Others include AIDS, viral infections, and immunological diseases.

The business case is relatively straightforward; Noxopharm is in cancer research, a potent and singular investment theme. Provided the company continues to keep the market well informed then shareholders can make sound decisions about their investment.

Like many small caps (junior miners are an exception), it is relatively immune to broader macro trends in the economy, so when the overall market comes under selling pressure it is less likely to be sold off than large caps stocks that offer investors greater liquidity.

Finally, stocks such as Noxopharm can be an important part of diversifying a portfolio. For example, an SMSF trustee, even in the pension phase, still needs to be conscious of capital growth as they live well into their 80s and 90s, so an investment in several, well-researched small caps as part of broader investment strategy is worth considering.