Livewire – How to uncover the next Afterpay

This article was published on Livewire Markets, 22 March 2021

In this episode of Buy Hold Sell, Livewire Market’s Ally Selby was joined by micro-cap experts James Dougherty from Lennox Capital Partners and Nick Guidera from Eley Griffiths Group, for their tips on finding the next undiscovered gem.

And because we here at Livewire are extremely kind and generous, we also asked our fundies to share one stock that they believe can climb its way up the index to the S&P/ASX20.

Note: You can watch, read or listen to the discussion below. This episode was filmed on 17 March 2021.

Edited Transcript

Ally Selby: If the opportunity to invest in the next major growth stock landed in your lap, would you take it? I’m guessing your answer is yes. Well, listen carefully my friends, because in this episode of Buy Hold Sell we’re taking it to the experts to figure out how you can find the next undiscovered gem. Plus, our fundies will do the heavy lifting for us and share one pick for the years to come. Joining me today on the show is James Dougherty from Lennox Capital Partners and Nick Guidera from Eley Griffiths Group. Nick, I’ll start with you. I’d love to know how assessing micro caps differs from their small and large peers.

Nick Guidera: I think at this end of the market it’s important to do a lot of fundamental research, because typically their under-researched stocks, you have to spend a lot of time on the qualitative functions. You have to spend a lot of time on understanding what the unit economics of these businesses look like, and fundamentally going deep into industries, because typically you can’t rely on broker research.

Ally Selby: Do you agree, James, or do you have anything else to add on how to assess micro caps compared to large or small caps?

James Dougherty: No, I agree with Nick. And what I would say is it’s generally when you’re analysing a micro cap versus a larger business, it’s more theoretical. With large businesses, you get a lot more tangible evidence. You have trends in sales, market share, you can understand what movement in those top-line numbers does to their profitability. With microcaps, it’s all about opportunities and blue sky.

Ally Selby: I’ll stay on you. I just want to know, is there one or two essential ingredients that are needed for a micro cap to grow?

James Dougherty: Firstly, you need to have a product or a service that has a clear competitive edge that is meeting a demand in a market there. But most importantly, to us, you need a driven, passionate, and aligned management team. You need a team of people that are going to work day and night to ensure the success of their strategy. And importantly, though, as an equity investor and often we’re minority investors, you need to make sure that they’re financially aligned with us. So you look at their incentives, their equity holdings, and make sure that it adds up.

Ally Selby: So a strong management team and a great product or service. Is it the same for you Nick or are there other essential ingredients that are needed?

Nick Guidera: Completely agree with James. You definitely need that management alignment. I think having a solid strategic plan, often in these early-stage companies, they pivot from one side to the next, depending on product successes, how well marketing campaigns go. I think believing in their product, understanding what the total addressable market looks like, understanding what the industry tailwinds or headwinds potentially look like. I think those ingredients all set up a decent criterion for these microcaps to grow into themselves and ultimately become much larger companies.

Ally Selby: I personally feel like a lot of micro cap investing is just timing and luck. What are some of the risks that you think investors should be aware of?

Nick Guidera: I wish. I think there’s plenty of risks and largely because their earlier stage companies. So, realistically they rely heavily on capital markets being kind to them so that they can continue to raise capital to fund their growth. Typically, they suffer from lack of liquidity because of ownership being tied up in either management, or board, or founding shareholders. So small moves in share ownership can trigger large price moves. I think there’s plenty of risks in this space, particularly, an over-promotional CEO, I’d say, can be a bit of a red flag, particularly given if it doesn’t necessarily line up with the fundamentals. But it certainly is a risky area of the market, which probably means you’ve got to rely on people that can do the fundamental work.

Ally Selby: Are there any other risks that you would add?

James Dougherty: No, really, just to kind of back up what Nick was saying, the intrinsic value of a lot of these businesses is largely built around earnings that are forecast to be much higher in the future and the growth that is required to get from today, where there’s usually very little earnings, to much higher earnings, means that pretty much, most things need to go right. So if you get a misstep from management or a change in the dynamics of their market or industry, these businesses can be worth not much pretty quickly.

Ally Selby: How much would you typically invest in a new idea?

James Dougherty: In a new idea? We run pretty concentrated portfolios. So between two and five per cent of our portfolio will go into an initial investment.

Ally Selby: And then how would that change over time?

James Dougherty: If the share price rallies and we don’t see an upgrade in earnings, then we’ll use that as an opportunity to take profits. But conversely, if we do additional research or if new information comes to hand that gives us greater conviction in our earnings or means that we were probably a little conservative in our initial earnings forecast, then we may add to the position.

Nick Guidera: Yeah, for sure. I think your level of initial investment depends on your comfort with the management team and the quality of the business. An example would be HUB24, it rolled out of the ASX200, I think nine, 10 months ago. Very good quality management team, significant tailwinds in terms of industry, good business that’s benefiting from platform consolidation. Purely was suffering in terms of valuation and lack of attention as a result of index moves. You got an opportunity to get involved in the stock, sub $10. I think earlier this week, it was announced to go back into the 200 and at that point, the stock’s back at $24.

Looking at that example, you can have a lot more conviction in the bet size because the business has been listed for a long time. And the reason why it’s coming into your universe is largely a technical reason rather than fundamental. If I look at the flip side and say an IPO that’s coming to market where the track record, perhaps, isn’t as strong as you would like, you haven’t got a whole history of financials or relationship with the management team. You’re probably going to be a little bit more cautious in terms of what position you would initiate at that point in time.

Ally Selby: The Buy Now Pay Later sector has really exploded over the past 12 months. In your mind, what’s the next growth sector?

Nick Guidera: I think Afterpay and the sector has certainly been almost a once in a generation phenomenon that we’re probably unlikely to see the same level of magnitude and attention from both retail investors.

Ally Selby: Isn’t this what this whole video is about? We’re trying to find the next Afterpay, Nick!

Nick Guidera: I’d love to give you one. But I think realistically, even when we were early investors in Afterpay, when we owned Touchcorp and it was bought by Afterpay, we certainly didn’t think at $3 that it was going to go to $150, but that’s the beauty of this sector. People can engage with the concept, people can engage with good brands, good products, as James has talked to.

And I think for me, the sector that kind of stands out, I think is online retail. It’s clearly been a big COVID-19 beneficiary, as people have shifted from traditional bricks and mortar to online, but we’re really only just scratching the surface. If you look at the penetration of online retail, particularly in the furniture and homewares category, we’re at about 5% of a $14 billion market, versus the US and the UK’s closer to 15% and 16%. So for me, it’s probably running a lot higher than 5% post-COVID-19, but it doesn’t feel like it’s going to settle at 5%. It feels like it’s going to settle a lot closer to 15% or 16%.

Ally Selby: If you had to pick one company in that sector to climb its way up the ASX to the top 20, what would it be?

Nick Guidera: I think for me, it’s Temple & Webster (ASX:TPW). It’s clearly been a beneficiary of COVID in terms of people not having the option to shop in the bricks and mortar. But ultimately it’s just been a great awareness campaign for a quality business and people that understand both good quality customer service, ease of delivery, and the need to go down to your local Harvey Norman, etc, to pick out a couch is probably a thing of the past. And that stock we think with great management, proven unit economics, can certainly make its way up the ASX in the years to come.

Ally Selby: Okay, James, your time in the hot seat. What sector do you think is the next BNPL?

James Dougherty: Similar to Nick, but maybe just a little bit of a broader view is cloud computing, which obviously plays into online retail. So that had a lot of attention specifically in the media a few years ago, but it’s growing just as fast, if not faster than it was a few years ago. And it was again a specific beneficiary of the pandemic. So I think if you look at the number of businesses that still need to migrate from on-premise to the Cloud, if you think about the behaviour of consumers, how they’re demanding mobility, more data, and lower latency. Any business that either supports the cloud, so stores or moves data, or uses the cloud whether its software as a service or platform as a service is going to have significant tailwinds for a number of years.

Ally Selby: Okay. And if you had to pick one stock to one day move up into the ASX20, what would it be?

James Dougherty: Similar to Nick, again, I’ll caveat this heavily where it’s going to largely come down to execution. But if I look at the structural qualities of Airtasker, which is an online marketplace, it certainly has the qualities that says it can be a much larger business than it is today. So it’s going to IPO within the next month. Its tech stack or its software is all cloud-based, which means it can scale very easily. So it can deploy to new geographies without significant investment in R&D or infrastructure. And it’s already expanded to four new geographies at a pretty early stage in its life, which shows that it can do that. If I look at the network effect that’s created by this platform or marketplace, once it reaches scale in a geography, it’s really strong.

So as new customers join the platform and as new taskers or task providers join the platform, the marketplace becomes stronger, which again, attracts more customers, attracts more suppliers. So you get to a point where the top-line growth just becomes self-perpetuating. So you don’t need to constantly reinvest in sales and marketing to grow the top line. And then importantly, with all these micro caps is the management team. So Tim Fung, who’s the founder and still the CEO didn’t sell a share into the IPO. James Spenceley who chairs the board founded and started Vocus Group and turned that business from a small startup into a multi-billion dollar telco. So it says that he has the skill and the experience to drive sustainable high growth for a number of years.

Ally Selby: No, I use Airtasker all the time. So I feel like it’s really exciting to see that IPO soon.

James Dougherty: That’s good evidence.

Ally Selby: Well, James picked Airtasker and Nick picked Temple & Webster, but we’d love to know what you think. Let us know what stock you think can climb its way up to the ASX20 in the comments section below. Remember to subscribe to our YouTube channel, so you never miss an update.

 

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