While the market attempts to navigate harsh conditions, we look into three ASX small caps that appear to be diamonds in the rough... IntroductionThe expected returns of most asset classes exceed that of the average investor. Why? Because the average investor is constantly rotating out of underperformers before they recover, and into strong performers before they decline. Historically it has been a losing strategy to try and time the market. Rather, downturns have provided the best opportunity to reinvest in the market. Current valuations are quite attractive, especially in small caps. In Australia, small caps are 27% below their long term average PE multiples, compared to an 11% discount for large caps. This is often the case when small cap buyers go “on strike” during bearish market sentiment periods. The good news is that when sentiment turns, and it always does, small caps tend to outperform in a material way, just like they did following the 2008 GFC, 2018 selloff and March 2020 crash. Good investors don't panic, rather they stick with their portfolio through a bear market. GREAT investors take advantage of bear markets. Take advantage of the opportunities as they come! We have three holdings inside our Australia Small Cap Income fund that are not only holding up nicely in CY22 but also look attractive over the long run. IVE Group: A Massive Moat FormingThe business: IVE Group (ASX: IGL) provides printing and digital marketing services for the majority of magazines, catalogues, and point of sale displays in Australia. Founded in 1921 and listed in 2015, IVE is Australia's leading holistic marketing company. The company operates through four services:
What’s happened recently? In the past two months, IVE has established itself as a monopoly in heatset web offset operations (i.e. specialised printing) in Australia by acquiring the assets of competitor Ovato from administrators for $16 million. This combines the two biggest businesses of its type in Australia. Outside of Ovato, IVE completed two smaller bolt-on acquisitions in FY22 in the area of retail display and third-party logistics. With a strong balance sheet and free cash flow generation, IVE Group is well positioned to continue strengthening its offerings by seeking attractive bolt-on acquisitions at low multiples that can easily integrate into the company's existing footprint. What’s next? The acquisition of Ovato is expected to be highly accretive, adding $160 million of revenue and $15 million of net profit after tax (NPAT). This substantially adds to the bottom line compared to initial FY23 guidance of $36 million NPAT. An additional $22 million will be spent on integration and CAPEX over the next 12 months, resulting in significant upside to the group. The group should generate in excess of $50 million of NPAT in FY24 and pay approximately $50 million of gross dividends then. With a current market cap of ~$325 million, this translates to a 16% income yield. The business is very well run and is a beneficiary of the trend to manufacture on shore. We value IVE at $3.50. SRG Global: part of a rare sector in the greenThe business: SRG Global (ASX: SRG) is a diversified industrial services company. It brings an engineering-led mindset to deliver critical services across construction, mining and asset maintenance. SRG Global provides bespoke across the entire asset lifecycle solutions, meaning customers only ever need one partner. The group helps build skyscrapers, bridges, dams, transport infrastructures, mining, and oil and gas projects for customers worldwide. In addition, the company offers drilling solutions, civil engineering, and industrial maintenance services. SRG’s growing strongly and has contracts with blue-chip clients with a global portfolio of work, including Emirates Tower in Dubai. What’s happened recently? After growing revenue greater than 13% to $646 million in FY22, SRG announced $145 million of new contracts in September alone. This included projects such as the specialist facades contract for the world’s tallest hybrid timber building, Atlassian Central. The company is fast becoming one of the highest quality earnings profile contractor and engineering firms on the ASX. SRG Global recently reaffirmed guidance for FY23, with operating earnings (EBITDA) at circa 25% higher than FY22 EBITDA result. Additionally, SRG’s balance sheet had $59 million in cash as of June 30, a healthy amount for a company's $309 million market cap. It is also sparsely traded and a long-way off the multiples that a bigger comparable, e.g. Monadelphous (ASX: MND), trades at. What’s next? SRG Global’s strategic transformation to a company with two thirds annuity style earnings has delivered both protection and opportunity in a difficult broader macro environment. It has also provided a solid platform on which to grow the business across critical services for major industries. Lastly, we have recently seen a bidding war for a listed peer in Maca (MLD), with Thiess looking to take the company private. We wouldn’t be surprised to see some similar corporate activity with SRG Global in the near future. Our valuation is 90 cents. Universal Stores: Robust Retail PerformanceThe business: Universal Store Holdings (ASX: UNI) describes itself as a specialty retailer of youth casual apparel that operates around 80 physical stores across Australia and two online stores. Those stores operate under the brands Universal Store and Perfect Stranger. It aims to provide a frequently changing and “carefully curated” selection of on-trend apparel products to a target 16-to-35-year-old fashion-focused customer. What’s happened recently? The business opened 11 new stores in FY22. Its “full potential” target is for at least 100 Universal Store sites across Australia and New Zealand. In the first half of FY23, five new stores are expected to open along with two store resizes. In the first half of FY23, it’s cycling against lockdowns and store closures in the prior year, meaning like-for-like (LFL) and total sales are looking comparatively very good. The company announced it’s going to acquire Cheap THRILLS Cycles (CTC) for an enterprise value of $50 million, representing 6.8x FY22’s underlying earnings before interest and tax (EBIT). This business offers “vintage and coastal inspired youth fashion apparel with broad appeal”. What’s next? The acquisition Of CTC is 18% EPS accretive on a proforma FY22 basis, and providing Universal with increased scale plus further growth optionality from exposure to a highly scalable wholesaling business. The company recently stated that FY23 has already started strong, with total sales already up 54% on this time last year to $12.5 million. It also says that fewer lost store days would be of benefit to earnings in FY23. Moreover, brick and mortar store sales growth reached 70% at this time last year, and Universal expects to open five new stores in H1 FY23. Universal is currently trading at 11.5x FY23 PE, has a robust balance sheet, strong free cash flow generation and is exposed to a young customer base that isn’t as impacted by rising interest rates. Our valuation is $6.50. Disclaimer: IGL.AX, SRG.AX and UNI.AX are currently held in TAMIM portfolios
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