Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 478

How to identify overvalued small cap companies

Investors are in a difficult period, and it's vital to get the fundamentals right, particularly in the small cap part of the market. Companies need to generate strong cash flows after capital expenditures and stock-based compensation, and the cash flows must be sustainable. For investors, a resilient market position and growth in that market are worth paying for.

Small caps also need a valuation anchor, a reason to buy the company underpinned by a favourable estimate of value. We want to know what the company is worth through the cycle. We don’t want to rely on finding a ‘greater fool’, someone foolish willing to buy a company that lacks substance.

Bubbles regularly occur in small caps, where assets are completely overvalued. In small caps, relatively modest amounts of money can move around the market capitalisations of companies. Passive money from index buying and even retail money can also swing prices around.

Examples of past and future bubbles

One example is BNPL, the Buy Now Pay Later sector. We did a lot of research on the sector and could not get comfortable with even low valuations. Afterpay came on the scene in 2018 but we could not see how the business model would make money. To date, it never has. At the time and in subsequent years, the market was looking for high growth and the narrative was good, they were penetrating markets and increasing revenues.

But then came a plethora of other stocks doing a similar thing – Sezzle, Zip, QuadPay - all IPO-ing and creating a huge bubble of enthusiasm. Any small cap fund manager not owning any of these stocks was hurt for a while and clients questioned their sanity. But eventually, when there was no business model and no cash flow coming through, they were found out. The tide went out and they were swimming naked, to paraphrase Warren Buffett.

Bubbles: When a bubble bursts…

Chart Source: Bloomberg. *2022 captures market cap from 1/1/2022 to 10/8/2022. Stocks include: APT/SQ1, ZIP, HUM, SZL, SPT

We believe interest rates going up is also like the tide going out. Economic gravity is reestablished and valuations and fundamentals are coming back to the fore.

We believe another bubble is forming in small cap lithium stocks. The following chart shows the market capitalisation of lithium stocks over the last few years. While lithium is in high demand now and there is a focus on EVs for a cleaner future, many of these companies do not generate positive cash flows or earnings. Of the nine or so stocks that comprise this market capitalisation, only one makes money. The other eight are currently exploring, with in many cases, many billions of dollars of valuation ascribed to those assets. We don’t think that's sustainable long term.

Bubbles: Will lithium be next?

Chart Source: Bloomberg. *2022 captures 1/1/2022 to 10/8/2022. Stocks include: PLS, AKE, LTR, CXO, LKE, VUL, PSC, ARG, SYA

Consider the copper cost curve and what it reveals about Economics 101. The highest-cost marginal producers set the price in the long-term equilibrium, and the copper price shows where the high-cost players are.

Copper and lithium cost curves and production costs

Source: Bloomberg, UBS and Canaccord (2022)

The lithium market is different. It's nascent on the supply side but with strong demand growth which is overriding and outweighing the lack of supply. But the supply response is coming with new mines opening and production coming online. It will catch up at some point. At the moment, the low-cost operators are the brine producers in Latin America. The high-cost end of the market includes Australian lithium hard rock miners, and their costs are hugely higher. As the market expands, these operators will set the price.

We believe the lithium price will probably fall to around US$40,000 per tonne in the long term, and the high-cost miners will be in a difficult equation. The money to be made is at the low end of the cost curve, and that's the brine producers. We think a bubble has formed here.

Prospects for two high-profile small caps

In addition to avoiding these bubbles, we also flag a couple of stocks that have been prevalent in micros and smalls for a long time that have limped on through multiple capital raisings.

Mesoblast is really a gold stock masquerading as a biotechnology name, claiming everything from a cure for cancer to a cure for COVID using stem cells. While we like new ideas, we also look for proven commercial development of any technology.

This chart shows the cash flow consumption over the last decade. It's been almost $100 million a year of R&D effort. And to date, there's no commercial cash-earning business after burning through around $1 billion. The only thing compounding are the shares on issue. A buyer 10 years ago has lost about 90%. Obviously, there are periods of enthusiasm where it trades well, followed by a large rights issue. Investors should look through the fundamentals for actual cash flows and strong businesses.

Example of a cash burner company

Source: Morningstar, IRESS, Spheria

In contrast, a stock we do own has a good history of cash flow generation. NZME, New Zealand Media and Entertainment, is the Number One masthead in New Zealand. It owns the leading set of newspapers in New Zealand, the number one radio business, and operates the digital license for iHeartRadio. 

The big kicker is the digital side of the business, called OneRoof, which is similar to Domain in Australia. It's the number two player in the market behind TradeMe, similar to how REA in Australia is ahead of Domain. We see upside in the property digital market because New Zealand has lagged Australia in developing the potential. The market is going from print to digital with a lot of money to be made and a valuable position going forward. This is in addition to its main masthead where digital subscriptions are outweighing deliveries of the print edition. While the company is going from old world to new world, it’s trading at about four times earnings, and we think it will rerate at significantly higher levels.

Takeover potential in the small cap market

What happens in the small cap sector if the price re-rating does not occur? For quality companies, it’s always worth looking at the takeover potential. We have seen 25 takeovers in six years at the small end of the market. The last big one was Class, a leading player in the SMSF software market. It was a subscription business with a great cash flow, a strong balance sheet and the valuation was attractive.

Small cap takeovers over time, % premium

Source: IRESS

Investing in small caps

Over a long period of time, by avoiding the bubbles and not trying to time the market, identifying enduring businesses with good economics will eventually be recognised by the market mechanism either through takeovers or through dividends or buybacks or just share price appreciation. Our approach is to sort through a big universe of stocks using good technology and our team of analysts, and discard a lot of areas that don't generate cash and earnings. Avoid the hype and focus on conservatively-geared businesses that make good cash flows.

 

Marcus Burns and Matthew Booker are Portfolio Managers at Spheria Asset Management, an affiliate manager of Pinnacle Investment Management. Pinnacle is a sponsor of Firstlinks. This article is for general information purposes only and does not consider any person’s objectives, financial situation or needs, and because of that, reliance should not be placed on this information as the basis for making an investment, financial or other decision.

For more articles and papers from Pinnacle Investment Management and affiliate managers, click here.

 

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Latest Updates

Planning

Will young Australians be better off than their parents?

For much of Australia’s history, each new generation has been better off than the last: better jobs and incomes as well as improved living standards. A new report assesses whether this time may be different.

Superannuation

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Investment strategies

A steady road to getting rich

The latest lists of Australia’s wealthiest individuals show that while overall wealth has continued to rise, gains by individuals haven't been uniform. Many might have been better off adopting a simpler investment strategy.

Economy

Would a corporate tax cut boost productivity in Australia?

As inflation eases, the Albanese government is switching its focus to lifting Australia’s sluggish productivity. Can corporate tax cuts reboot growth - or are we chasing a theory that doesn’t quite work here?

Are V-shaped market recoveries becoming more frequent?

April’s sharp rebound may feel familiar, but are V-shaped recoveries really more common in the post-COVID world? A look at market history suggests otherwise and hints that a common bias might be skewing perceptions.

Investment strategies

Asset allocation in a world of riskier developed markets

Old distinctions between developed and emerging market bonds no longer hold true. At a time where true diversification matters more than ever, this has big ramifications for the way that portfolios should be constructed.

Investment strategies

Top 5 investment reads

As the July school holiday break nears, here are some investment classics to put onto your reading list. The books offer lessons in investment strategy, financial disasters, and mergers and acquisitions.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.