Merewether Capital sees big opportunity in ASX small-cap tech...

Merewether Capital sees big opportunity in ASX small-cap tech
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MoneyTalks is *’s regular drill down into what stocks investors are looking at right now. We’ll tap our extensive list of experts to hear what’s hot, their top picks, and what they’re looking out for.

Today we hear from Merewether Capital portfolio manager Luke Winchester.



What’s hot right now?
“I am a contrarian by nature so I’m always looking at the parts of the market that are unloved at a given moment,” Winchester says.

“52-week low lists are a crude but effective tool to quickly see what is out of favour, and right now I find myself hunting around small-cap tech.

“The sector has been sold off significantly for the better part of six months partly because valuations got extreme (almost bubble-ish in my mind) and also because of macroeconomic developments, in particular rising bond yields.

“Of course, babies always get thrown out with the bathwater and there are some businesses that have genuine products/services on their way to becoming substantially larger businesses which are down 50%+ from highs,” he adds.

“I’m not buying something just because it has fallen, some remain overvalued despite large falls which shows how absurd some valuations were last year, but it is a great area to start looking at.”



Major trend: The divergence between profitable and unprofitable tech
“In a nutshell, the market’s risk tolerance quickly pivoted from a return on capital to a return of capital,” he says.

“Businesses who are still in their early growth phases and burning cash to grow have been punished much more than peers who are able to self-sustain from their own cash flows.”

One reason for this, Winchester explains, is because businesses that generate positive cash will have a fundamental floor in their valuation, and when the market pulls back they can use excess cash to buy back their own shares or look for M&A if peers have been sold off.

“For businesses burning cash they have been caught in a Catch-22,” he says.

“They need capital injections from the market every year or two to fund their growth, but as share prices fall the dilution they must accept to issue new shares drastically increases.

“The ideal opportunity with this trend is a business that the market believes needs to raise capital leading to a heavy share price decline, but because of actions taken by management (usually to the cost base) they are able to reach cash flow break even faster and avoid a dilutionary capital raise.”



Top picks
Xref (ASX:XF1)
The largest stock right now in the Merewether Capital Inception Fund is software company Xref (ASX:XF1), which has had “a bit of a run in the last few months” but is an excellent example of the situation Winchester just described.

“XF1 is a provider of cloud based reference checking software and when Covid hit, management drastically wound back their cost base from ~$20mn to ~$16mn and went from significant losses to cash flow breakeven.

“Since then growth has continued strongly and the cost base has only increased modestly meaning the business is truly self sufficient and likely to generate $5-6m free cash flow in FY22.

“At a $110m market cap that is a reasonable price to pay for a tech business still growing 20-40% and only beginning expansion into the US.”