Microcaps: The quiet engines of long-term wealth creation

Not many people realise it, but there are four stock markets on the Australian Securities Exchange (ASX).

First, there are the “large caps,” the companies at the top of the market-capitalisation pyramid: the Top 50 of the ASX, roughly from Commonwealth Bank, with a market capitalisation of $287 billion, down to miner South32, valued at $12.2 billion. Then there are the “mid caps,” anywhere down to a market valuation of $2.5 billion. After that, there are the “small caps,” where the valuation can be as low as $250 million.

Beneath that strata live the “microcaps,” and there’s about 1,500 of them.

That is the world where Joel Fleming, portfolio manager of the $119 million UBS Microcap Fund (managed by Yarra Capital management), spends his time.

Fossicking down at that level of the stock market is very different from investing at the top end, says Fleming: it’s the inefficient end of the Australian market, where information gaps, lack of liquidity, and limited coverage of companies create opportunity. “Markets are dynamic, economies evolve, and we believe this is the space where investors can capture tomorrow’s leaders before the broader market even knows about them,” Fleming says.

“Investing in microcaps is all about compounding wealth over years – sometimes decades – through exposure to businesses that, with patience, can become substantial players in their industries.

While stocks must have a market capitalisation below $250 million when the fund buys into them, Fleming is prepared to look at businesses as small as a $30 million valuation. “At that very small end, positions are naturally limited by liquidity and risk, but we genuinely look at companies of that size,” he notes.

The discipline here is not only about finding opportunities, but also knowing what to do when they succeed. Unlike some strategies that exit once a stock grows too large, Fleming is reluctant to sell prematurely. “The really good ones can return 10, 20, 50, even 100 times your money,” he says. “If we’ve done the work, built conviction, and the market is only just catching up, then we want to hold on as long as possible.”

One of the recurring challenges for microcaps is visibility. Many small businesses remain unnoticed and under-owned, limiting their ability to grow. It’s a bind for many companies: because they’re small, not many analysts and fund managers are prepared to look at them; and because no-one covers them, they remain small. But Fleming sees this not as a drawback, but as an advantage.

“I go back to basic economics. If a company is profitable, generating cash, and growing market share, that’s tangible value,” he says. “Yes, many are overlooked, but that’s where inefficiency creates opportunity to do the research on them, and get to know them. Then, as these companies start to get bigger, they attract coverage, enter indices, and benefit from institutional inflows. That inflection point can be incredibly powerful.”

Microcap investing is, by definition, contrarian. “We are often the only, and first, institution on the share register,” Fleming admits. “That means we have to be comfortable relying on our own work, our own conversations with management, our own assessment of markets.”

At the microcap level, he says, there is no substitute for face-to-face research. “I want to meet the management in person and walk the shop floor,” he says. Within an hour he will know whether the company can achieve greatness by observing how happy and engaged employees appear to be. “It’s about sitting down with management and working out what they want to achieve and whether they have the skills, culture and balance sheet in place to go and have a crack,” he says.

For many investors, the term “microcaps” conjures images of speculative miners or blue-sky biotech ventures. Fleming acknowledges this perception, but says it misses the reality. “Most of our portfolio is in profitable, dividend-paying industrials,” he says. “Yes, there are promoters and stories that never amount to anything, but there’s also a lot of high-quality businesses exposed to structural growth themes. They’re often trading at discounts compared to larger peers.”

He stresses the importance of time horizon. “Markets are obsessed with the next five minutes, but we’re thinking three years out. If the consensus expects a company to earn two cents a share, and we believe it’s going to be ten cents, that’s where we create value.”

This approach demands patience and conviction, but also shields the fund from the herd mentality that dominates activity in the larger, more liquid names. “Our job is to identify the stocks that, in 18 months or two years, everyone else will be clambering to buy,” says Fleming.

Every microcap investor has war stories. Fleming recalls medical imaging IT provider Pro Medicus as his calling card. “We bought it at 86 cents on day one of the fund, in 2014. It was profitable, had cash, and paid dividends. Management was high-quality. That business has gone on to become a global leader.” (PME last traded at $300 a share.) Although the fund eventually sold the stock it remains a powerful example of the wealth-creating potential of microcaps. On the flip side, he cites education provider Nexted as a costly lesson. “We were caught out during COVID, and misjudged some policy changes afterwards. We held too long, and it hurt. You learn from those experiences.”

That is the essence of microcaps: they’re potentially higher growth, but with commensurately higher risk. “You accept that, because the winners punch above their weight,” he explains. Importantly, the fund is structured to manage downside risk so that volatility is not dramatically higher than the market. “There are also correlation benefits. Microcaps move differently to large caps, which can improve portfolio efficiency. We position them as a satellite allocation, complementary to core equities holdings.”

Currently, the fund’s largest holding is Energy One (EOL), a $480 million software provider to the energy sector. “Energy One provides the systems that help renewable projects operate within the grid – dispatching energy, managing complexity, enabling deregulation,” Fleming explains. With recurring software revenues, expanding margins, and global opportunities, the stock embodies the kind of structural theme Fleming seeks. “They had a false start after a failed takeover bid, but the business has repositioned and is now executing strongly. It’s been a standout for us over the past year.

For Fleming, microcaps represent both challenge and opportunity. “It’s not for everyone. Capacity constraints are real, risks are higher, and patience is essential. But for those seeking long-term capital growth, it’s where the inefficiency lies. It’s where the next great Australian success stories will emerge.”

In a market often obsessed with the short term, the UBS Microcap Fund is a reminder that the path less travelled – backing small companies with ambition, discipline, and conviction – can be the most rewarding of all.

James Dunn

James is an experienced senior journalist and editor of The Inside Network's publications.