ASX small caps offering great value right now
Considering investing in small caps? See our top ASX picks.
Mentioned: Deterra Royalties Ltd Ordinary Shares (DRR), Manawa Energy Ltd (MNW), Vanguard MSCI International SC ETF (VISM), BHP Group Ltd (BHP), Dimensional Gbl Small Comp Active ETF (DGSM)
Following on from my previous article Should you invest in small caps?, I explore two ASX players that currently offer great value.
How to invest in small caps
Whether you are investing in large or small cap companies, Morningstar’s approach to stock investing comes down to four consistent principles:
- Having an intimate knowledge of the company’s sustainable competitive advantages or moat.
- Determining the value of its shares.
- Understanding the inherent risk in the business as represented by the uncertainty rating.
- Only buying the stock when there’s a significant margin of safety in doing so.
Echoing the sentiments above, Morningstar emphasises the importance of owning high quality, competitively advantaged companies bought at reasonable prices.
I decided to run a screen to find the best ASX small caps using the below criteria:
- Market capitalisation under $2.5 billion
- 4 or 5 stars Morningstar Analyst Rating
- Narrow or wide moat
- Low or medium uncertainty
- Positive forecasted revenue growth
All the above criteria address the risks discussed in my previous article and attempt to negate the effects of them to find undervalued ASX players with value proposition.
Unsurprisingly, these rigid criteria excluded most small caps with only two companies meeting the requirements. Investors should be encouraged to adjust their screening criteria based on personal goals and investing strategy.
Deterra Royalties Limited DRR★★★★
- Fair Value Estimate: $4.25
- Moat Rating: Wide
- Share Price: $3.53 (as at 14/04/25)
- Price to Fair Value: 0.83 (Undervalued)
- Uncertainty Rating: Medium
Resource royalty player Deterra Royalties Limited (“Deterra”) engages in the management and growth of a portfolio of royalty assets across a range of commodities, primarily focused on bulk, base and battery metals.
Shares have been battered amidst a slide in first-half net profit as lower iron ore prices continue to depress revenue.
Impact of tariffs
Deterra’s earnings are underpinned by a high-quality, long-life iron ore royalty over BHP’s Mining Area C (“MAC”). The asset comprises virtually all of our fair value estimate.
Morningstar analyst Jon Mills notes that prices and currencies have been more volatile than usual in the wake of US tariffs. Despite investors responding to each announcement and rumour, mining is a margin business.
Whilst commodities are generally priced in USD, much of the effect of price changes is likely to be offset by movements in input costs and producer country currencies moving against the USD.
Mills notes that despite updates to commodity price assumptions, prices could change materially depending on new tariff developments.
Diversification efforts
Deterra aims to grow into a diversified royalty company with multiple cash flows. The acquisition of Trident Royalties is likely the first of additional royalty and/or streaming purchases. Despite this, iron ore is likely to continue driving Deterra’s earnings over our five-year forecast period.
MAC asset drives wide moat
The wide economic moat rating is primarily supported by intangibles and cost advantages. The MAC royalty agreement with BHP and their minority partners sets out terms for royalties for iron ore produced and additional payments for increasing mine capacity.
The cost advantage stems from both the low cost to acquire the MAC royalty area and the low-cost production with underpins the royalty. The certainty of cash flows that arise mean that production is highly likely to continue even in a cyclical downturn of iron ore prices.
What we think
Despite elevated volume to boost near-term earnings, over the longer term we expect the iron ore price to decline and offset much of the benefit of higher production.
We assume iron ore averages USD ~95 per metric tonne from 2025 to 2027 based on the futures curve. This tapers off to a midcycle assumption from 2029 of USD ~72 per metric tonne. China’s demand which accounts for ~75% of seaborne iron ore trade is supportive of near-term prices but expected to simmer to moderate as steel production peaks and starts to decline.
We find that Deterra is consistent with its strategy to grow into a diversified royalty firm with its Trident Royalties purchase likely to provide modest diversification from iron ore.
Shares currently trade 17% below our value value estimate of $4.25 per share.
Manawa Energy Limited MNW-NZ ★★★★
- Fair Value Estimate: NZD 6.10
- Moat Rating: Narrow
- Share Price: NZD 4.72 (as at 14/04/25)
- Price to Fair Value: 0.77 (Undervalued)
- Uncertainty Rating: Medium
Manawa Energy, formerly Trustpower, generates and supplies electricity to commercial and industrial consumers across New Zealand. As the 5th largest generator in New Zealand, Manawa have 26 relatively small hydroelectric schemes producing ~1,940 gigawatt hours of electricity in an average rainfall year.
Most recently the company received an attractive takeover offer from competitor Contact Energy comprising of 0.57 Contact shares and NZD 1.16 in cash.
Shares sky rocketed upon announcement of the deal in October 2024 and were further bolstered in February upon Contact Energy’s reiteration of interest despite regulatory concerns.
Tariff safe haven?
The Reserve Bank of Australia modelling suggests US tariffs have the potential to wipe 1% from the level of Australian gross domestic product over the next few years. We expect Australian and New Zealand economies to slow marginally, but electricity demand and prices are unlikely to be materially affected.
Morningstar analyst Adrian Atkins maintains his earnings forecasts for Australian and New Zealand utilities, citing that they are unlikely to be materially affected with electricity futures prices remaining rock solid for the moment.
Cost advantages drive moat
Narrow-moat Manawa finds its footing through efficient scale and cost advantages, compared with new generation supply. Despite subdued electricity demand in New Zealand due to economic weakness, wholesale prices have been strong - a function of high coal, gas and carbon prices.
New Zealand is in a unique situation with 80% of power coming from renewable energy with thermal power slated to be almost entirely replaced by 2035. Hydro-power schemes produce 55-60% of the nation’s electricity in a normal year.
Generators such as Manawa sell electricity to the wholesale market with prices set in auctions by marginal suppliers - typically higher-cost thermal. This sets the wholesale price well above the renewable generators’ cost of production, underpinning solid returns.
Hydroelectric power stations are expensive to build but cheap to run, providing a clear cost advantage over thermal power stations.
What we think
Our fair value estimate sits at NZD 6.10 per share. We believe it is an attractive business with long-life renewable generation assets, a sound balance sheet and good medium-term growth potential.
Due to dry weather conditions, we forecast EBITDA to fall sharply in fiscal 2025 however should grow ~32% per year on average in fiscal 2026 to 2028. The fair value estimate implies a forward price/earnings ratio of 66x which appears expensive but should fall rapidly as earnings grow from fiscal 2026 - 2028.
Atkins believes there is significant upside if Contact’s takeover offer for Manawa gains regulatory approval or, failing that, over the medium term as contracted electricity prices rise toward futures prices. Shares currently trade at ~23% below fair value.
Alternative small cap investing
Whichever conclusion you drew from my previous article about whether you should invest in small caps, we can appreciate that the single stock risk is high. Further, the question of whether the time it takes to actively manage and research a portfolio of small caps may not be for the average investor. A collective investment vehicle like an exchange traded fund might be preferable.
I screened for gold medallist rated small cap ETFs and found the below three results:
- Dimensional Global Small Company Active ETF DGSM
- Vanguard MSCI International Small Companies Index ETF VISM
For the purpose of this article, I will be covering Vanguard MSCI International Small Companies Index ETF with the lowest cost ratio of the group at 0.32%.
Vanguard MSCI International Small Companies Index ETF VISM
The global small cap market is fraught with many incoherent risks that foster inefficiencies and has led to a wide range of outcomes. VISM provides an unbeatable cost value proposition over active and passive peers alike, and it has highly efficient access to the developed market small cap stocks via a diversified index.
The index is composed of majority US stocks accounting for ~67% of the MSCI World ex Australia Small Cap Index. The benchmark also has significant stakes in healthcare, industrials and technology with only a modest allocation to basic materials providing diversification for Australian investors.
Given the great risk in small cap investing, Morningstar does not expect these companies to form core positions in any portfolio. Each investment should be foregrounded by your individual goals and risk appetite.
