Three quality small caps that could attract attention as the valuation gap widens

Richard Hemming, founder of Under the Radar Report, looks at the week ahead and three undervalued companies that may appeal to larger corporate buyers.

• Pantoro (ASX: PNR)
• NexGen Energy (ASX/TSX: NXG)
• Nanosonics (ASX: NAN)

Markets face more of the same this week as investors continue to digest the US Federal Reserve’s latest interest-rate decision and its signal that further tightening is being factored in. Closer to home, Reserve Bank of Australia Governor Michele Bullock is also due to speak.

The pressure on rates remains upwards around the world. Higher energy prices are proving persistent, while supply constraints continue to add to inflationary pressures.

So, what should investors do?

Our approach is straightforward: buy quality companies when they are trading cheaply. That discipline matters in any market, but it can become particularly rewarding when takeover activity accelerates.

Undervalued companies can attract private equity buyers looking for financial returns, or corporate buyers seeking strategic growth. When both groups recognise the same opportunity, competition can produce a substantial premium for shareholders. The recent bid for OFX is a striking example.

We have just completed our latest research rundown covering more than 100 small caps.

From that work, I have selected three stocks investors should have on their radar. None is guaranteed to receive a bid, but each has qualities that could attract a larger buyer.

1. Pantoro (ASX: PNR)

Gold-sector consolidation is gathering pace as cashed-up producers look to acquire reserves, production and growth.

Regis Resources (ASX: RRL), Evolution Mining (ASX: EVN) and Westgold Resources (ASX: WGX) all have the financial capacity—or strategic incentive—to assess acquisition opportunities. Recent transactions involving Vault Minerals and Magnetic Resources illustrate the appetite for quality Australian gold assets.

Pantoro could fit that picture.

The company produces more than 100,000 ounces of gold a year from its Norseman project in Western Australia, near major producers and established infrastructure. Norseman also sits within a highly prospective gold region, and Pantoro controls an extensive exploration position.

Continued exploration success could support higher future production. Yet the stock remains inexpensive because Pantoro has disappointed investors several times in the past. Underground mining is difficult, and execution has not always met expectations.

That history helps explain the valuation discount. It may also create an opportunity for a larger, better-resourced gold producer that believes it can extract more value from the assets.

2. NexGen Energy (ASX/TSX: NXG)

NexGen Energy owns Rook I, a large, development-ready, tier-one uranium project in Saskatchewan’s Athabasca Basin in Canada—one of the world’s most important uranium-producing regions.

The asset is located near established uranium operations and has the scale to interest major global resources companies. BHP, Rio Tinto and Glencore are among the groups with the financial capacity to consider large strategic opportunities in commodities where long-term supply is constrained.

Developing Rook I will require substantial funding, potentially around $1 billion or more. For NexGen, that is a major capital requirement. For a global miner, however, the funding hurdle may be much easier to overcome.

That combination—a high-quality strategic asset, a large funding requirement and potential interest from well-capitalised majors—is what makes NexGen worth watching.

3. Nanosonics (ASX: NAN)

Nanosonics already owns a high-quality medical-device business in trophon, its automated system for the high-level disinfection of ultrasound probes.

The installed base and recurring consumables revenue have helped trophon grow into a valuable global franchise, generating earnings of more than $50 million.

Nanosonics also had more than $155 million of cash at last count and no debt.

The problem has been Coris, the company’s proposed growth engine for endoscope cleaning. Endoscopes are more complex instruments that allow doctors to examine the inside of the body. Coris addresses a large potential market, but its commercial development has taken longer and cost more than investors initially expected.

Repeated delays have weighed heavily on the share price. At about $2.88, we estimate that Nanosonics trades at a cash-flow multiple of roughly 13 times when we isolate the trophon business. Our valuation work suggests trophon alone could support a value closer to $5 a share.

That does not mean a bid is imminent. It does, however, highlight the valuation gap between Nanosonics’ market price and the potential strategic value of its established technology, recurring revenue and global distribution footprint.

Why the small-cap valuation gap matters

Corporate buyers can often justify paying more than public-market investors because they may capture cost savings, revenue opportunities and greater strategic control.

The maths can be compelling. If a company can fund an acquisition at an interest cost of about 7% and buy a quality business for around 10 times adjusted earnings, it may acquire growth more cheaply than it could create that growth internally.

There is also a valuation differential at work. Large companies frequently trade on higher earnings multiples than small caps. Buying an undervalued smaller business can therefore be earnings-accretive even after the buyer pays a takeover premium.

That is why the widening gap between small-cap and large-cap valuations is so important—and why quality small companies with valuable assets, strong balance sheets or proven products deserve close attention.

Pantoro, NexGen Energy and Nanosonics are three very different businesses. What they share is strategic value that may not be fully reflected in their current share prices. With takeover activity building, they are stocks worth putting on your radar.

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This article is general information only and does not constitute personal financial advice. Investors should consider their own objectives, financial circumstances and needs before making an investment decision.