A smorgasbord of small caps

Small caps are expected to outperform the ASX in the months ahead, and the Eureka team is on the trail of 21 favourites.

PORTFOLIO POINT: With small caps expected to outperform the ASX in the months ahead, we highlight 21 stocks to run your ruler over.

Very few large cap stocks were untouched by the greasy odour of profit downgrades in this year’s reporting season. In contrast, small cap stocks were surprisingly strong; what’s more, they’re undervalued, underappreciated by institutional investors and ripe for an investor thinking long-term.

Since January this year, the sector has really been firing, lifting at twice the pace of the broader market: the ASX Small Ordinaries Index is up 13.14%, while the All Ordinaries is up only 7.3%.

At Eureka Report, we have been following the trend and, since the start of the year, we have ramped up coverage of some of the talented small caps that are responsible for the index surge.

Furthermore, where once investors used small caps as a riskier – and therefore potentially more rewarding – play on economic trends, an emerging development is that more and more eyes are being drawn to the sector. This is largely because of the stellar performance over the past two years of resources small caps, yet in every industry sector it’s the minnows that are expected to provide better returns compared to their larger rivals.

Why? John Campbell, managing director of Bennelong Funds Management’s emerging companies fund Avoca, says better-than-expected results in the February reporting season are sustaining confidence about the sector among fund managers, while demand from China will keep the money pouring in to support resources stocks for at least the next two years.

“The main thing driving it has been a pretty good interim reporting season where results [for] the larger small caps were good and '¦ compared to what we saw out of big caps, probably pound for pound a degree better,” Campbell says.

“It’s the composition of the small cap index where you’ve got more direct exposure to China; I think that’s the benefit and the risk of small caps: that they’re very intertwined with the long term future of China.”

Eureka’s Scott Francis says the traditional reason small caps are attractive is that their greater risk translates into lower share prices. If a small cap company does well, there is far more potential for gain as its share price is going to move a lot further than that of a larger business, which doesn’t have that risk priced in.

Michael Feller says the drawcard of Australian small caps in particular is that the ASX200 is overwhelmingly dominated by big miners and banks, so investors wanting exposure to alternative themes have no choice but to head for those listed companies with market caps under $1 billion (the traditional definition is between about $50 million and $1 billion).

In a reflection of Alan Kohler’s preference for mining services companies (such as Forge Group or Southern Cross Electrical) over miners themselves (such as BHP or Rio), Campbell’s emerging companies fund is also weighted in that direction due to the difficulty in finding good value and high-quality small cap miners. (To read more on BHP, see Roger Montgomery’s piece today click here).

Eureka’s small cap coverage – led by Alan Kohler and contributors Michael Feller, Stewart Oldfield, Tim Treadgold, Roger Montgomery and Robert Calnon – broadly falls into two categories: mining-related companies and traditional industrials. (David Haselhurst’s weekly Speculator column does cover micro-cap stocks, but he is a pure speculator rather than a longer-term investor).

-Mining services
Company
Code
Market cap ($m)
Share price 03/04 ($)
% movement 01/01/2012- 03/04/2012
P/E
Forge Group
FGE
555.9
6.66
38.46
14.23
Mastermyne
MYE
180.9
2.40
50.94
11.43
Skilled Group
SKE
555.7
2.38
44.24
17.4
Southern Cross Electrical
SXE
213.2
1.32
65
23.2
Swick Mining Services
SWK
88.9
0.38
22.95
13.25


-Industrial
Company
Code
Market cap ($m)
Share price 03/04
% movement 01/01/2012- 03/04/2012
P/E
ARB Corp
ARP
671.9
9.27
19.92
17.61
Clover Gorp
CLV
63.6
0.39
28.33
14.71
Domino's Pizza Enterprises
DMP
622.1
8.90
12.66
25.43
Greencross
GXL
70.7
2.25
60.71
17.15
iProperty Group
IPP
220.4
1.30
32.65
-102.36
Plan B Group
PLB
43.3
0.53
6
9.83
Service Stream
SSM
117.6
0.42
38.33
6.33
SFG Australia
SFW
251.7
0.35
7.81
6.91
WHK Group
WHG
224.1
0.85
2.42
21


-Energy & resources
Company
Code
Market cap ($m)
Share price 03/04
% movement 01/01/2012- 03/04/2012
P/E
Cue Energy
CUE
205.1
0.30
40.48
9.61
Minemakers
MAK
62.8
0.28
0
-8.59
New Standard Energy
NSE
209
0.72
138.33
-405.56
NorWest Energy
NWE
62.9
0.07
132.26
-14.42
Orocobre
ORE
188.85
1.83
44.09
-112.26
UCL
UCL
25.1
0.31
72.22
-15.87
Venture Minerals
VMS
90.7
0.39
39.29
-34.17

Among the selection of industrial small caps made by our group are: omega-3 manufacturer Clover Corp, veterinarian Greencross and Asian online real estate database operator iProperty Group, companies spotted by Michael Feller last year and part of Alan Kohler’s 2012 portfolio; these are companies with either first-mover advantage or a unique niche in a potentially huge market.

NBN infrastructure company Service Stream is another industrial that suffered a fall from grace after the financial crisis, and is now looking at 10 years of huge capital expenditure being sent its way.

Furthermore, even though most large financial stocks aren’t expected to make waves this year, Stewart Oldfield pointed to three wealth managers that he thinks are not only good value but are also potential takeover targets. The big four banks are hungrily eyeing the funds management sector and WHK Group, SFG Australia and Plan B are all in the firing line.

Michael Feller has a liking for food stocks as a hedge against future food shortages and rising demand. Phosphate producers UCL and Minemakers are one way to play this theme, as they provide the fertiliser that will promote better crop yields. Tim Treadgold has also nominated these two companies in recent weeks.

Feller’s other conviction is the value of energy. South American Lithium miner Orocobre is a small cap play on the surging market for lithium batteries, and Cue Energy is a company that he believes, right now, is possibly the most prospective oil and gas investment in the small cap sector.

In his latest weekend briefing, Alan Kohler put his money where his mouth is and said he’s added Southern Cross Electrical, Forge Group, recruitment services provider Skilled and Orocobre to his personal portfolio.

Tim Treadgold added shale gas companies Norwest Energy and New Standard Energy to the list of small energy plays and highlighted Tasmanian tin and tungsten possibility Venture Minerals after a trip to the Mines & Money conference in Hong Kong. Treadgold attracted the ire of the Tarkine National Coalition in the process, and they’re vowing that Venture’s three iron ore mines in Tasmania’s Tarkine valley – intended to bankroll the tin and tungsten operations – aren’t going ahead'¦ever.

Roger Montgomery suggested a few small caps this year that look good on everything except his beloved fundamental value indicator. Queensland coal mining services provider Mastermyne is one, while two others are Australia/Europe fast food operator Domino’s Pizza and four wheel drive parts maker ARB.

Last but not least, Robert Calnon has located Swick Mining Services. Swick finally impressed Robert in February after having to go into “survival mode” after too much debt and not enough work almost blew it up following the financial crisis.

Although small caps can provide enormous returns for investors who get in early (just look at Cochlear and JB Hi-Fi), their very size makes these companies more exposed to the quality of management talent and balance sheet debt.

Carlos Gil, CEO of specialist small cap investment fund Micro Equities, says investors need to give extra attention to these details.

“Management depth is a lot thinner than in large cap companies [and] key executives play a determining role in eventual business and investment outcomes, so the quality and competency of management should be a very important element in an investor’s research,” he says.

Moreover, good businesses “fund themselves” without needing to tap markets or take on large amounts of debt. Dilutive capital raisings by small companies is a red flag.

“Management and boards should consider that their scrip is a highly valuable asset and only be willing to entertain selling it when there is a very good business and investment case around it.”

Gil says his funds focus on industrials over miners (he likes ASG, DWS, Oakton, Clover and SMS in particular) but says the sector as a whole is undervalued, with a number of companies trading at decent discounts and providing high-dividend yields.

“The sector is still a very under-invested asset class'¦ There’s very good value around there for those investors willing to take a longer medium-term approach and they can ride out the cyclicality.”

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