Beating the small caps index

Small caps bolted from the starting gate in early 2012, then they gave up a lot of gains, but our six picks have convincingly beaten the index.

PORTFOLIO POINT: When selecting small caps, the best strategy is to pick stocks with good management, solid business models, low debt, and that are resilient.

Good stock picking – especially when it comes to small caps – is always about doing your homework beforehand and, in my case, the time spent on research has definitely paid off.

Against the negative return of 13.35% from the Small Ordinaries Index, my small caps stock portfolio returned (-2.10%). In fact it might have been better but overall portfolio was weighed down by one stock in particular, with all our other small caps returning positive results. As the table below illustrates, our best stock pick, M2 Telecommunications, delivered a return of almost 19%, an impressive result in the current market environment.

So, with the full-year August reporting season on our doorstep, I thought it would be an opportune time to reflect on the stocks I have covered at Eureka Report over the past six months and look at what we are expecting from them next month and beyond.

For reference, the table below displays the performance of stocks both in terms of absolute return and returns relative to the ASX Small Ordinaries Index (ASX:XSO).

OC Funds Management - Eureka Report




Small Ords Acc*
































*Performance from publication to COB 26 July 2012 including dividends but excluding franking.

M2 Telecommunications Group (ASX:MTU)

MTU’s acquisition of Primus Telecom has been flagged as a potentially transformational deal for the Melbourne-based independent provider of retail and wholesale fixed-line, mobile and data services. And all the signals so far indicate this will indeed be the case. With head offices already merged following the May acquisition and the two legacy sales forces combining well and looking for cross-sell opportunities, the acquisition synergies are likely to come thick and fast over the coming months (and at both the revenue and expense lines).

The market consensus* is looking for FY12 EBITDA of around $60 million, although this number will likely be clouded by the Primus acquisition part way through the year.

Perhaps more importantly, looking forward, will be the current earnings run rate the merged business is achieving and any indications from management around FY13 earnings.

When combined with commentary around the state of the ongoing business, we expect MTU to be painting a bright future for FY13 and beyond.

Super Retail Group (ASX:SUL)

Since covering SUL in early April, the stock has continued to be a stand-out among its peers in the ongoing harsh retail environment. Indeed SUL, the operator of Supercheap Auto, Boating Camping Fishing, Ray’s Outdoors and Rebel Sport Group retail chains, reported solid like-for-like sales growth across all divisions in early May. This is particularly impressive given the flagship chains, Supercheap Auto and Boating Camping Fishing, were cycling very strong comparable period growth rates of 6.7% and 10.6% respectively.

The market consensus* is looking for FY12 earnings per share of $0.53ps and guidance of 15% growth in FY13.

Along with the result, we will also be looking for a download from management on the progress of the Rebel Sports Group acquisition and the associated brand development strategy (following on from a market update provided in late May).

Service Stream (ASX:SSM)

When I covered SSM in early March, I suggested its exposure to the NBN rollout over the coming decade was one of its key business attributes which could deliver a resilient earnings stream regardless of the state of the broader economy. In the intervening period, SSM has continued to win NBN contracts (new estates), refinanced its debt facilities ($140 million with ANZ and Westpac) and rolled over a key plank of its near term earnings, being the Telstra AAS contract, to the end of 2012. And industry sources suggest SSM continues to impress the NBN Co. with its work on the massive nationwide infrastructure project and there are potentially further NBN contract wins coming in the next three months.

The market consensus* is looking for FY12 EBITDA of around $35-36 million and guidance of 10% growth in FY13.

SSM’s share price has bounced back after taking a pounding in the equity market sell-off of April-May and it continues to offer compelling value at current levels (including a healthy yield).

Automotive Holdings Group (ASX:AHE)

Immediately following my article on AHE in late June, the news out of the Perth-based national auto dealer and logistics business really started to flow. AHE announced in early July that it had completed its syndicated property deal (delivering some $40 million cash to its balance sheet), then it spent $6.5 million acquiring the Toll Refrigerated business (a nice bolt-on for its burgeoning logistics operation) and proceeded to cut some underperforming Gold Coast car dealerships ($4.5 million sale consideration).

All this paled into insignificance, however, when major shareholder, Vern Wheatley, sold a large chunk of his 20% holding in AHE to rival listed Queensland-based auto dealer, AP Eagers (ASX:APE). Transacting at a price approximating $2.90 per share (versus AHE’s trading price in the mid $2.50’s) Wheatley interests sold a 16.3% stake in AHE to APE and simultaneously took a 6.1% stake in APE .The Wheatley family holds an ongoing stake in AHE of around 8%.

Whilst it is unclear what the end game is for APE or the Wheatley family, one thing is for sure ... watch this space!

The market consensus* is looking for FY12 NPAT of around $60 million and guidance of 10% growth in FY13.

Mastermyne Group (ASX:MYE)

Since we covered MYE in May, conditions in the East Coast coal markets have continued to deteriorate. However, it is a testament to MYE’s resilient business model and relatively undemanding valuation that its share price has managed to remain steady. Despite export coal pricing continuing to disappoint, ongoing industrial relations disputes (not involving MYE) and continued infrastructure setbacks for the sector, the specialist outsource service provider to coal miners will deliver another year of strong growth in FY 12.It is worth noting that MYE’s earnings are predominantly exposed to producing and profitable coal mines unlike many mining services peers that rely on greenfield project and brownfield expansions. 

The market consensus* is looking for FY12 earnings per share of $0.20cps (affirmed by MYE in mid June) and guidance of 20% growth in FY13.

Critical to my assessment of the business going forward will be an update on the state of MYE’s order book and tender pipeline. Discussions with management in June continue to point to solid growth for the company in FY13.

Swick Mining Services (ASX:SWK)

The Perth-based underground drilling contractor has continued to deliver incremental gains over the past six months; unfortunately during the same period its share price has gone backwardS. With revenue growth of 25% per annum through the last four years and net debt reduced to virtually nil, SWK is well positioned with its exposure to predominantly brownfields gold/copper projects. However, the market is unlikely to reward SWK in the short to medium term due to the tightening capital market conditions placing capital constraints on junior miners/explorers. This usually flows through to impact charge-out rates for drillers such as SWK, notwithstanding the fact that its clients are typically larger companies. On top of this, SWK has experienced some disappointing outcomes in relation to some of its North American contracts (cancelations/delays).

The market consensus* is looking for FY12 EBITDA of around $28 million and another small dividend (0.5 cents per share ... perhaps more).

As the only name on our list to have underperformed the ASX Small Ordinaries Index, we are disappointed with the share price action of SWK. Indeed, as it became apparent that certain factors (mentioned above) were taking the shine off SWK’s outlook, we exited our position during the last quarter. Whilst we will continue to watch the business closely, as fund managers we are cognisant of our responsibility to actively manage our portfolio and adapt to changing circumstances rather than take a “set and forget” approach.

*Market consensus is based on Iress Consensus Estimates. In certain instances, OC Funds’ expectations may be either higher or lower than the market consensus.

Graph for Beating the small caps index

Robert Calnon is portfolio manager at OC Funds Management.

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