Five small cap trends for 2014

The Uncapped 100 is on track to close the year with a solid lead over the market, even as equities struggle to finish the last month of 2013 on a positive footing.

Eureka Report’s collection of the most exciting emerging stocks has generated a total return of 21.5% on a market cap weighted basis, or 7.5% ahead of the ASX All Ordinaries Index including dividends.

However, the Uncapped 100’s strong showing belies the tough year for most market juniors, with the S&P/ASX Small Ordinaries Index chalking up a 6.1% loss since January.

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The sad truth is small cap stocks are entering unprecedented territory as they lag the S&P/ASX 200 Index by a whopping 19% in 2013 following last year’s 11.4% underperformance to their bigger rivals. Never before has the Small Ords fallen behind the top 200 benchmark by double-digits over two consecutive years, and you need to go back to 2000 to find a worse relative annual outcome for the juniors.

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The underperformance isn’t all driven by small resource stocks either. The S&P/ASX 200 Industrials Index’s 15.7% year-to-date jump is nearly twice that of their smaller counterparts.

Passing the baton

But it is this woeful result that is partly fuelling my belief that 2014 will be the year for small caps. Besides the “reversion to the mean” argument, there are fundamental reasons to suspect that the New Year will provide some tailwinds to the embattled sector.

For one, the expected pick-up in economic growth bodes well for small cap stocks. Economists believe that Australia’s gross domestic product (GDP) has troughed in the September quarter at 2.3% and will accelerate in 2014, as shown in the chart below.

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What’s interesting is that the Small Ords has outperformed the large caps in four of the last five cases when the quarterly GDP figure rebounded from below 2.5%. The average capital gain in the four quarters from the trough in GDP since 2000 for the Small Ords is 2.15%, compared with the S&P/ASX 200’s 1.12%.

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What’s more, there’s room for upside earnings surprise among small industrials stocks as the median earnings per share (EPS) consensus estimate is forecasting growth of 10.5% in 2013-14 compared with the five-year average of just over 15%.

If the economy is re-accelerating, I would expect to see stronger EPS growth rates given the operating leverage and the fact earnings are cycling off a relatively low base. This doesn’t mean it’s carte blanche for small caps. Some are better placed to run ahead than others.

Five themes to watch for

I am bullish on risk assets for 2014 and Shane Oliver made a compelling case for growth assets last week. I believe embattled cyclical stocks will finally feel some love from the market as rising prices in the large caps push investors up the risk curve in search of value.

So, while next year will likely be far kinder to small caps, 2014 will belong to emerging resource companies if things play out to expectations (see Tim Treadgold’s article on December 6).

1) Junior miners returning from the cold: I am not calling the return of a golden era for this out-of-favour sector, but I expect a large chunk of the pessimism drowning these stocks to subside given the 46% crash in the ASX Small Resources Index so far this year. This is the biggest loss since the dark days of the global financial crisis in 2008.

Sceptics should remember this – it’s dangerous to bet against commodities (and, by extension, mining equities) when global growth is picking up pace. Economists are forecasting growth of 1.96% in calendar 2014 for the G10 countries (the world’s 10 largest economies), which would mark the fastest economic expansion for the group since 2010.

This doesn’t mean junior resource companies will be able to completely shake off funding fears, as capital for new projects will still be hard to come. This will be particularly so for high-cost mines due to the ramp-up in supply of a number of hard commodities in the coming years from the mining majors.

This is why I have, and continue to favour, well capitalised emerging miners with low-cost operations that are transitioning from an explorer to a producer.

The two from the Uncapped 100 that check these boxes are African copper miner Tiger Resources (TGS) and gold and base metals producer YTC Resources (YTC). Gold producer Beadell Resources (BDR) is also well placed, although the outlook for gold is harder to read given that the price of the precious metal isn’t generally bolstered by economic activity.

However, don’t expect sentiment to turn markedly for the sector in the short run. Mining heavyweights Rio Tinto (RIO) and BHP Billiton (BHP) will have to rally by at least 30% from their July lows before we will see greater investor interest in mining minnows. We have an “outperform” on the three stocks.

2) Northern exposure: Companies that generate most of their sales in the United States and Europe will be in a sweet spot for two reasons.

The first is the falling Australian dollar. If you thought the upside from the exchange rate is largely factored into stock valuations, you’d be wrong. Most analysts are still using rates that are close to parity to the US dollar in their models, but there’s good reason why they are slow to react.

While the Australian dollar has tumbled sharply to around US90 cents, most companies will not feel the impact for a while yet as sales are booked on an ongoing basis throughout the year. The 365 day moving average for our dollar is still hovering around US99.2 cents, or 10% above where the spot price is.

The other factor is economic growth and it appears that the US, Europe (including the UK), and maybe even Japan will be leading the charge. It is the change in the rate of growth I am referring to, and not the absolute growth number.

These economies are in the midst of rebounding from rock bottom levels and their reawakening heralds a pretty exciting moment for companies leveraged to these markets.

While most small cap companies tend to be more domestically focussed, there are a handful of Uncapped 100 stocks (outside of commodity producers that typically sell their products in US dollars) that are well placed to benefit from this thematic.

Consumer financing company ThinkSmart (TSM) is arguably the most exposed now that management has agreed to sell its Australian and New Zealand operations to rival Flexigroup (FXL) so it can concentrate fully on its UK expansion.

The market’s attention has been captured by the dramatic drop in the Australian currency against the US greenback, but the local dollar’s fall from grace against the British pound is just as pronounced as the exchange rate is around a near four-year low of 54.8 pence.

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The chart looks ominous for the Aussie and our dollar could trade lower given that the UK economy has been recovering strongly. That’s good news for ThinkSmart, which will generate almost all of its profit in pound sterling after it signed deals with a number of leading UK retailers to provide financing solutions to their customers.

Other Uncapped 100 stocks with material exposure to this thematic include communications equipment maker NetComm Wireless (NTC), medical disinfection device developer Nanosonics (NAN), property owner Astro Japan Property Group (APA) and global payment solutions company eServGlobal (ESV).

We have an “outperform” rating on Nanosonics and eServGlobal. We do not have a recommendation on NetComm or Astro.

3) Barbarians at the gate: Predicting an increase in merger and acquisitions (M&A) activity won’t come as much of a surprise as we have seen a 63.6% surge in the value of announced deals in the current quarter to $23.7 billion compared with the September quarter. This trend is likely to continue into 2014 as M&A activity is still low by historical standards.

I suspect private equity buyers will be helping fuel takeovers too as the spate of initial public offers by private equity vendors will leave these deal makers cashed up and hungry for the next opportunity, particularly while interest rates are still hovering around historical lows.

The area that these buyers are likely to be active in is mining services. Private equity has a long history of playing in this sector and they know the industry well. Bradken (BKN), which made a takeover bid for Austin Engineering (ANG) last night, used to be owed by private equity before its market float in 2004.

Further, many mining services firms are under pressure due to the drop-off in project work and are trading materially under their net tangible asset values.

It isn’t wise to invest in a stock just for its takeover potential, but a number of mining services companies are looking good value despite the risk of an earnings downgrade, and their share prices could just get a kick next year from takeover speculation.

Mining services stocks in the Uncapped 100 with an “outperform” recommendation include LogiCamms (LCM), NRW Holdings (NWH) and WDS (WDS).

4) The great rotation: We are likely to see some capital rotated out of better-performing industrial stocks and into beaten-down cyclical names as confidence towards global growth improves next year.

One small cap sector that could be used as a funding source is telecommunications. Many in the sector have generated enviable total returns in 2013 and similar returns are unlikely to be repeated. Stocks like Vocus Communications (VOC) has delivered a total return in excess of 80% this calendar year, while M2 Telecommunications (MTU) and Amcom Telecommunications (AMM) have delivered a more than 40% total return to their shareholders.

The yields on most of these stocks are close to the bottom of their five-year averages, and if interest rates start to rise next year as some economists are expecting, their appeal could tarnish – although maybe less so than industry giant Telstra, given that the smaller telcos have better growth options.

Having said that, I am resisting changing my “outperform” recommendation on M2 for now as the stock has come off its highs, has a higher expected yield than most of its peers, and is trading at an undemanding one-year forward price-earnings of around 12 times, or a 30% discount to its five-year average.

I am also expecting some profit taking from the big banks, with the cash being redeployed to smaller lenders trading on a more attractive valuation, such as Wide Bay Australia (WBB). I am recommending the stock as a buy based on the belief that the Queensland regional housing market will rise along with the national market. If that comes to pass, we will see a re-rating of the stock.

5) Event investing to persist: I might have a positive view on the economy for 2014, but I think “event driven investing” will play an ever increasing role in most investment portfolios.

Event-based investing refers to buying a stock on the belief it will run hard if management achieves a company specific event or milestone. This milestone is not directly tied to the broader economy, and even if we were to fall into a recession this should not stop a significant re-rating of the stock.

The most obvious examples can be found in the biotech sector, and while there are risks involved (as highlighted in Justin Braitling’s article this week), the industry has matured remarkably over the past decade. Perhaps the most promising development is the fact that it has become far easier to find capable managers with a proven track record in biotech these days than it was just a few years ago.

Event investing isn’t just about biotechs. It is mainly about commercialising intellectual property in whatever sector it might be and the risk profile for such stocks is similar to investing in an early stage explorer.

The truth is, Australia’s love affair with the mining industry is unlikely to run as passionately as it did before. Even hardened speculators have been taught the importance of diversifying across sectors following the walloping of the junior resources sector. This is one lesson investors aren’t likely to forget anytime soon.

Think big, go smalls!

This is the last Uncapped article for the year. While stocks with my “outperform” rating have returned some of their robust gains in the past few weeks, they are still up 10.1% since we first rated the stocks, or 21.4% on an annualised basis. This is 11.6% ahead of the S&P/ASX Small Ordinaries Index and 7.4% above the S&P/ASX 200 Index. I am expecting 2014 to be a big year for emerging stocks, as you can tell from the positioning of my portfolio, and I look forward to taking you further into the world of small caps in the New Year. Have a wonderful and safe festive season.