Small cap signals for the second half

Telcos have scored this year... but look to financials, internet and outsourcing stocks in the months ahead.

PORTFOLIO POINT: Investors have been able to achieve gains among small caps stocks since the GFC, but it has been a slow grind for many.

As the investment malaise sets in you might be asking yourself, does this time around feel any different to the depths of the global financial crisis? Is it déjà  vu all over again?

But this time around, amongst the small caps sector, there are some obvious differences. The S&P/ASX Small Ordinaries Index fell 66% between November 2007 and March 2009. Between February 2011 and now however, the index is down around 27%.

The sell-down during the GFC was across-the-board mayhem – no sector was left unscathed as there was a broad readjustment of risk tolerance. The best performed small cap sector was the telco sector, and even that was down 36%. The worst performed was the small cap industrials, down 70%.

We would cite examples of individual stock performance during the carnage but it’s all still too raw.

But the blind panic that pervaded 2008 has been replaced by a slow grind. This time around the sell-down has been more selective, so perhaps experience has made us more discerning.

There are pockets of resilience if not outright gains where companies are believed to be successfully exploiting pockets of strong growth with sufficient barriers to entry to protect margins, at least in the short term.

Figure 3 shows there have been ample opportunities for committed stock pickers to prove their mettle.

The star performer in this latest cycle has been telecommunications and utilities, up 18% and 8.5% respectively.

Among the telecommunication stocks, Telecom Corp of NZ (ASX: TEL) is up around 40% from April last year, assisted by buying from US fund manager Blackrock Investment Management. Then there is national broadband provider iiNet (ASX: IIN), up more than 20%, and Singapore Telecommunications is up by a similar percentage (ASX: SGT).

Among small cap utilities, Hastings Diversified Utilities Fund (ASX: HDF) is the biggest contributor, up a handy 60% thanks to a takeover bid by APA Group (ASX: APA). Australian Infrastructure Fund (ASX: AIX) is up around 30% after it embarked on a policy of selling non-core assets and announced plans to internalise its management.

The much pilloried financial services sector has also taken a shot at redemption after shedding two thirds of its value during the GFC. Its index is up around 1% since April last year.

The star financial performer is vendor and retail point-of-sale finance company FlexiGroup (ASX: FXL), which has rebounded more than 30%. FXL has forecast that FY2012 cash profit will be up by between 12% and 15% due to growth in demand for its services and product innovation.

All up, nine of the 195 components of the Small Ordinaries are within 10% of a record high.

The big loser this time around has been the materials sector – down 37% over the 15-month period – as noted by Roger Montgomery is his column earlier this week.

We spotted at least 18 stocks down more than 60%, including Rex Minerals (ASX: RXM), Mirabela Nickel (ASX: MBN), Ivanhoe Australia (ASX: IVA), Bathurst Resources (ASX: BTU), Intrepid Mines (ASX: IAU) and Ampella Mining (ASX: AMX). They may not be household names but someone out there must be hurting.

Good fund managers are still complaining about so-called lobster pots: small cap stocks that were easy to get into but difficult to exit. But there aren’t too many who would swap the current conditions to what they were experiencing in 2008.

The message is to back companies exploiting growing niches such as the internet, outsourcing or infrastructure with committed management teams able to exploit economies of scale. And then hold your nerve.

Hugh Robertson is an executive director of Investorfirst Securities.

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