Small cap surprises for 2014

Companies that have delivered positive earnings surprises are in the box seat.

Summary: Research shows that companies that have delivered higher than expected earnings results tend to outperform the market over the short to medium term. Below are two stocks that surprised on the upside in their latest results.
Key take-out: Three-quarters of large caps that manage to beat earnings expectations last August have produced average returns that are 15% ahead of the market.
Key beneficiaries: General investors. Category: Small caps.
Recommendations:
Specialty Fashion Group Limited (SFH): Outperform.
Forge Group Limited (FGE): Outperform.
McMillan Shakespeare Limited (MMS): Neutral.

Picking the best performing stocks for the year ahead may be easier than you’d think. It seems that companies that deliver a positive earnings surprise are likely to count among the best performing stocks over the next several months.

A number of studies from around the world have shown that a majority of stocks that handed in results ahead of market expectations will outperform the broader market over a six- to 12-month period.

Smaller cap stock enthusiasts will be pleased to know that this phenomenon appears to apply to the Uncapped 100.

This is significant, as broking house CIMB found that earnings surprises is one of the most reliable share price predictors for the top 200 stocks on the ASX.

Three-quarters of large caps that manage to beat earnings expectations last August have produced average returns that are 15% ahead of the market, according to CIMB analyst Eben Van Wyk.

If you looked at Uncapped 100 stocks that have delivered earnings before interest, tax, depreciation and amortisation (EBITDA) above consensus expectations, you’d find a more impressive outcome, with nearly four-in-five of these stocks outrunning the broader market.

There are 46 Uncapped 100 stocks that fit the bill, and the average total return for these stocks in the group is 42%. In contrast, the S&P/ASX Small Ordinaries Index is hovering close to breakeven and the ASX All Ordinaries is up around 21% over the period.

Experts point to behavioural biases to explain why companies with positive earnings news outperform over so many months.

“Investors tend to initially underestimate the value of new positive information,” Van Wyk writes in his note.

“This allows informed traders to capture the remaining informational value during the following months when the share price continues to trend upwards.”

Other research done on this phenomenon supports this belief. Investors have a tendency to underappreciate good news, but are quick to overreact to bad news.

Armed with this knowledge, we can look for buying opportunities among Uncapped 100 stocks that posted positive earnings surprises last month. The interesting thing is there are far fewer stocks that have beaten EBITDA expectations this time around.

While the number of earnings surprises in August were a little below the longer-term average, only 14 Uncapped 100 stocks managed to beat their EBITDA forecast compared with 46 in August last year. If you excluded biotech and resource stocks (these stocks are driven more by milestones than earnings), the list drops to 10.

The market has reacted positively to around two-thirds of the total group, as measured by the announcement effect in the table above. The announcement effect is the share price performance relative to the ASX All Ordinaries in the three days following the earnings release.

There are a couple worth highlighting in the table. Mining contractor Forge Group (FGE) is one that I suspect will do well in the coming year.

The group has a good management team and track record, and is trading on a relatively modest one-year forward price-earnings multiple of around seven times. I have an “outperform” recommendation on the stock.

Another that has the potential to do well is women’s apparel retailer Specialty Fashion Group (SFH). Management’s turnaround strategy is gaining traction, with the company posting a credible U-turn in net profits: $13 million was booked in for 2012-13 compared with a loss of $2.8 million in the previous financial year.

Analysts have low expectations this year, with the consensus expecting relatively flat revenue and EBITDA growth due to the challenging retail environment and falling Australian dollar adding pressure to import costs.

This leaves room for the group to surprise on the upside if consumer confidence improves materially in the coming months under the new Abbott Government. Specialty Fashion is also likely to benefit if cotton prices soften further into 2014, as commodity analysts are expecting, particularly since the group has hedged the exchange rate at US95 cents for 2014.

Global apparel brands like Levi Strauss and Hanes have reported a strong uplift in margins on the back of falling cotton prices.

I have an “outperform” recommendation on the stock.

On the flipside, I would be hesitant to buy salary packaging company McMillan Shakespeare (MMS) even though the new federal government has promised to keep the current tax benefit scheme on vehicles in place.

McMillan Shakespeare has a good management team, but the stock is looking fully priced on a forward P/E of around 15 times.

Management will need to diversify its core business to remove the regulatory risks before the market is willing to re-rate the stock. This is likely to happen, but you won’t see the results for a few years.

I have a “neutral” recommendation on the stock.

Think big, go smalls!


Brendon Lau holds shares in FGE.

Uncapped 100 - Australia's most interesting small cap stocks
Small cap stocks covered by the Uncapped team
CodeNameRationaleMarket cap ($m)Total return 1-year (%)Sector (GICS)
BRG Breville Group Well covered but good candidate for core holding due to good track record.1,123.3770.73Consumer Discretionary
MTU M2 Telecommunications Group Amazing growth story and well run company. High free float and strong insto support.1,111.1690.05Telecommunication Services
NHF NIB HoldingsOnly listed health insurer. Widely held. Good performer.935.0833.86Financials
ARP ARB Corp Well covered but good candidate for core holding due to quality management.875.5728.1Consumer Discretionary
MRM Mermaid Marine Australia Its strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.872.8728.4Industrials
GEM G8 Education Only listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.864.65172.43Consumer Discretionary
MMS McMillan Shakespeare One of the best performers since the GFC, but change to FBT rules is threatening growth.860.75-4.83Industrials
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding.741.1451.27Consumer Discretionary
SRX Sirtex Medical A shining star in the biotech space and one of the best performing stocks in 2012. Great product (liver cancer treatment) and bright outlook.730.7255.03Health Care
AUB Austbrokers Holdings The insurance broker is a strong performer. Widely held and well liked by small cap investors.640.9946.17Financials
SGN STW Communications Group One of few companies able to benefit from online shift. Widely held and good insto support.629.9761.67Consumer Discretionary
BDR Beadell Resources Will be a very big FY14 for miner as it has to prove it aims to produce 200,000 ounces of gold a year.593.18-19.95Materials
RFG Retail Food Group Owns a number of well know franchise brands. Widely followed by instos.587.6669.5Consumer Discretionary
ACR Acrux One of the most successful Australian biotechs in recent history. Widely held by instos.539.533.37Health Care
CCV Cash Converters International Strong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.536.1874.11Consumer Discretionary
BGA Bega Cheese Corporate interest in Australian food companies makes the cheese maker worth following.526.98110.84Consumer Staples
NXT NEXTDC The cloud computing company is an IT sector darling. Fairly widely held and followed.511.8331.57Telecommunication Services
BRU Buru Energy Substantial size but not often covered by press. Widely held with good insto support.511.70-35.77Energy
CWP Cedar Woods Properties Property developer with good ROE and earnings growth track record.502.5186.95Financials
AMM Amcom Telecommunications Well covered junior telco but good candidate for core holding.494.0180.05Telecommunication Services
SEA Sundance Energy Australia Analysts have a favourable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.490.3741.33Energy
RCR RCR Tomlinson Good first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?490.33125.44Industrials
CCP Credit Corp Group Strong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.465.7663.75Industrials
FGE Forge Group One of the better performers in its industry. Good track record and potential core holding.454.5429.6Industrials
TOX Tox Free Solutions Widely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.433.3426.79Industrials
HZN Horizon Oil One of better regarded small energy stocks that doesn't receive much media attention.428.1613.4Energy
SLX Silex Systems Its uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.427.33-37.56Information Technology
MYS MyState Well regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.408.8649.1Financials
NWH NRW Holdings One of the better regarded mining & civil contractors with good track record in delivering on projects.396.02-33.58Industrials
UXC UXC Company has turned corner and enjoyed re-rating. What's next?373.7843.06Information Technology
UNS Unilife CorpThe developer of one-use prefilled syringes is close to an inflection point as the market is expecting the company to announce a major contract with a pharmaceutical giant in the coming weeks.358.6126.8Health Care
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal liner on diabetics.350.9828.57Health Care
MYX Mayne Pharma Group Sizeable generic drug maker with interesting board members.347.94111.71Health Care
TGA Thorn Group One of few retail stocks that is performing well. The Radio Rentals chain owner is also well supported by instos.339.4930.26Consumer Discretionary
MOC Mortgage Choice Has a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.324.6287.08Financials
BNO Bionomics One of the larger cancer treatment developers in this market.284.0098.3Health Care
RKN Reckon Fierce competition for cloud base accounting software puts it in firing line.275.810.49Information Technology
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 274.6048.36Financials
SPL Starpharma Holdings Noteworthy for its good pipeline of innovations. Well run, widely followed.264.09-39.81Health Care
MXI MaxiTRANS Industries Transport equipment maker posted good interim result. Has appealing yield and growth.262.6599.34Industrials
SHV Select Harvests Noteworthy for turbulent past and exposure to soft commodity market.254.27309.12Consumer Staples
RIC Ridley Corp High corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.253.95-17.22Consumer Staples
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.239.9534.16Financials
SIV Silver Chef Strong jump in the share price of the equipment financing group has attracted a good following.239.21107.99Industrials
IMF IMF Australia Litigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.234.7137.05Financials
GXL Greencross Acquisitive veterinary group. Good profit growth and share price performance, but gets little press.224.73139.19Health Care
CLH Collection House In similar space as Credit Corp. Strong stock performance has attracted a following and the stock appears to be well placed to run further220.5699.7Industrials
TFC TFS Corp The sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.218.1187.95Materials
IPP iProperty Group Worth watching as it is trying to be the REA Group of Asia.217.6820Information Technology
VOC Vocus Communications Telecom stocks are in favour but Vocus is one of the least covered213.0958.48Telecommunication Services
NWT Newsat Potential large cap if it can launch its own satellite in 2015.210.63-28.7Telecommunication Services
NAN Nanosonics A successful medical tech story. Should be close to turning in maiden profit with its disinfection device.207.6362.89Health Care
DWS DWS Will be a big beneficiary if governments start spending on IT again.201.190.13Information Technology
TGS Tiger Resources Future lies in its Kipoi copper mine expansion in the Congo but miner is fully funded with DRC govt holding 40% stake in tenement. Next 12mths will be interesting.197.37-13.97Materials
IFM Infomedia Interesting tech play in the car parts market. Strong share price gain but gets little air play.189.00179.29Information Technology
PFL Patties Foods Illiquid stock but has suite of well recognised consumer brands. Defensive yield.188.43-10.75Consumer Staples
WBB Wide Bay Australia The building society is trying to turn its fortunes around. Also worth watching for its exposure to Queensland housing market, particularly around major resource projects.180.83-20.44Financials
SFH Specialty Fashion Group In early stages of turnaround. Can the women's apparel retailer sustain the momentum?178.7893.57Consumer Discretionary
IMD Imdex Drilling company is well supported by instos and should benefit from any rebound in exploration activity.178.38-44.8Materials
DTL Data#3 Well respected IT company that receives little press coverage.170.14-0.09Information Technology
RCG RCG Corp The footwear retailer is one of the best performing consumer stocks as online competition is not a big threat. Company has a good yield as well.169.9690.04Consumer Discretionary
HSN Hansen Technologies Operates in a high potential/growth industry but is not covered by press or brokers.166.6628.68Information Technology
ACL AlchemiaOne of the few biotechs with revenue stream. Good pipeline of oncology treatments.165.26-3.77Health Care
CKF Collins Foods One of the few food franchise listed companies.165.0767.45Consumer Discretionary
MLB Melbourne IT A perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.144.3114.56Information Technology
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.136.1812.23Health Care
MCP McPherson's The personal care and household products supplier had been relatively insulated from volatile discretionary spend and online threat, but its latest profit warning shows it's not immune.129.03-14.49Consumer Discretionary
AZZ Antares Energy Liquid with good insto support. Already in production with exploration upside in Texas.126.226.45Energy
SAR Saracen Mineral Holdings Emerging gold producer that is widely held by instos. Hitting milestones and looks cheap. Key asset is close to gold majors, which makes it a potential takeover target.123.52-52.3Materials
BGL BigAir Group The wireless microcap has gained strong following over past year or two but is often overlooked by investors and the press.123.1656.3Telecommunication Services
AMA AMA Group Good turnaround story but under the automotive services group is radar of most.121.2795.48Consumer Discretionary
LCM LogiCamms Strong price performance and reasonable valuation attracting interest.120.2967.37Industrials
REX Regional Express Holdings Well run airline that is overshadowed by Virgin and Qantas.118.90-10Industrials
ESV Eservglobal Mobile money transfer company that has been gaining traction. Widely held by instos but low press coverage109.58131.58Information Technology
NEA Nearmap A stellar performer with an Interesting business that offers high quality aerial maps to companies & government.108.32857.14Information Technology
WDS WDS Widely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.107.8335.24Industrials
CLV Clover Corp One of the star performers in 2012. Operates in growing but relatively stable niche.94.1524.96Health Care
CAA Capral An aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 94.1023.53Materials
POH Phosphagenics The biotech with a game changing FY14 year ahead. Good insto following but questions of poor audit and governance standard could dog company.93.88-26.4Health Care
JIN Jumbo Interactive Innovative small cap facing off industry dominated by giants. Worth watching to see if it can carve out a profitable global business.87.9865.05Consumer Discretionary
DRM Doray Minerals Widely held by instos. One of the more favoured gold explorers by brokers.82.99-30.8Materials
AOH Altona Mining Noteworthy copper play with Xstrata pull-out of Roseby project in Australia and the good ramp up of its Finnish project.82.49-44.64Materials
BOL Boom Logistics Crane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid. Won't be surprised to see corporate interest.80.00-51.43Industrials
PEN Peninsula Energy Widely held by instos and large free float. It's the only uranium miner on the list.78.45-8.62Energy
RUL RungePincockMinarco IT company to resource industry. Facing tough operating climate with new CEO trying to restructure and turnaround company.77.7426.44Industrials
LGD Legend Corp Electronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.69.14-2.81Information Technology
TAN  Tandou The only direct equity exposure to cotton prices. Also trades water rights and receives little press.68.0026.13Consumer Staples
YTC YTC Resources Next 12-mths will be eventful after YTC secured funding for its projects from Glencore.67.21-8.93Materials
CKL Colorpak The small cap packaging company has grown via acquisitions over past few years.66.0566.42Materials
CUV Clinuvel Pharmaceuticals Interesting skin disorder treatment developer that has done reasonably well over past year64.976.25Health Care
GXY Galaxy Resources Good upside potential if it can get its problem-prone Jiangsu plant back on track. Won't be easy to right this ship.64.06-79.53Materials
TSM ThinkSmart Potential turnaround story worth keeping eye on.57.62115.15Financials
OTH Onthehouse Holdings Alternative small cap to online property leader REA Group. It is trying to use more timely housing data as a competitive edge against REA.54.2443.19Consumer Discretionary
UML Unity Mining Growing Tassie gold producer with high free float. Valuation looks compelling too.52.65-42.31Materials
KOV Korvest The construction products and services supplier has been hit by project delays and deferrals. But its relatively high yield could give it some support.46.811.92Industrials
EBT eBet Potential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.41.99237.07Consumer Discretionary
NTC NetComm Wireless Under appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.31.53122.73Information Technology
PGC Paragon Care Emerging hospital equipment supplier that has been ignored by market.15.3769.05Health Care
MBO Mobilarm Unique product that could change global maritime safety practices with its man-overboard location beacon.13.69-7.25Information Technology
ISS ISS Group ISS delisted on Aug 9 after being acquired by  P2ES0.00n.a.#N/A N/A
Source: Eureka Report, Bloomberg

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