Small cap surprises for 2014

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.

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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.

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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.