Small caps in the sunshine

Small cap stocks are outperforming, and it’s only the beginning.

Summary: The Australian small caps sector has been outperforming the broader market since July, but in reality it’s still playing catch-up. The Small Ordinaries is still trailing the S&P/ASX 200 Index by over 20%, close to its widest gap on record. The biggest drag on the small caps bunch has been poorly performing junior resources stocks, but many are starting to get fresh legs.
Key take-out: The general rebound in business and consumer confidence, particularly since the federal election, is likely to be material for small companies.
Key beneficiaries: General investors. Category: Shares.

The Australian small caps index is only now starting to overtake the big caps, and is likely to pull further ahead. In effect, its 15 minutes of sunshine has only just begun.

The S&P/ASX Small Ordinaries Index is capturing market attention, with its robust 15% gain since the start of the financial year on July 1. This compares with the relatively modest 11% increase on the top 200 stock index.

Why is it only the beginning? To put things into perspective, the Small Ordinaries is still trailing the S&P/ASX 200 Index by over 20%, which is 4 percentage points worse than during the depths of the global financial crisis and close to its widest gap on record.

As I highlighted last week, small caps have plenty of room to play catch up if they revert to the mean, which is around a 4% price discount to their larger rivals on the S&P/ASX 200.

If you look at the United States experience, it too bodes well for our market juniors. The Russell 2000, which is the small caps “gold standard” for the US market, overtook the S&P 500 Index at the start of the year and just kept going. The Russell 2000 is currently up 24% in 2013, or 8% ahead of the S&P 500.

But not all will agree with the bullish assessment. Detractors will point out a number of holes in the argument. Firstly, some analysts believe small cap valuations are starting to look full in absolute terms and relative to large caps. They note that if smalls keep running, surely the threat of a valuation bubble will surface at some stage in the near term?

They also point out that the composition of the small cap benchmarks in the US is very different from Australia. If anything, the reason why our small ordinaries have gone to the dogs is largely because of junior resource stocks.

If you separated the non-resource stocks from the Small Ordinaries index you would find that this group has rallied much to the same extent as the S&P/ASX 200. To think that small caps will keep outperforming, you must be a resources bull – and resources, particularly mining, is an area that is still facing a fair amount of uncertainty.

I don’t think investors will need to worry about a valuation bubble. If anything, I suspect we are in a cum-upgrade cycle for small cap earnings. This contradicts what some analysts are saying as they warn that 2013-14 profit expectations are still looking a little too lofty.

Improved sentiment

But there is no denying there has been a marked change in sentiment since the federal election. It’s hard to quantify the rebound in business and consumer confidence, but it is likely to be material, particularly for small companies.

This is in part due to their operating leverage (where a small increase in revenue will lead to a larger increase in profit due to fixed costs), but it’s also because their absolute profit is relatively small. This means winning one or two contracts will have a much larger bottom-line impact on a percentage basis than for a big corporate.

There is no arguing about the other point regarding small resources stocks. While some of them still face the risk of shutting down due to the lack of funding and sub-optimal projects, a good number are starting to show signs of early life as hard commodity prices have begun to stabilise, if not recover, over the last few months.

It is no coincidence that eight out of the 10 best performers on the S&P/ASX Small Ordinaries Index are resources-related. Stocks in this list that are on the Uncapped 100 and rated a “buy” include emerging copper producer Tiger Resources (TGR), gold miner Beadell Resources (BDR) and mining contractor NRW Holdings (NWH).

Given how badly the mining and mining services sectors have been de-rated over the past year or two, I think they will continue to lead the charge forward as the global economic outlook is far rosier than it was in the first-half of the calendar year.

The lead indicators to watch are BHP Billiton (BHP) and Rio Tinto (RIO). When these stocks jump 20%-30% from their June lows, that’s when the juniors will really fire up – and we are getting close to that point.

However, the S&P/ASX Small Ordinaries is really a flawed benchmark to measure the innovation and opportunities our emerging companies bring to the market due to the index’s quirks and biases. Its heavy exposure to junior explorers and the inclusion of demoted large cap stocks with gaping holes in their business models are the key points of contention.

This is why Eureka Report created the Uncapped 100. If you are a small cap believer, you should be hunting for selected opportunities within the Uncapped 100 and not the small ordinaries.

Think big, go smalls!