Small caps regain momentum

Smaller capitalisation stocks started outperforming again in August, with some Eureka Report favourites doing very well.

PORTFOLIO POINT: Small cap stocks outperformed the broader market in August on the back of some strong earnings results. But, as always, there were winners and losers.

With the August reporting season all but behind us, it’s well worth reflecting on some highlights in the small-mid cap space. This year, more than ever in recent memory, stocks have been reacting sharply to not only earnings delivery (or earnings misses, as the case may be) but also to the earnings outlook. A secondary factor has also been at play these past few months, with investors seeking shelter from resources exposure by chasing previously unloved or overlooked traditional industrial stocks.

On the earnings delivery/outlook front, a classic case in point was seen just yesterday with global minerals drilling services and product supplier, Boart Longyear (BLY:ASX). BLY delivered its first-half result (December year-end) broadly in line with market expectations but went on to paint a bleak outlook for the balance of calendar year 2012, and indeed into 2013. After reporting first-half EBITDA of some US$208 million, BLY downgraded its full-year forecast to US$360-390 million (from previous recent guidance of US$460 million). This slippage in CY12 guidance was not taken well by the market and the stock was dumped some 37% to $1.50 at the close of hostilities (well off its highs less than six months ago above $4).

Adding to yesterday’s carnage was the extrapolation made by analysts in relation to CY13. With consensus growth previously forecast of 10%-plus, these numbers will be pared back to flat or negative over the coming days. As a large, liquid bellwether for the mining services space, the BLY scenario only reinforced the market view that investors would rather have less resources related exposure than more. The implications of the downgrade reverberated through the mining services sector, with many names down significantly including Imdex (IMD:ASX) (-19%), Ausdrill (ASL:ASX) (-11%) and NRW (NWH:ASX) (-7%).

To this end, investors have been keenly watching the results of previously overlooked sectors such as gaming and telecommunications; even some beaten-up retail exposed names have been enjoying their time in the sun.

Another sector that captured investors imagination over reporting season is the online space. Online real estate spruiker, REA Group (REA:ASX), and its car toting cousin, Carsales.com (CRZ:ASX), both hit all-time highs after reporting excellent full-year numbers in August. These businesses continue to attract investor attention due to their ability to grow earnings regardless of the prevailing state of the economic cycle. They also enjoy strong cash flows, balance sheets and market positioning.

Indeed, as larger blue-chip stocks in the ASX Top 50 issued regular poor results over recent weeks, small cap stocks resumed their outperformance of the blue chip index as they had throughout the first half of the year.(see graph below).

(Source: Google Finance)

Some other sector/stock specific small-mid cap reporting season highlights on the upside included:

  • Retailers – The Reject Shop (TRS:ASX) and Breville Group (BRG:ASX). The discount retailer, TRS, was the beneficiary of a short squeeze after reporting numbers above market expectations. The share price of BRG, a supplier of electrical kitchenware to predominantly Australian and North American retailers, has doubled in the past six months to all-time highs on the back of successive upgrades and continued strong sales forecasts into FY13.
  • Gaming – Aristocrat Leisure (ALL:ASX) and Ainsworth Game Technology (AGI:ASX). These gaming machine companies each delivered strong August earnings reports and talked up the outlook for the balance of CY12 and into CY13 on the back of strong demand from their local and offshore customer base. AGI in particular has had an extraordinary run since Christmas, with its share price up more than four times from around $0.50c to present levels well above $2.
  • Telecommunications - M2 Telecommunications Group and Service Stream (see below).

And some lowlights on the downside included:

  • Adelaide Brighton (ABC:ASX). The cement and lime producer/supplier, ABC’s half-year report was marginally below market expectations and management provided an understandably cautious outlook commentary, which led the market to cut the shares down some 10% post the result.
  • Fleetwood (FWD:ASX). WA-based recreation vehicle maker and accommodation provider to the mining industry disappointed the market with its bearish outlook for FY13. The stock was marked down 10% post the result as investors removed the P/E premium that the stock has enjoyed for some years now.
  • Norfolk Group (NFK:ASX). Whilst not actually reporting its result, engineering company, NFK, released guidance to the market for its September year-end, which was not taken at all well. The downgrade to guidance was blamed on project delays and global economic uncertainty and the stock traded down 30% over coming days and is yet to recover.

And just to show investors do not always get it right immediately, Fletcher Building (FBU:ASX) was initially down more than 5% after reporting its results but recovered all of this and more in subsequent days as it got on the road and fully explained its results to the broader investor community. Terms such as “jumping to conclusions” and “throwing the baby out with the bathwater” come to mind.

So how did our recently mentioned stocks perform during August?

  • Super Retail Group (SUL:ASX) – Continues to be the stand-out ASX-listed retailer, reporting another excellent result, which saw the stock track to all-time highs above $8. Outlook and growth prospects remain very solid for this retailer.
  • Automotive Holdings Group (AHE:ASX) – Another result to surprise the market on the upside, with earnings being led by strong growth in the cold storage and logistics division. The stock is trading at four-year highs as investors jump on board the “Autos (station) wagon”.
  • M2 Telecommunications Group (MTU:ASX) – The stock closed the month 10% higher on the back of a solid result and further evidence that its acquisition strategy (including the recent chunky Primus buyout) is on track. A telco stock delivering a quality product to a niche market; standby for more growth in 2013.
  • Service Stream (SSM:ASX) – Delivered a workman like performance in FY12 and comfortably beat earnings guidance; the stock now looks well supported at the $0.40c level. Further near-term NBN contract wins will be the key to this one continuing to deliver growth in FY13 and beyond and I remain comfortable with its prospects.
  • Mastermyne Group (MYE:ASX) – East coast coal mining services company reported bang in line with market expectations. It’s ‘A-grade’ management team are the ones to back in what is proving to be a difficult operating environment for their coal producing customers. Unlike many of its peers in the coal sector, further growth is expected in FY13 on the back production based contracts at low cost, world class mines.
  • Swick Mining Services (SWK:ASX) – The result again showed plenty of promise and a recent meeting with management confirms they are confident of delivering on strategy. A share buyback kicks off this month, which should help support the stock price though general mining services sentiment may continue to weigh on this one. As mentioned previously, OC has exited its position in SWK but I continue to watch it closely.

Robert Calnon is portfolio manager at OC Funds Management.