Small caps take out gold

Small caps will dominate the ‘surprise winners’ in this year’s reporting season … but many are priced too high. Here’s a guide to value.

PORTFOLIO POINT: Small caps are odds-on favourites to head the list of companies with the highest EPS growth in the FY12 reporting season.

Small cap stocks are undoubtedly entering this year’s reporting season – which starts this week – with a greater burden of expectations than their larger peers – that is, those local stocks with a market capitalisation of more than $1 billion.

Indeed, if you look closely at the figures you’ll find that companies with a market capitalisation of less than $1 billion have taken 17 of the top 20 positions for consensus non-resources EPS growth targets. Even if I extend that list to the top 50 companies, these sub-$1 billion market capitalisation companies will still take up 78% of the list.

But the issue for investors is expectation. The challenge of existing high P/E ratios is that any disappointment in the actual results – most companies report full-year accounts for the year to June 30 2012 in the next six weeks – could be punished. As a result, one of the most sensible ways to approach the rich selection of small caps featured in figure 2 below is to consider stocks that have less downside surprise risk. Or, to put it another way, a stock that might have a P/E ratio that is at reasonable levels.

Figure 1

Source: Capital IQ, Investorfirst

Figure 2

Source: Capital IQ, Investorfirst

And those large companies that do make it to the growth honour role are either in the mid-cap range, like minerals-driven laboratory testing group Campbell Brothers (ASX code; CPB), which ranks 26th with a market cap of $3.2 billion and a consensus expectation that it will achieve 60% EPS growth; or they are turnaround stories like QBE Insurance (ASX code: QBE).

CPB also fits another key trend—16 of the 50 industrials with the highest FY12 EPS growth expectations are servicing the resources sector.

Overall, consensus sets positive growth expectations for 61% of the 342 companies that had positive EPS in FY11 and are not expected to make a loss in FY12, as set out in Figure 1. And double-digit growth is expected from 41% of those companies.

On the downside, 29% of these profitable companies are expected to take a double-digit EPS tumble, including 23% of industrials.

And companies capped at less than $1 billion claim exactly the same portion of positions among the 20 and 50 greatest EPS decline targets.

Mining services and online growth stories

From my coverage universe, online plays Webjet (ASX code: WEB) and Jumbo Interactive (ASX code: JIN) rank in the top 50 growth stories; and both ADG Global Supply (ASX code: ADQ), ), Ausenco (ASX code: AAX) and Lycopodium (ASX code: LYL) are among the army of mining services groups also within the top 50 growth stories.

At the other end, Warrnambool Cheese & Butter (ASX code: WCB) and Lifestyle Communities (ASX code: LIC) are among the 50 greatest declining targets (note that with LIC revaluations are a key driver of reported earnings in the near term and are not included in the normalised EPS figure used in this analysis). Tandou (ASX code: TAN) and Select Harvests (ASX code: SHV) are also stocks Investorfirst researches that are among the 50 greatest declining targets.

Across stocks I cover, I expect positive EPS growth for only 55% of those companies that had positive EPS in FY11.

Historical achievement doesn’t mean much in terms of the investment outlook

Looking back at the FY11 reporting season, 61% of companies achieved earnings growth but only 44% have achieved share price growth between the beginning of that reporting season (end of July 2011) and the conclusion of last week. And the correlation between reporting EPS growth and subsequent sustained share price performance is close to non-existent, based on the FY11 outcome, as shown in Figure 3.

So the reporting season focus has to sit squarely on surprise results, and the leeway or lack thereof that its market valuation permits. A stock with high growth expectations and a 25x PE has, in my view, little room for negative surprise relative to a company the market is not “in love” with.

In my coverage universe, the stocks standing out on the highest prospective FY12 P/E multiples are Webjet (on 19.5x our FY12f EPS, which is conservatively 3% below consensus), and CO2 Group (ASX code: COZ— on 23.6x FY12f EPS with no consensus).

Eight stocks under coverage are priced on single-digit PE multiples and, thus, have less downside surprise risk and greater potential for a stronger-than-forecast FY12 result to drive a re-rating. Stocks where FY12f EPS expectations are lower than consensus are: Bega Cheese (ASX code BGA) (-4.8%), Select Harvests (ASX code SHV) (-11%), and Equity Trustees (ASX code EQT) (-10%). Of these three, Select Harvest stands out on a single-digit P/E of 8.4x.

A negative number reflects the amount our expectations are lower than the consensus of the market.

Hugh Robertson is an executive director of Investorfirst Securities.

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