Small company returns are sizzling

Small companies are leading the way in the nascent recovery that appears to be under way on the Australian sharemarket.

While share prices of the broader market are up about 5 per cent since the start of this year, small companies are up more than 12 per cent.

"If you have a view that the market will recover over the next six to 12 months, then the sizzle and excitement is going to be in small caps," says a manager of the Pengana Emerging Companies Fund, Steve Black.

In the recently concluded profit reporting season, some of the best results were posted by small companies, he says.

The editor of the FNArena financial news and analysis service, Rudi Filapek-Vandyck, says relatively high interest rates, a high Australian dollar, weak consumer spending and concerns over global growth make it hard for large companies to increase profits.

"The highest growth is among the small- and mid-caps," he says.

Managers of small-company funds and analysts say many of the best stock ideas are among the mining services companies that supply the picks, shovels and skilled labour to mining companies.

Steve Black's fund holds about 60 stocks and one of its larger holdings is the mining services company Mastermyne Group, which reported one of the best results of the season. Mastermyne provides mining services to the Australian coalmining industry.

Its share price has risen on the good results but Black is still "pretty bullish" on the stock.

The co-founder of the small companies specialist manager Eley Griffiths Group, Brian Eley, likes Ausdrill, a diversified mining services company. About 10 per cent of its revenue comes from exploration drilling, with the rest from drill and blast, load and haul and the manufacture of drilling consumables such as drill bits.

"It is quite diversified and has been growing very rapidly," Eley says.

The head of smaller companies at BT Investment Management, Paul Hannan, likes Decmil Australia. It provides engineering, construction, maintenance and industrial services to the resources industry and government. He also likes RCR Tomlinson, which provides engineering services to the mining, resources and energy sectors.

"This is an example, along with Decmil, of companies stepping up to the plate and transforming themselves from being small companies into taking on bigger contracts," he says. Both companies have good management.

"We pick these companies as they go through that transformation stage from subcontractor to prime contractor, where they get better margins and better control," Hannan says.

Filapek-Vandyck also likes the mining services sector. Many of the companies have full order books, have contracts with mining companies for the next two to three years and many are cashed-up and paying dividends.

However, Filapek-Vandyck says investors must be careful. Mining services companies are benefiting from the huge expenditure from the mining companies as they bring projects online.

Filapek-Vandyck says expenditure is peaking. In another three years, he expects the spending will taper off but the market could start to anticipate that earlier. Those mining services companies on big price-earnings multiples could see their share prices drop, he says.

Other sectors

Information technology and telecommunications are other sectors doing well.

Filapek-Vandyck favours ASG Group, which supplies IT consulting and support services. About 70 per cent of the company's revenue is under long-term contracts and it pays a dividend of about 8 per cent, fully franked, he says. Filapek-Vandyck likes stocks that pay secure dividends because it usually means the company's share price has a limited potential downside.

Black's fund holds shares in M2 Telecommunications and Amcom Telecommunications.

Both companies delivered standout results in the reporting season, Black says. Amcom rolls out optical fibre, has its own network and competes with Telstra.

M2 Telecommunications provides phone, mobile and internet services to businesses in Australia and New Zealand.

Filapek-Vandyck also likes Hansen Technologies, which provides customer billing services to telcos and energy utilities around the world.

Black and Filapek-Vandyck say the Breville Group is an outstanding example of how a manufacturing company can do very well despite the high Australian dollar. Breville makes small kitchen appliances and sells them to the world. In the US and Canada, Breville is regarded as a premium brand by consumers. "Breville is just pure management talent," Filapek-Vandyck says. "The Australian dollar is working to its disadvantage but it is still doing very well." Black says Breville is expanding its business rapidly in the US, where it still has only 10 per cent of the premium market.

Breville shares are trading on a price-earnings ratio of only about nine times next year's earnings. It also has lots of cash on its balance sheet and no debt, Black says.

Regis Resources is a gold explorer and producer that is favoured by Eley. "It is an extremely well-run and highly professional organisation and has an exceptional track record of delivery," he says.

He holds the stock not so much because the company produces gold as for its good management, though the outlook for the gold price is reasonable. "It is producing gold for $US500 an ounce and selling it for $US1700 - it's hard not to make a quid doing that," Eley says.

Steve Black also likes realestate.com.au. "The latest profit report showed us that it is a resilient business," he says.

Despite a soft market for real estate sales, the company generated a profit growth of nearly 20 per cent.

It shows it is benefiting from real estate classifieds migrating from print to online, Black says.

He owns shares in realestate.com.au and not classified websites for employment, cars or accommodation because the migration to online in those markets is well advanced. Real estate's move has further to go, he says.