Sticking with the junior stocks

The market pullback this month – a 2.6% tumble in the ASX All Ordinaries Index and 2.1% fall in the S&P/ASX Small Ordinaries Index – mark the end of the relatively smooth sailing equity investors have enjoyed for the last six months.

It’s hard to imagine stocks rebounding quickly after such a large sell-off.

But this shouldn’t stop investors from expecting great things from smaller stocks this year. Worries about overstretched market valuations and global economic headwinds won’t stop the juniors from delivering a strong return in 2014.

It’s a bold call to make given the panic on emerging currency markets, the slowing Chinese economy, rising domestic unemployment and the difficult rebalancing act Australia has to pull off as mining investments come off the boil. But I believe small stocks will scale the “wall of worry”.

There are three factors outlined below that are supporting my optimism:

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1. Here come the upgrades

One factor that will keep small industrials well supported is the potential for earnings upgrades this year as we head into the February reporting season.

The profit season will be even more heavily scrutinised following this week’s market shake-up, as investors will be looking for new reasons to stay bullish on equities. I don’t think shareholders will be disappointed.

While analysts have already been lifting their earnings projections modestly over the past few months, earnings expectations are still relatively subdued and there’s plenty of room for forecasts to rise if the rebound in business confidence takes hold.

Don’t get me wrong, I am not expecting a stellar set of numbers for the February reporting season as companies hand in their report cards for the six months to December last year. That period was mixed at best, given the uncertainties hanging over the global economy and the Australian political landscape.

The more important thing to be watching for will be the outlook statements, as I suspect company managements will be sounding more upbeat about the future than they have in some time. That could be enough for analysts to take a relook at their 2013-14 and 2014-15 assumptions.

As it stands, consensus estimates are tipping an 8% increase in total earnings per share (EPS) for stocks on the ASX Small Industrials Index to $31.92 for 2013-14. Sure, the outlook for the domestic economy is far from rosy and the forecasts do vary greatly within the group, but the growth estimate still looks too conservative.

For one, the five-year average EPS growth for the group is 32%. Further, the lift in EPS is predicated on a similar revenue growth rate.

Total sales for the 134 stocks on the ASX Small Industrials Index are forecast to rise 7.9% for the current year to $154.6 billion before a further modest 3.2% lift in 2014-15.

This implies the lack of operating leverage. That doesn’t sound right as profits typically increase faster than sales at this point of the business cycle because costs rise slower than revenue. There should be a fair amount of operating leverage in the sector given that companies have been aggressively cutting costs to weather the downturn in business.

Also, if the recovery does take hold this year as we are expecting, sales growth in 2014-15 should be well ahead of the current financial year.

2. The liquidity boost

Operating leverage isn’t the only lever managers can pull to bolster profit. There is also financial leverage through the use of debt.

This is a very significant factor as it can provide a huge boost to the cash holdings of small industrials given that companies outside the resources space appear to have plenty of capacity to borrow.

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Depending on the matrix you use, the level of debt for the small industrials group is the lowest it has been in almost a decade, if not longer. For example, if the debt-to-asset ratio for small industrials was to return to the 10-year average of around 35% from its current level of 26%, it could theoretically inject an additional $22.2 billion into their coffers.

To put this in context, the cash infusion from debt would nearly double the existing cash holdings of the sector.

The capacity to borrow is greater among small industrials than their larger rivals too, since both the debt-to-equity and debt-to-asset ratios for the S&P/ASX 100 Industrials are hovering around their historical averages.

Indeed, the low gearing at the smaller-end of the market isn’t driven by banks. While financial institutions were very reluctant to lend to small businesses coming out of the global financial crisis (GFC), this isn’t the case anymore. The low debt level is now caused by companies’ reluctance to borrow due to their lack of confidence. When confidence and earnings rebound, demand for debt will rise.

This may not happen in the near future, but is significant because junior industrials will be relatively unencumbered by the lack of financial muscle when they choose to expand – either organically or through acquisitions.

3. Takeovers accelerating

This brings me to the last factor that is likely to support the sector: acquisitions.

Nothing fires up animal spirits like takeovers, and you can bet that managers in better-placed companies are running a ruler over their competitors to consolidate their market position for the eventual recovery.

Powered by their ability to borrow, they know the clock is ticking. Interest rates won’t stay low forever and the value of companies are poised to rise this year, making takeovers more expensive and riskier to pull off.

We highlighted mergers and acquisitions as one of the themes for 2014 last year, and there has already been a more than three-fold increase in corporate activity on last year in the first month of the year.

The value of announced and completed deals in January currently stands at $3.97 billion compared with $1.11 billion for the same month in 2013.

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Even junior gold miners are jumping in on the act, with Northern Star Resources offering to buy Barrick Gold’s 51% stake in the East Kundana joint venture and Barrick’s 100% interest in the Kanowna Belle mine in Western Australia for $75 million. Also, Saracen Mineral Holdings has signed an agreement to buy the Thunderbox and Bannockburn gold mines in Western Australia from Norilsk Nickel for $20 million plus an earn-out payment and royalty fee.

This is a noteworthy indicator of confidence as junior gold miners are arguably the most beaten-down sector on our market.

Think big, go smalls!

* This article is part of the “It's Time” series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.