Stress testing the Uncapped 100

Some gains have been given up in recent weeks … but the top 10 are still well ahead.

Summary: Our “outperform” rates stocks have given up some ground in recent weeks, but overall the top 10 are still well ahead of the market. Indeed, so far they have generated an average total return of 42%. But there have also been a few clangers, generally reflecting specific company issues.
Key take-out: Material changes in the ratio between cash flow and profit from year to year can often be a useful early indicator for non-financial companies.
Key beneficiaries: General investors. Category: Shares.

The end of the year shouldn’t only be associated with merry-making and presents. It should also be a time to review your investments, particularly after what can only be described as a trying few weeks.

The S&P/ASX Small Ordinaries Index has given up around 7% since November (with the top 200 stocks down around 2%), and one-off disasters such as the Forge Group (FGE) rout are still ringing in the ears of shell-shocked shareholders.

But in small caps, it’s all about having big winners that can neutralise negative surprises: gaming systems provider eBet (EBT) has more than doubled since our “buy” call, while emerging copper producer Tiger Resources (TGS) has lifted 73%, and mining contractor WDS (WDS) has climbed 65%.

Don’t forget the top 10 stocks with our “outperform” recommendation have generated an average total return of 42% so far.

However, not all the stocks we like have done so well. The 20% average gain on our “outperform” rated stocks earlier on has halved in the past few weeks. But our buy calls, which still outperform the wider market, are meant to deliver double-digit returns over a year – not a few months.

Indeed, there are nine that are behind the broader market by 10% or more, and the close of the year is the perfect time to do a stress test on the laggards.

Stressing the stress test

The Forge debacle has taught us a thing or two: The smoking gun was in its full-year result in August, when the engineering contractor reported a 28% surge in net profit to a record $62.9 million but an 80% decline in cash from operations to $17.9 million.

If anyone had caught that anomaly and dug a little deeper, it would have revealed liquidity problems in the business and the fact that it was booking a lot of profit well ahead of receiving the cash.

Uncapped 100 stocks with the lowest cash flow to net profit conversion

CodeNameCPS/EPS* FY13 (%)CPS/EPS FY12 (%)Change WC** (%)Total debt/equity (%)Est FY13 P/E (x)
CWP Cedar Woods Properties-40.6696.52-37.9419.6311.70
TAN Tandou12.5510.42-4.1329.8322.86
FGE Forge Group32.46189.6344.1612.043.78
CCP Credit Corp Group32.56145.820.296.8212.04
CCV Cash Converters International36.4910.98-41.1929.3511.48
TFC TFS Corporation39.18-325.180.2650.5712.43
CLV Clover Corporation41.56178.789.950.0020.60
* Operating cash flow per share to earnings per share    **Change in working capital from FY12 to FY13
Source: Eureka Report, Bloomberg

Material changes in the ratio between cash flow and profit from year to year can often be a useful early indicator for non-financial companies and is easy to work out from a company’s balance sheet.

The ratio should generally be above 100% as depreciation and amortisation is taken out of profit but not cash flow. Investors should be asking questions when the ratio strays too far below that point, especially if this has not been the case before.

The good news is our “outperform” recommendations comfortably meet this rule. This is true even for mining services companies NRW Holdings (NWH), LogiCamms (LCM) and WDS (WDS). NRW’s operating cash flow to operating profit ratio stands at 159%, while LogiCamms and WDS come in at 139% and 255%, respectively.

This means they are unlikely to deliver a similar nasty surprise as Forge did, although this doesn’t make them immune from a profit downgrade given the slow pick-up in capital spending by resource companies and the competitive bidding environment. Investors should be cognisant that the sector is only for the risk tolerant, although I continue to see value in the three names.

Wooden spoon goes to resources

Worst performing Uncapped 100 stocks with an outperform recommendation

NameCodeArticle dateArticle nameTotal rtn* (%)Alpha** (%)
Horizon OilHZN17-Jul-13Five bargains for under a buck-18.62-27.24
Beadell ResourcesBDR28-Aug-13Short-selling gold signals-20.81-25.95
YTC ResourcesYTC9-Oct-13Xmas sale starts early for small caps-23.08-25.84
Universal BiosensorsUBI4-Sep-13Smalls in sweet spot-21.32-24.40
ThinksmartTSM21-Aug-13Biggest smalls earnings surprises-18.31-23.46
Starpharma HoldingsSPL17-Jul-13Five bargains for under a buck-12.23-20.85
Silex SystemsSLX3-Jul-13Why a dog can be an investor's best friend-3.02-17.12
NewsatNWT3-Jul-13Why a dog can be an investor's best friend-2.53-16.64
M2 Telecommunications GpMTU10-Jul-13Big expectations for small caps-3.60-14.02
*Total return (including dividends) since article was published   **Alpha = difference in performance between stock and ASX All Ords
Source: Eureka Report, Bloomberg

But it is not our mining services calls that are giving the most grief. It is the resources names like Horizon Oil (HZN), Beadell Resources (BDR) and YTC Resources (YTC) that are at the bottom of the performance table. They are lagging the ASX All Ordinaries Index by over 25% each as they struggle with a variety of issues.

Horizon has fallen out of favour as shareholders’ dividend hopes were dashed and as the oil price trended lower over the last several weeks.

The market was expecting to hear management give a more concrete guidance on when the emerging oil and gas producer would start a payout policy, but management backed away due to a shutdown of the Maari field in New Zealand that will see a $13 million revenue deferral and $7 million in upgrade costs.

But Horizon remains one of the better valued fledging oil producers and the stock should be trading at 60 cents, not 30-plus cents. It should get there once investors become more confident about the ramp-up and sustainability of output from its Beibu field in China and the restart of Maari.

Oil prices are also likely to rebound in the near term. November has historically been the weakest month for crude, while the first half of the calendar year tends to see the strongest gains.

Gold miner Beadell Resources is also in the dog house. There is nothing wrong with the company – the problem is the gold price, which has been on a downtrend since August as it shed 14% of its value.

There are real concerns that gold will retest an important support level at $US1,200 an ounce in the coming weeks, if not days. If gold falls under that psychologically important level, it will likely fall to $US1,000 an ounce.

The upside for Beadell is that its flagship Tucano gold mine in Brazil can probably survive when an ounce of gold fetches around $US1,000, as its cash cost is hovering round $US600 an ounce. The question is where gold will end up if it does breach $US1,000, and that is the key reason why investors have shied away from the stock.

If you believe gold will hold above $US1,000 an ounce and you want equity exposure to gold, Beadell is arguably the best stock to hold. Otherwise stay away.

Diversified metals miner YTC Resources (YTC) rounds up the worst three on our “outperform” list, with the stock re-testing its three-month low of 20 cents.

Investors have been quick to dump the stock after its latest drill result at Nymagee North failed to find the mother lode of base metals. Expectations were high as the down-hole electromagnetic (DHEM) test indicated a large body of mineralisation.

Management believes there is still a good chance of finding the ore body and that the body may be deep and not wide.

However, investors are in no mood for disappointments, and have decided to sell first and ask later, especially since YTC is also exposed to gold through its Hera project, which will start commercial production next year. YTC also mines for copper, lead and zinc.

While exploration results will impact on the stock, I like YTC because the Hera project is fully funded and the company is transitioning from an explorer to a producer. The “corridor” between Hera and the adjacent Nymagee projects in New South Wales is also highly prospective, and I suspect we will see more good news from the ongoing drilling program.

But you shouldn’t think that all our “buy” calls have the same risk profile. Resource and resource-related stocks were always going to be more volatile compared to other stocks we are bullish on, such as packaging company Colorpak (CKL) and automotive services and products company AMA Group (AMA).

Funding Sources

The sell-downs of medical device developer Universal Biosensors (UBI), consumer financing solutions company ThinkSmart (TSM) and biotech Starpharma Holdings (SPL) are primarily driven by investors looking to free up cash.

The issues for investors is that there are around $8 billion worth of small cap initial public offerings, a number of capital raisings have been announced since September, and fund managers are selling off some stocks to raise cash to participate in these events.

The good news is that nothing has fundamentally changed for the three stocks. If anything, ThinkSmart has confirmed that its turnaround remains on track and that it will start paying a dividend a year sooner than most were expecting.

Starpharma also recently released good news. The preclinical study using its dendrimer formulation in cancer blockbuster drug docetaxel yielded positive results, but that was not enough to save the stock from falling 20% since October.

Universal Biosensors is the only one that gave investors good reason for its price pause. The launch of the company’s anti-coagulation testing device that it is developing with Siemens has been pushed into the first half of 2014 from the end of 2013.

The three stocks represent very good value and I reiterate my “outperform” call on them in anticipation that their share prices will rebound over the next 12-months.

Other Stragglers

The final three underachievers have company specific issues that are dogging their share prices. Laser developer Silex Systems (SLX) is weighed down by worries that the two uranium enrichment plants using its technology will not be built due to the poor sentiment surrounding nuclear power.

The spot uranium price was trading close to $US50 a pound in September, but has given up a quarter of its value since.

However, the uranium price seems to have found a floor around $US34 a pound and is trading around $US36 per pound currently.

The proposed Paducah plant in the United States also took a big step forward to becoming a reality last week, although the truth about investing is Silex is that it is a “slow burn”. Investors will need to be patient as the company will need a few years to live up to its potential.

It is anyone’s guess when the final investment decision for Paducah in Kentucky or the Wilmington plant in North Carolina will be given by Silex’s joint-venture partner GE-Hitachi Global Laser Enrichment (GLE).

The plants themselves take a few years to build, and Silex’s new solar panel system will take a similar amount of time to prove that it can be a commercial success. Buying such stocks is always a high-risk endeavour as Silex’s future is almost a binomial outcome. It needs to get at least one of its products to become an industry standard if the stock is to be worth anything.

I fear local investors are not patient enough to back what could be one of the greatest Australian innovations.

Satellite hopeful Newsat (NWT) is one I am having the most doubts on among the “outperform” calls. The company’s surprise revelation about the funding facility it obtained with Orbital Capital gives me cause for concern as the debt is supplied on what I consider “loan shark” terms.

The fact that the deal, which I believe is material to the value of the company, wasn’t announced earlier makes me wonder what else management is not saying.

However, the launch of its satellite in 2015 appears to be on track. Now that the funding is in place, the successful launch of the satellite is really out of management’s hands. If the satellite makes it to orbit (and works), the stock will be strongly re-rated.

For this reason, I will keep the “outperform” recommendation, at least for now; but it is one that you need to keep your eye on.

Meanwhile, telecommunications reseller M2 Telecommunications Group (MTU) is on the out with investors, with the stock trading at a five-month low of around $5.50.

The weakness is not specific to M2. Its peers, such as iiNet (IIN) and TPG Telecom (TPM), have also been under pressure since November. The drop in their share prices isn’t particularly surprising either as these stocks have done very well.

While the All Ords has delivered a 17% total return in 2013, M2 has generated returns that are more than double the broader market.

I believe M2 will find favour with investors again due to its attractive valuation and strong track record. Corporate activity also cannot be ruled out.

Think big, go smalls!

Uncapped 100 - Australia's most interesting small cap stocks

Small cap stocks covered by the Uncapped team
CodeNameRationaleMarket cap ($m)Total return 1-year (%)Sector (GICS)
NHF NIB Holdings Only listed health insurer. Widely held. Good performer.1,058.0026.09Financials
MTU M2 Telecommunications Group Amazing growth story and well run company. High free float and strong insto support.1,031.4659.07Telecommunication Services
MMS McMillan Shakespeare One of the best performers since the GFC, but ongoing risk of change to FBT rules will hang over the company.922.61-3.13Industrials
GEM G8 Education Only listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.920.43122.23Consumer Discretionary
ARP ARB Corp Well covered but good candidate for core holding due to quality management.863.2514.11Consumer Discretionary
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding.802.0149.94Consumer Discretionary
MRM Mermaid Marine Australia Its strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.761.944.71Industrials
BGA Bega Cheese Corporate interest in Australian food companies makes the cheese maker worth following.693.01149.06Consumer Staples
AUB Austbrokers Holdings The insurance broker is a strong performer. Widely held and well liked by small cap investors.690.9249.67Financials
SRX Sirtex Medical A shining star in the biotech space and one of the best performing stocks in 2012. Great product (liver cancer treatment) and bright outlook.666.292.18Health Care
RFG Retail Food Group Owns a number of well know franchise brands. Widely followed by instos.617.9259.31Consumer Discretionary
SGN STW Communications Group One of few companies able to benefit from online shift. Widely held and good insto support.595.6545.04Consumer Discretionary
BDR Beadell Resources Will be a very big FY14 for miner as it has to prove it aims to produce 200,000 ounces of gold a year.531.76-37.73Materials
AMM Amcom Telecommunications Well covered junior telco but good candidate for core holding.503.7954.8Telecommunication Services
CWP Cedar Woods Properties Property developer with good ROE and earnings growth track record.494.7561.39Financials
TOX Tox Free Solutions Widely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.463.6824.04Industrials
SEA Sundance Energy Australia Analysts have a favourable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.460.3023.6Energy
TGR Tassal Group Salmon farmer is finally turning a corner with an improved harvest strategy and growing demand for product.449.04134.36Consumer Staples
RCR RCR Tomlinson Good first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?426.4986.4Industrials
MYS MyState Well regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.418.4542Financials
NXT NEXTDC The cloud computing company is an IT sector darling. Fairly widely held and followed.411.6312.63Telecommunication Services
CCP Credit Corp Group Strong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.405.9617.73Industrials
BRU Buru Energy Substantial size but not often covered by press. Widely held with good insto support.396.83-51.81Energy
ACR Acrux One of the most successful Australian biotechs in recent history. Widely held by instos.388.83-16.1Health Care
MYX Mayne Pharma Group Sizeable generic drug maker with interesting board members.385.97114.06Health Care
HZN Horizon Oil One of better regarded small energy stocks that doesn't receive much media attention.379.94-34.22Energy
SLX Silex Systems Its uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.367.84-29.41Information Technology
MOC Mortgage Choice Has a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.363.9185.48Financials
IPP iProperty Group Worth watching as it is trying to be the REA Group of Asia.352.82126.16Information Technology
BNO Bionomics One of the larger cancer treatment developers in this market.350.34171.43Health Care
NWH NRW Holdings One of the better regarded mining & civil contractors with good track record in delivering on projects.346.524.43Industrials
UXC UXC Company has turned corner and enjoyed re-rating. What's next?344.598.18Information Technology
CCV Cash Converters International Strong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.343.17-18.53Consumer Discretionary
TGA Thorn Group One of few retail stocks that is performing well despite its flat outlook for FY14. The Radio Rentals chain owner is also well supported by instos.340.9726.7Consumer Discretionary
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 311.7033.11Financials
VOC Vocus Communications Telecom stocks are in favour but Vocus is one of the least covered286.77125.74Telecommunication Services
GXL Greencross Acquisitive veterinary group. Good profit growth and share price performance, but gets little press.286.39151.01Health Care
RKN Reckon Fierce competition for cloud base accounting software puts it in firing line.284.39-4.39Information Technology
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal liner on diabetics.274.9311.9Health Care
SHV Select Harvests Noteworthy for turbulent past and exposure to soft commodity market.273.47262.81Consumer Staples
RIC Ridley Corp High corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.266.26-13.21Consumer Staples
IMF Bentham IMF Litigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.265.137.48Financials
TFC TFS Corp The sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.252.53106.64Materials
TGS Tiger Resources Future lies in its Kipoi copper mine expansion in the Congo but miner is fully funded with DRC govt holding 40% stake in tenement. Next 12mths will be interesting.247.9314.29Materials
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.239.9526.96Financials
NAN Nanosonics A successful medical tech story. Should be close to turning in maiden profit with its disinfection device.231.2877.78Health Care
NWT Newsat Potential large cap if it can launch its own satellite in 2015.230.67-25Telecommunication Services
SPL Starpharma Holdings Noteworthy for its good pipeline of innovations. Well run, widely followed.226.24-27.73Health Care
CLH Collection House In similar space as Credit Corp. Strong stock performance has attracted a following and the stock appears to be well placed to run further216.0283.97Industrials
SIV Silver Chef Strong jump in the share price of the equipment financing group has attracted a good following.215.3154.52Industrials
MXI MaxiTRANS Industries Transport equipment maker posted good interim result. Has appealing yield and growth.212.5126.41Industrials
WBB Wide Bay Australia The building society is trying to turn its fortunes around. Also worth watching for its exposure to Queensland housing market, particularly around major resource projects.212.36-2.65Financials
RCG RCG Corp The footwear retailer is one of the best performing consumer stocks as online competition is not a big threat. Company has a good yield as well.195.4289.77Consumer Discretionary
PFL Patties Foods Illiquid stock but has suite of well recognised consumer brands. Defensive yield.194.80-3.24Consumer Staples
NEA Nearmap A stellar performer with an Interesting business that offers high quality aerial maps to companies & government.191.641343.75Information Technology
HSN Hansen Technologies Operates in a high potential/growth industry but is not covered by press or brokers.189.4846.01Information Technology
ACL Alchemia One of the few biotechs with revenue stream. Good pipeline of oncology treatments.183.29-0.88Health Care
DWS DWS Will be a big beneficiary if governments start spending on IT again.180.681.09Information Technology
IFM Infomedia Interesting tech play in the car parts market. Strong share price gain but gets little air play.179.9264.36Information Technology
SFH Specialty Fashion Group In early stages of turnaround. Can the women's apparel retailer sustain the momentum?173.9747.16Consumer Discretionary
ESV Eservglobal Mobile money transfer company that has been gaining traction. Widely held by instos but low press coverage166.8681.08Information Technology
CKF Collins Foods One of the few food franchise listed companies.165.5447.4Consumer Discretionary
DTL Data#3 Well respected IT company that receives little press coverage.153.97-8.01Information Technology
MLB Melbourne IT A perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.150.8128.51Information Technology
MCP McPherson's The personal care and household products supplier had been relatively insulated from volatile discretionary spend and online threat, but its latest profit warning shows it's not immune.143.11-5.2Consumer Discretionary
BGL BigAir Group The wireless small cap has gained strong following over past year or two but is often overlooked by investors and the press.134.2040.43Telecommunication Services
GHC Generation Healthcare REITOne of the more interesting REITs. Income is more defensive than typical property stock and its greenfield expansion gives it earnings growth potential.133.0633.31Financials
AZZ Antares Energy Liquid with good insto support. Already in production with exploration upside in Texas.128.77-3.81Energy
WDS WDS Widely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.124.4879.87Industrials
AMA AMA Group Good turnaround story but under the automotive services group is radar of most.120.330.39Consumer Discretionary
POH Phosphagenics Sizable biotech with a game changing FY14 year ahead. Good insto following but questions of poor audit and governance standard could dog company.117.35-20.69Health Care
IMD Imdex Drilling company is well supported by instos and should benefit from any rebound in exploration activity.113.66-53.62Materials
SAR Saracen Mineral Holdings Emerging gold producer that is widely held by instos. Hitting milestones and looks cheap. Key asset is close to gold majors, which makes it a potential takeover target.111.61-56.4Materials
MNW Mint Wireless Huge market potential if the mobile card payment solutions provider can gain market traction. Management aiming for $1 billion in transaction value a year.111.061427.78Information Technology
JIN Jumbo Interactive Innovative small cap facing off industry dominated by giants. Worth watching to see if it can carve out a profitable global business.107.1913.34Consumer Discretionary
LCM LogiCamms Strong price performance and reasonable valuation attracting interest.101.9648.82Industrials
REX Regional Express Holdings Well run airline that is overshadowed by Virgin and Qantas.100.24-14.55Industrials
RUL RungePincockMinarco IT company to resource industry. Facing tough operating climate with new CEO trying to restructure and turnaround company.96.8348.91Industrials
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.87.32-43.82Health Care
CLV Clover Corp One of the star performers in 2012. Operates in growing but relatively stable niche.85.8916.14Health Care
LGD Legend Corp Electronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.83.4135.59Information Technology
DRM Doray Minerals Widely held by instos. One of the more favoured gold explorers by brokers.82.99-26.42Materials
EML Emerchants Trying to change way corporates and governments disburse cash with its trackable and controllable debit card offering. If company can get $1 billion in loaded value on cards, the stock will surge.81.03225Financials
CAA Capral An aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 80.450Materials
AOH Altona Mining Noteworthy copper play with Xstrata pull-out of Roseby project in Australia and the good ramp up of its Finnish project.77.17-42Materials
TAN  Tandou The only direct equity exposure to cotton prices. Also trades water rights and receives little press.68.7219.56Consumer Staples
CKL Colorpak The small cap packaging company has grown via acquisitions over past few years.67.6849.95Materials
PEN Peninsula Energy Widely held by instos and large free float. It's the only uranium miner on the list.66.94-38.89Energy
BOL Boom Logistics Crane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid.65.29-50.89Industrials
YTC YTC Resources Next 12-mths will be eventful after YTC secured funding for its projects from Glencore.57.60-34.85Materials
FGE Forge Group Good track record has been marred by a recent shock downgrade and capital raising. How long will it take to redeem itself?57.30-79.19Industrials
KOV Korvest The construction products and services supplier has been hit by project delays and deferrals. But its relatively high yield could give it some support.55.09-0.47Industrials
OTH Onthehouse Holdings Alternative small cap to online property leader REA Group. It is trying to use more timely housing data as a competitive edge against REA.51.77-7.35Consumer Discretionary
CUV Clinuvel Pharmaceuticals Interesting skin disorder treatment developer that has done reasonably well over past year50.83-26.11Health Care
TSM ThinkSmart Potential turnaround story worth keeping eye on.47.8859.46Financials
EBT eBet Potential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.42.91191.46Consumer Discretionary
NTC NetComm Wireless Under appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.39.90129.63Information Technology
GXY Galaxy Resources Good upside potential if it can get its problem-prone Jiangsu plant back on track. Won't be easy to right this ship.39.80-86.06Materials
UML Unity Mining Growing Tassie gold producer with high free float. Valuation looks compelling too.33.70-63.08Materials
PGC Paragon Care Emerging hospital equipment supplier that has been ignored by market.22.34110.69Health Care
Source: Eureka Report, Bloomberg

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