Stress testing the Uncapped 100

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.

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

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!