|Summary: As the full-year profit season approaches, the market and investors will primarily be focused on one thing – those that have delivered and those that have failed. And it’s these performance expectations that are hanging over the small cap sector. Based on their first-half results, it’s evident many smaller companies will struggle to meet their full-year profit expectations.|
|Key take-out: As a group, in the first half small caps only delivered 33% of their forecast full-year earnings before interest, tax, depreciation and amortisation and 44% of sales.|
|Key beneficiaries: General investors. Category: Small caps.|
The recent resilience shown by the ASX as it tracks higher despite global dramas in both the Middle East and the Ukraine has increased the risk of things turning ugly this August when companies hand down their profit score cards.
The reporting season begins in earnest next week and runs through until mid-September. It's no exaggeration to say it is the most important reporting season in years. Here’s why: For the last two years many stocks have rafted higher as the market staged a widespread recovery, but in the months ahead it is expected that only the companies with strong earnings will continue to see stock price rises. To see this week’s webcast on the reporting season outlook, click here.
If anything, the ‘jitters’ have been heightened by the strong rally in equities, with the ASX All Ordinaries Index flirting with a six-year high after notching up a 12% gain over the past 12-months. Remember, this is against a background of below trend economic growth.
Small cap investors have more to fear than blue-chip stock investors from the reporting season. This isn’t because of overstretched valuation concerns ,given that small industrial stocks have only managed to chalk up half the gains of the broader market. But it’s because earnings expectations are crucial this time round. More to the point, earnings expectations for the second half of the year (the six months to June 30, 2014) are often expected to bring home the bulk of the result.
It’s the “curse of expectations” that is haunting the small cap sector.
Research carried out by Eureka Report shows that small caps need to bring in earning improvements that are literally twice as strong to satisfy the market.
Analysts polled on Bloomberg are expecting an 11% uplift in earnings before interest, tax, depreciation and amortisation (EBITDA) to $1.53 billion for stocks in the S&P/ASX 100 Index for 2013-14.
In contrast, growth forecasts for small cap stocks are much higher. Consensus estimates is tipping a 24% jump in EBITDA to $151.6 million for companies in the S&P/ASX Small Ordinaries Index.
This in itself isn’t necessarily a worry. After all, small cap stocks are generally better placed to deliver higher earnings growth as their profits are coming off a lower base. Besides, who’d invest in small caps if they offered the same growth rates as blue chips?
No, the thing that should concern investors is the “earnings stretch”, as this is far more extreme for these juniors when compared to their bigger rivals.
The “earnings stretch” refers to the profit a company needs to make in the second half of the financial year in order to meet full-year profit expectations.
In the case of the large caps, these companies have on average already booked 52% of their expected full-year EBITDA and 59% of annual sales in the six months to end December last year; while small caps have only delivered 33% of full-year EBITDA and 44% of sales in the first half.
The disruption caused by the federal election is largely to blame for the large second-half skew, but the data is also somewhat distorted by significant earnings growth divergence between stocks in the Small Ordinaries and by the lower quality of consensus data as there are far fewer analysts covering the junior end of the market.
However, there’s little doubt that trading conditions would need to improve markedly in the second half if many small cap companies are to meet expectations.
I am not saying there is an impeding earnings disaster in August, but certainly the risk of disappointment is greater among smaller stocks. One cannot be complacent by giving management the benefit of the doubt while business and consumer confidence remains fragile.
This threat is underscored by the fact that 85% of the 55 companies with an earnings stretch of 65% or more in the second half have a market capitalisation under $3 billion, according to data compiled from Bloomberg.
Nevertheless, small companies have a number of levers they can pull. Indeed at Eureka Report we believe our selection of small cap stocks made over the last year can comfortably transcend the hurdles ahead for the wider market and thrive in the months ahead. To read more on the Eureka Report outlook for the earnings season click here for Brendon Lau’s stocks Bring it on for these guys, and click here for Simon Dumaresq’s stocks, Healthy outlook in chosen few.
Indeed, it is also true that many small-caps beyond our immediate selection have specific positive factors that need to be taken into consideration. Take sandalwood grower TFS Corporation (TFC) for instance. Management said this month that it would deliver a record net profit of at least $70 million in 2013-14 thanks to the acquisition of plantations worth $35 million. The company had delivered a first half net profit of merely $3.2 million. TFS is not covered by Eureka Report.
There are also signs that the embattled information technology consultancy sector has turned a corner as government and enterprise customers cut back on IT projects. Data#3 (DTL) told investors last week that it has experienced a “very strong fourth quarter”, and UXC (UXC) defied sceptics last month by forecasting a doubling in underlying EBITDA to between $23.2 million and $25 million in the second half over the first half.
Simon Dumaresq has a “buy” recommendation on UXC as he felt too much bad news was being priced into the stock, and he will provide a more detailed update when the company releases its full-year earnings. Data#3 is not covered by Eureka Report.
Small cap investors should be feeling nervous given the complacency that’s hanging over our market, and I am expecting a rebound in market volatility in August. If volatility returns to five-year averages, we will see around a 50% increase in share price swings.