Three small caps morphing into market leaders

Here’s a myth worth busting: no advantage can be gained by buying stocks that are about to be included in a large cap index.

There is a widely held view that inclusion in a key market index, such as the S&P/ASX 100 or S&P/ASX 200, does not preface a period of outperformance by the newly promoted stock.

The primary motivation to invest in small caps is to pick tomorrow’s market leaders, but investors haven’t regarded this rite of passage that all leading companies have to undertake as a “buy” signal.

There are a few reasons for this. For one, experts don’t believe that demand for a stock changes much post index inclusion.

While WilsonHTM Investment Group estimates that index funds (funds that are obliged to buy stocks in their respective index) have two to three times more influence over the price of companies moving in or out of the S&P/ASX 100 Index compared to a year ago, the impact of these funds accounts for only around 1.5 percentage points of a stock’s movement.

Further, funds that only invest in stocks at the bigger end of town can take their time to buy the new index recruits. And given that these “newbies” will have relatively small market capitalisations compared with existing stocks in the index, the new stocks aren’t usually a priority for these fund managers.

There are also valuation concerns over the new entrants, as investors generally see these stocks as having run too hard. After all, stocks that climb into the top 100 index must have performed well before Standard & Poor’s (the operator of the main ASX indices) will consider them for a promotion.

However, there is empirical evidence to suggest that these stocks do outperform the market in the months following their promotion into an index.

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Morgan Stanley studied S&P/ASX 100 entrants since 2001 and found that 70% of them (excluding resource stocks) posted better returns than the market in the first month of their inclusion, with a median outperformance of 2.5% over the top 100 benchmark. This outperformance is called “alpha”.

At the three-month mark, 68% of these stocks outperformed with a median alpha of 5.2%, and 62% of new entrants outperformed by a 7.5% margin after 12-months.

One likely reason for this is because these new index members have proven themselves to have a superior business model compared to their rivals.

On the other hand, resource stocks entering an index behave more erratically as they are generally more volatile and their continued success often hinges on exploration success or hitting production milestones.

Small caps on the cusp

Picking fledgling industrial stocks before they are added to the S&P/ASX 100 Index should yield even better returns.

From this perspective, investors should be looking at education services company Navitas (NVT) and business standards auditor SAI Global (SAI), as both are likely candidates and “high conviction” buys, according to Morgan Stanley.

Other high conviction candidates listed by the broker include outdoor and auto retailer Super Retail Group (SUL) , funeral services company Invocare (IVC), and pizza delivery chain Domino’s Pizza Enterprises (DMP).

But picking juniors that are about to be included in the S&P/ASX 200 Index may be a more rewarding exercise.

“Most hedge funds I speak to about [index trading] don’t trade the ASX 100,” said WilsonHTM strategist, Damien Klassen.

“The ASX 200 index and the MSCI Australia indices have been more reliable than the ASX 100 at producing short-term returns.”

Newbies to the S&P/ASX 200 Index also seem to deliver superior alpha over the medium term.

Data compiled by Eureka Report of juniors that were added to this index from the December 2010 to March 2012 quarters show a similar percentage of stocks running ahead of the market as in the Morgan Stanley study, but with a stronger median excess return of 10.7%.

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The result is more stunning at the six-month mark, with all of the new entrants outpacing the S&P/ASX 200 Index with a median alpha of 12.1%.

These juniors are coming off a lower base, so their better percentage return over their bigger brothers is understandable.

S&P chooses stocks based on market capitalisation and liquidity (the percentage of all shares that can be freely traded). The question now is which small cap stocks are strong contender for the S&P/ASX 200 Index and trading on reasonable, if not attractive, valuations.

Forge Group (FGE)

The engineering and construction group fits the bill, with Clough having sold its 35.9% stake in Forge last month.

This has dramatically increased the liquidity of the stock, with the 30-day average trading volume jumping more than three-fold since to 1.5 million shares a day.

Critics will say this is the wrong time to be looking at the sector given that miners are cutting back on spending, but Forge appears well placed in this downturn.

As Foster Stockbroking pointed out last week, miners are cutting costs by going straight to subcontractors instead of using larger manager contractors. They are also electing to operate their own facilities as opposed to outsourcing the work. Forge isn’t exposed to either of these areas.

Further, the group has an order book of $1.04 billion, which essentially means its 2012-13 and first-half 2013-14 revenues are locked in.

The group is forecasting around a 25% increase in full-year sales to between $950 million and $1 billion, and around a 34% surge in net profit to between $63 million and $70 million.

Not many engineering firms can offer that much transparency when it comes to future earnings, and all brokers polled on Bloomberg are urging investors to buy the stock.

Forge is already a sizable company as its market cap stands close to $500 million, but its share price (and market cap by extension) can grow by one-third before it reaches the average broker price target.

The stock closed at $5.50 on Tuesday.

MACA (MLD)

The Western Australian engineering group has much in common with Forge. OC Funds portfolio manager, Rob Calnon, believes that the recent boost in MACA’s liquidity and the amount of revenue coverage from its current order book makes the stock a likely S&P/ASX 200 candidate in the next 12 months.

“Its founders recently sold down $35 million of stock to take their collective holding to around 32%,” he said. “This should be looked upon favourably by the ‘index gods’.”

Calnon isn’t the only one that’s convinced that MACA has a bright outlook, even in this challenging environment.

Hartleys calls MACA a “high conviction buy” as it estimates that the group’s existing work alone, which stands at around $400 million a year for the next three years, more than justifies the stock’s current price.

The negative sentiment towards the sector has sent the stock crashing 20% since it hit a record high of $3 a little over a month ago.

Hartley conservatively values the $353 million market cap stock at $3.97 a share, which implies a 68% upside to its closing price on Tuesday.

Linc Energy (LNC)

The $1 billion market cap oil and gas explorer is likely to be considered for inclusion at the next S&P/ASX 200 Index rebalance in June.

However, this is arguably the most speculative call of the three and is only suited for those with a strong stomach for risk.

It is always hard to predict the outperformance of an energy stock post index inclusion. I have been buying the stock whenever it traded comfortably below its asset value and selling when I have made two to three times my money over the past three to four years.

However, it is more challenging to value Linc on asset value since it announced a major oil find in January this year at its Arckaringa Basin project in South Australia.

The basin is estimated to hold around 3.5 billion barrels of recoverable oil and Linc is seeking to partner with a major oil company to develop the project.

The scale and complexity of the project is mind boggling, and it’s difficult to separate facts from the hype. But if the company’s Arckaringa and other North American projects live up to expectations, the stock could follow in Aurora Oil & Gas’s (AUT) footsteps.

Of all the stocks added to the S&P/ASX 200 Index in the last 2-½ years, Aurora has been the best performer at the six- and 12-month marks, as it has generated alpha of 43% and 52%, respectively.

Just about all brokers covering Linc rate it a “buy”, with an average price target of $3.30 a share. Linc closed at $1.95 on Tuesday.

Brendon Lau is the editor of Uncapped and may have interests in some of the stocks mentioned in the article.