Three small caps striking core values

The belief that emerging stocks have no place in a conservative “buy and hold” equity portfolio is grounded more in myth than fact.

While blue-chip stocks make ideal core holdings for less active investors because of their relative stability, proven business model and balance-sheet strength, a number of companies in the Uncapped 100 list have similar qualities.

The key difference between the Uncapped 100 candidates and the blue-chips is market capitalisation, as these emerging stocks have yet to crack the $1 billion milestone, although I suspect it is only a matter of time.

Opening your core portfolio to a select group of Uncapped 100 stocks will give you better diversification given that holding blue-chips will automatically give you an overconcentration in the big banks and resources.

But there’s good news and bad news to this strategy. The good news is that you will be spoilt for choice, as there are at around 20 members in the Uncapped 100 fraternity that would make ideal supplements to your core holdings.

These are companies with battle-tested business models (who said crises and economic lethargy are bad things?), at least a three-year track record in delivering earnings growth and a robust return on equity, and which are in industries with a good to stable outlook.

The bad news is that the vast majority of these stocks are looking fully if not overvalued, as they have rallied hard over the past few months on the defensive yield trade.

The buying opportunity for these stocks is probably months away if things play out the way I think they will, with investors rotating out of defensive plays and into embattled cyclical stocks, such as the miners.

This is already starting to happen, with the banks and telcos underperforming over the past few weeks, but we are really only at the start of this rotation and defensive stocks look set to get cheaper.

However, those with a different view of the market or who are reluctant to wait might like to have a look at the following three Uncapped 100 stocks. These stocks have also run up strongly, but they still represent the best fundamental value of the 20.

G8 Education (GEM)

The childcare centre operator is probably the least known of the three, but it has been a stellar quiet achiever.

The stock has returned a stunning 244% over the past year as it aggressively expands its network of facilities through acquisitions.

I normally shy away from so-called roll-up models, which essentially are companies buying their smaller peers and rolling them into the enlarged group, because bigger is not always better.

The strategy only works if the expanded company can gain synergies from the bolt-on acquisitions, and people often underestimate how hard it is to find synergies (such as finding cost efficiencies, increased productivity, etc).

Management has enough of a track record now for me to feel comfortable about recommending it as a potential core holding, given that earnings before interest and tax has grown at a compound annual growth rate of 54% since 2010, while revenue has jumped 39%.

The company has come a long way since its disastrous initial public offer at the pre-global financial crisis peak in 2007 (it was previously called Early Learning Services). The collapse of ABC Learning Centres and the turbulent market saw the stock plunge to under 10 cents compared with its IPO price of $1 a share.

But G8 probably benefited from the demise of its larger competitor as there were plenty of opportunities to buy well-placed centres at a reasonable price during the crisis.

One might not have guessed it in the wake of ABC Learning, but the childcare industry is a relatively stable industry that is not particularly sensitive to economic cycles.

The only downside to G8 is that I believe there is a decent chance it will fall in the coming months. Not only has the stock run up harder than most, but it has also formed what technical analysts call a “double-top”.

The stock tried on two separate occasions to break above $2.50 and failed, and each time it retreated, it fell to a lower point before recovering.

I won’t be surprised to see the stock fall to under $2 before finding renewed support, although the $2.80 average broker price target listed on Bloomberg suggests there is fundamental support for the stock.

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NIB Holdings (NHF)

Shares in Australia’s only listed health insurer are within striking distance to last month’s record high of $2.39, even though its first-half result and full-year guidance were softer than analysts had expected.

Investors are happy to overlook the minor infringements because of the group’s excellent track record, with management delivering an enviable 61% three-year average earnings per share growth – the fourth highest in the Uncapped 100 list.

NIB will also appeal to conservative investors as it is the least volatile stock in the list. In fact, its one-year share price volatility of around 20% is only slightly ahead of the big four banks.

While the stock’s one-year forward price-earnings (P/E) multiple of 13.5 times may not look cheap on face value, it represents a 34% discount to NIB’s five-year average. Further, NIB has a bankable dividend and is on a 2013-14 grossed-up forecast yield of around 7.5%.

The average broker price target stands at $2.38 a share, but if NIB can replicate its success in the New Zealand market, analysts are likely to upgrade the stock.

The group posted a 10.5% increase in premium revenue to $612.8 million for the six months to the end of December last year, but an 8.6% decline in net underwriting profit to $39.1 million. Management believes full-year profit will range between $75 million and $78 million.

Amcom Telecommunications (AMM)

Amcom and the wider telecom sector have recently lost favour with investors due to valuation concerns.

The stock has shed nearly a quarter of its value since it raced up to a 13-year high of $2.13 on May 15.

While the fibre-optic network company is still far from being considered a deep value stock, its current share price of around $1.65 is at least comfortably under the average broker price target of $1.94 a share.

Regardless of whether you are looking to buy it now or wait to see if you can get it cheaper, Amcom has a lot going for it. Management is aiming to deliver a 20% increase in underlying earnings in the current financial year and analysts are forecasting a double-digit increase in profits over the next three years at least.

Data and telephony demand is also fairly resistant to economic downturns, and Amcom has the added advantage of being exposed to the fast-growing cloud computing services industry.

Brendon Lau may have interests in some of the stocks mentioned in the article.