Three small caps to ward off the triple curse

Three key risks are overhanging the market, but there are turnaround signs for three small cap contractors.

Summary: Fundamental, technical and quantitative measures are pointing to further downside risk for the sharemarket. Yet, three small cap contractors stand out as undervalued ugly duckling stocks that could be transformed into swans.
Key take-out: Out of favour contracting stocks, trading on low price earnings ratios, offer a relatively fertile hunting ground.
Key beneficiaries: General investors. Category: Growth.

Junior industrial stocks are suffering from the winner’s curse.  These stocks may have enjoyed their second-best start of the year performance on record, but there won’t be any standing ovations from investors.

If anything, most shareholders are probably thinking about fleeing for the exits to lock in profits on worries that the market has run too hard after the ASX Small Industrials Index surged 8.8% in the March quarter (versus 6.8% for the S&P/ASX 200 Index).

Some would say that the index is now “triple-cursed” – meaning the fundamental, technical and quantitative measures are pointing to further downside risk for the sharemarket.

The fundamental measure includes items such as earnings forecasts, while the technical measure refers to price movements and quantitative uses relative measurements (for example, yield and price/earnings multiples) as a filter to work out the direction of a security or market.

Some of these concerns about how stretched the market looks are valid, but small cap investors should be looking to rotate their investments instead of selling out of the market for a number of reasons.

Firstly, the forecast price/earnings (P/E) ratio of the market is not as stretched as some might argue.  While the Small Industrials Index looks like it’s close to full value on a 16 times multiple, the ratio is based on 2012-13 earnings estimates.

The forecast for 2013-14 is the more important one to watch given that the current financial year is nearly over; and the P/E ratio for the following year sits on a fairly modest 13.5 times.

Looking to the 2013-14 P/E estimates for the S&P/ASX 200 Index also shows that the market is not looking as stretched as some might believe, although value is more apparent at the small end of the market.

I also suspect that the Australian economy will surprise sceptics on the upside as we head into the second half of this calendar year, which is another reason to be optimistic about small industrials. 

The market is so fixated on falling hard commodity prices that many are missing the bigger picture – the non-resource parts of our economy are actually stirring to life.

The Reserve Bank of Australia noted as much when it decided to hold interest rates steady on April 2, and recent data, such as housing and retail sales, has only strengthened this argument.

What this says to me is that economic growth in this country is probably going to be more sustainable than it has been in many years as we do not need to depend on only one industry to come riding to our rescue.

Small industrial companies in particular are well placed to benefit from this thematic should it prove true as they are more leveraged to the domestic economy than large caps.

This doesn’t mean our sharemarket isn’t poised for some near-term weakness though.  But instead of closing positions and returning to cash, investors with a more upbeat outlook might prefer to take profit on stocks that have run hard and buy the laggards.

You need to be careful with this strategy, as a good number of underachievers will likely remain out of favour regardless of where the market goes.

However, backing the right under-achiever not only gives you exposure to any upswing in market sentiment, but it could also limit downside risk just in case the market takes a little longer than expected to rebound, as these stocks are already trading at a heavy discount.

It is times like these that I think about the “buy at 5, sell at 10” strategy often used by fund managers when it comes to listed contractors: The idea is to buy these stocks on a P/E of five times and sell at 10 times. While a P/E of 10 is not usually seen as being expensive, these listed contractors don’t generally deserve to trade at double-digits because their earnings beyond the next 12-months are nearly impossible to predict.

Considering how these stocks have been on the nose over the past few months due to their lack of earnings visibility, worries about mining project deferrals and the impact of the high Australian dollar on competitiveness, the sector offers a relatively fertile hunting ground.

NRW Holdings (NWH)

The civil and mining engineering contractor is one poor performer that could rebound from its 65% slump over the past 12-months.

The stock is trading on a one-year forward P/E of around five times and investors are worried that the group will either not meet its $1.4 billion to $1.5 billion revenue guidance for the current financial year or that this year will mark the peak in revenue due to the sluggish commodity market.

The backlash against coal seam gas mining in this country is also likely to reduce NRW’s opportunities to continue to grow its $1.35 billion order book.

If history is any guide, buying the stock when it’s on a current year estimated P/E of around five to six times is usually a rewarding experience in spite of the earnings outlook.

For one, analysts have already factored in a slide in revenue and net profit for the group past 2012-13 and even the most pessimistic analyst polled on Bloomberg has a price target above the current share price.

NRW is also one of the more reputable contractors in the industry thanks to its good track record in delivering on projects.

The fact that the $400 million market cap group has a well-diversified business, strong balance sheet and good cash flow generation puts it in a good position to ride out the current cyclical downtrend and gives it some leeway to protect its 10% plus forecast dividend yield.

I am not saying NRW’s dividend is iron clad.  Far from it, but the downturn will need to be a lot more severe and protracted before the stock looks unattractive on a P/E and yield basis.

Boom Logistics (BOL)

The crane and lifting equipment company is another that has been doing it tough over the past 12 months with its share price falling around 20%.

Difficult trading conditions have forced to company to undertake a restructure to cut costs and investors are unsure if that is enough for management to meet its 2012-13 earnings before interest and tax guidance of around $39 million, which represents a 10% increase over the previous year. 

Its guidance also hinges on favorable weather conditions, no major contract loss and some improvement in demand for its services on the East Coast of the country.

Boom Logistics is a riskier proposition to NRW given its material exposure to the embattled coal mining industry, less diversified business and smaller size, but the stock is approaching levels where the risk reward trade-off is looking compelling.

If the $115 million market cap stock slides to just under a P/E of five (and it won’t take much to get there), it could signal a good entry point for risk tolerant investors with a medium term investment horizon given the prospect that the industry may have hit a cyclical low and the fact that the share price represents less than half of its net tangible asset value.

Austal (ASB)

The $230 million market cap shipbuilder is a different beast to a mining contractor, but the “5/10” strategy applies given that Austal’s earnings more than a year out are just as challenging to forecast.

Fears of defense budget cuts by the United States and a capital raising last year have contributed to a more than 50% plunge in Austal’s share price.

Compounding these concerns are reports that some US military leaders have criticised the Littoral Combat Ships (LCSs), being built by Austal, for not having enough firepower.

While there are legitimate concerns about the earnings outlook for Austal, that isn’t enough to justify the stock sitting on a 2013-14 P/E of four times based on consensus earnings.  This would mark the stock’s lowest P/E multiple on record if analysts’ estimates prove accurate.

Further, worries about US budget cuts and how the navy could pressure Austal to build the ships for less might also prove overdone.  Austal has received funding from the US government to build the fifth and sixth LCSs (out of a 10-ship contract) last month on similar terms to the previous year.

Based on the average broker price target, the stock has the potential to jump around 60% over the next 12-months from its current share price

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

Graph for Three small gold stocks ready to shine

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