Uncapped 100 beats the pack

The last 100 days has been the most exciting time for small cap investors since the market’s dramatic bounce in 2009 coming out of the global financial crisis.

The turnaround in performance of small stocks should be a wake-up call for “blue-chip only” investors, as the recent outperformance of smalls over large stocks is likely to continue over the coming months.

Our buy calls on stocks in the Uncapped 100 have generated returns of around 21% since we officially kicked off in June. The gains on these emerging stocks are 14% ahead of the top 100 stock index and the S&P/ASX Small Ordinaries.

The Uncapped 100 stocks as a whole have performed very well, producing a return of 14% compared with a 9% return by the S&P/ASX 200 Index.

The next 100 days will be just as exciting for small caps, as many in the sector have only just started to emerge from their most trying periods in history in terms of performance against their larger rivals.

But first let me recap on the last 100 days. To say small cap stocks have been on the nose would be an understatement, with the sector briefly entering bear territory in June. The S&P/ASX Small Ordinaries Index plunged 21.8% after hitting a nine-month high of 2,414.5 in mid-February, and fell to its lowest level since early 2009 on June 25.

A loss of more than 20% is regarded as bear territory, but we are unlikely to see the June low for some years now that we have rebounded around 17% from the bottom.

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In spite of the decent recovery, the small caps index is still trailing the S&P/ASX 100 Index by a near record, and this means its recent outperformance against its larger peers has more room to run.

This performance chasm can largely be attributed to the “mining bust scare”, when falling commodity prices spurred investors to run for the exits as the economics for a number of projects were starting to look questionable.

Small miners took the brunt of the sell-down, as they are generally the highest-cost producers of minerals and the ones most in need of additional funding. Mining services contractors also quickly lost favour as their clients scrapped spending on project development.

Many are not out of the woods, but the sell-down was an excellent buying opportunity for select resource juniors that have quality projects and funding locked in, and well-managed engineering contractors with good reputations in delivering on projects.

This was essentially why we recommended subscribers buy the dips for emerging copper producer Tiger Resources (TGS) and engineers WDS (WDS), NRW Holdings (NWH) and LogiCamms (LCM).

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Tiger Resources closed at 30 cents on Tuesday and is up 58% since we recommended it as a buy on July 3, while WDS and NRW are 43% and 33% higher at $75 cents and $1.51 respectively since we wrote about the prospects of a mining services rival over a month ago.

LogiCamms is not far behind, with the stock up 25% at $1.75 after we called it a “buy” based on its dividend growth prospects on August 7.

However, what is more pleasing is that the strong performance of our “outperform” recommendations aren’t concentrated on the highly cyclical mining-related sectors. In fact, the best performing stock on the list is gaming systems company eBet (EBT).

The New South Wales company, which provides pokies machines and monitoring and management systems to gaming venues, has seen its share price surge 140% to Tuesday’s close of $2.67 after we highlighted its earnings growth potential three months ago.

Another star performer is medical device developer GI Dynamics (GID), with the stock being one of our five bargains for under a buck back in mid-July. The company is trying to commercialise its intestinal liner to help control the diets of obese people and diabetes sufferers, and I think the stock still has room to run higher over the next six to 12 months, even though it is up 41% since the article was published.

This is also true for the other stocks mentioned above. While some like WDS and LogiCamms may be starting to look fairly valued, they are likely to be well supported on dips, in part due to their relatively generous forecast dividend yields for 2013-14 of 7.9% and 5.8%, respectively.

On the flipside some of our bullish calls have yet to pay off, although their underperformance is quite modest. Horizon Oil (HZN) is the biggest drag, with the stock falling 7% from when we called it a “buy” 10 weeks ago to yesterday’s close of 32.5 cents.

The energy junior surprised us with a capital raising at the end of July, and that is one of the factors capping the stock. More alarmingly, some have taken the $53.5 million new share offer at 33 cents a pop as a warning sign that the deal to sell part of its Papua New Guinea project to Osaka Gas may have hit a snag.

We are keeping our “outperform” rating on Horizon, but this development does materially lift the risk profile of the stock, which is likely to stay range bound until there is greater clarity on this front.

Beadell Resources (BDR) is another that is only suited for those with a stomach for risk. The emerging gold producer has not gained traction since our “buy” call a month ago as the entire gold sector has been knocked around by the volatile spot gold price.

The precious metal is giving investors vertigo, with the market on edge as it tries to second-guess when the US Federal Reserve will start to wind back its $US85 billion a month bond buying program.

This bond splurge has been credited to giving some asset classes like gold a big lift. and any talk about the tapering of the program will be a drag on these assets.

Equipment financing group Thinksmart (TSM) is also carrying the wooden spoon. The stock is down 3% at 34.5 cents since we put it on the buy list. The issue is not the fundamentals of the company but the stock itself.

The stock price is 30 plus cents, and a one cent movement can cause a big change on a percentage basis. The stock is also lightly traded and this means it is prone to drift. On the other hand, these shortcomings could work in favour of those looking to buy the stock as it can present a good entry point.

This brings us to the question of where to from here? The next 100 days is still looking good for emerging stocks, even though the so-called “Santa Rally” (a seasonal pattern that usually sees the market outperform close to Christmas and into January) tends to favour large caps over small caps.

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Barring an unforeseen major economic shock, this year could be different for small caps for a few reasons.

First is the timing of the market bounce. Small caps tend to fall harder in a market correction and lag in the recovery, as investors favour larger stocks due to the perception that they are safer investments.

Small caps have only just started on the current recovery and are likely to outperform large caps in the coming months.

This is particularly so for small miners. The sector giants like Rio Tinto (RIO) and BHP Billiton (BHP) have already been re-rated by the market, and as investors start feeling more confident about the outlook for commodities they will climb the risk curve and buy the smaller miners.

Another reason why small caps will find greater favour is because investors are starting to focus their attention more on stocks with good growth prospects and dividend yields.

The big defensive stocks that have been the favourites of the market are looking fully stretched and offer relatively limited upside at current levels. This is going to force investors to turn to alternatives that offer a good mix of growth and yield, and you are a lot more likely to find these opportunities at the small end of the market than among blue-chips.

This is exactly why professional investors are wading back into small caps, as I wrote on July 31 (see Big boys scramble into small caps).

The last factor that will keep the wind on the backs of small caps is the “honeymoon” period following the federal election earlier this month. As highlighted in the June article (Stand by for a post-election small caps rally), junior stocks have a habit of performing strongly for up to six months following an election.

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However, one shouldn’t get carried away. Small caps are still a higher-risk proposition that you need to keep an eye on. The vast majority of them are not suitable as a blind “buy-and-hold” strategy.

This is why most investors should treat small caps as a supplement to a blue-chip portfolio, and not a replacement.

It is also important to keep following the Uncapped 100 on Eureka Report, as we will continually highlight opportunities in this space (the “outperform” recommendation table above is a good place to start) and keep you updated on market-moving events afflicting the 100 stocks on our watch list.

The Uncapped 100 will also be rebalanced every quarter, with new promising emerging stocks replacing those that no longer meet our criteria of inclusion in the list.

The rebalance will happen next week, and I will cover this in detail in the next Uncapped article.

Think big, go smalls!