Under the Radar: Under review

PORTFOLIO POINT: Our second year’s selection of small cap stocks has been buffeted by macroeconomic headwinds and general risk aversion, but last year’s group is still, on average, whopping the benchmark.

Despite Australia being the miracle economy of the Western world, 2011 hasn’t been a good year to be an investor in the domestic sharemarket. With the ASX 200 down 7.4% and the All Ordinaries down 7.7% over the past 52 weeks – even counting yesterday’s late day rally – not only are we suffering a negative return, but compared to other major markets Australia loses out as well with only China – funnily enough – doing worse.

And when taking apart the domestic market itself, we can see it’s been especially tough for small companies, with risk-aversion seeing increased flows to blue-chip companies, demonstrated by the relative outperformance of the ASX 20, the index of the largest blue-chip stocks.

Yet throughout all this time both I and Alan Kohler have advocated a strategy where carefully selected small-cap stocks are the ones you buy-and-hold for growth, whereas blue chips – unless you’re investing for the yield – are for shorter-term trading. And while that suggestion may appear counter-intuitive, measured on a longer time scale it has proven successful in the past.

Either way, this has been the experience with stocks in Under the Radar, a column of interesting small cap companies introduced over the second half of last year and re-introduced this year. While like the Small Ords, this year’s Under the Radar selection lagged behind the All Ords – in our case by an average of -2%, exacerbated by disappointing performance in two stocks in particular – last year’s stocks are still beating the All Ords by an impressive margin: a 19% positive return, on average, versus -3% for the benchmark.

A tough year in 2011 '¦

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But still going strong from 2010

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With performance varying quite widely across the companies listed above, small cap investing is obviously no less volatile than any other area of the sharemarket, yet a diversified portfolio of small caps can and does hedge what can be otherwise very idiosyncratic risks. And while dividend yields are not enjoyed by all small cap companies, income investors can nonetheless find appeal as well.

-Under the Radar stocks
ASX	Name	Market cap (m)	Price	Broker target	Price / NTA	P/E	Yield
ASZ	ASG Group Limited	$153	$0.90	$1.10	11.88	9.27	8.38%
BGL	Bigair Group Limited	$39	$0.26	$0.43	5.48	20.9
CDA	Codan Limited	$208	$1.27	$1.53	13.62	8.99	7.09%
CLV	Clover Corporation Ltd	$50	$0.31		1.94	10.93
CSS	Clean Seas Tuna Ltd	$44	$0.09		0.65	-1.24
CST	Cellestis (delisted)	$362	$3.77		13.24	41.31	1.46%
DYE	Dyesol Limited	$52	$0.33	$1.20	9.34	-2.73
ESV	Eservglobal Limited	$93	$0.47		1.15	-10
GXL	Greencross Limited	$36	$1.17		-2.46	9.64	5.13%
HNG	HGL Limited	$64	$1.16		1.06	9.39	9.48%
HZN	Horizon Oil Limited	$266	$0.24	$0.46	1.87	17.33
IPP	Iproperty Group Limited	$190	$1.12	$1.26	26.17	-77.78
LGD	Legend Corporation	$61	$0.28	$0.43	2.69	7.61	6.43%
MRM	Mermaid Marine Australia	$686	$3.15	$3.58	2.52	15.5	2.86%
MSF	MSF Sugar Limited	$224	$3.24	$4.54	1.4	-55.86	0.77%
NDO	Nido Petroleum Limited	$69	$0.05	$0.28	1.33	-2.15
OOH	Oohmedia Group Limited	$85	$0.17	$0.30	11.81	9.14
RMS	Ramelius Resources	$395	$1.36	$1.63	2.57	6.39
SGH	Slater & Gordon Limited	$281	$1.86	$2.34	2.03	10.16	2.96%
SHV	Select Harvests Limited	$88	$1.57	$3.02	0.63	4.65	8.31%
SIV	Silver Chef Limited	$71	$3.05	$3.40	2.3	9.86	6.56%
TGA	Thorn Group Limited	$241	$1.65	$2.00	3.81	9.48	5.12%
VOC	Vocus Communications	$102	$1.68	$2.43	-16.15	11.56
Source: Stock Doctor, Morningstar, Datastream

What’s more, good value can still be found in many of these stocks, though liquidity and points of entry are always important, especially with some of the smaller names. And patience can indeed be rewarded. Investors in Cellestis who bought in September last year, when it was unpopular and languishing at $2.38, were rewarded 11 months later when a takeover offer at $3.77 came through from molecular diagnostics group Qiagen.

Not all small cap investments are such success stories, however. Nido Petroleum, with continual problems at its oil wells offshore The Philippines, has been a significant disappointment and despite reporting strong progress in developing their respective technologies, investors continue to shun Clean Seas Tuna and Dyesol, leading to net selling and, consequently, declining share prices.

The jury on these stocks will be out for another year at least and until then it’s incumbent upon investors to keep track of developing their own holdings. In small cap stocks, especially, it’s as important to know what price you’ll sell a stock for as it is to know what price you’ll buy it for. Indeed, unless you know the level you’ll sell at, you shouldn’t buy. While in several cases our Under the Radar stocks could be classed as speculative, each has a tangible underlying business whose value can be estimated with a little bit of leg-work. Value, of course, will always fluctuate, but don’t let wider market gyrations fool you into believing that this is a rational discovery of value.

As Benjamin Graham, Warren Buffett's mentor and the father of value investing, said: In the short term the market is a voting machine; in the long term it is a weighing machine. This was especially true in 2011. Many of our stocks may be unpopular now, but on the basis of their fundamentals, they each weigh up pretty well.