Xmas sale starts early for small caps

Christmas is still a while away, but right now is probably one of the best buying opportunities of the year.

The ongoing US budget deadlock has spooked markets around the world, and has cost Australian investors more than $32 billion so far, with the ASX All Ordinaries Index having slid close to 2% since the start of the month. But, in reality the US political kerfuffle has probably only brought forward the selling pressure in our market, as November tends to be one of the most trying months of the year for Australian shares in terms of the market’s probability of recording a loss.

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Nobody likes a correction, but this dip has historically been a good time for investors to position themselves for the so-called end-of-year “Santa Rally”, with the All Ordinaries recording a monthly loss in six out of the last 10 Novembers. The average loss for the month is 0.7%, which stands in contrast to the average 1.8% gain in the month of December.

The seasonal weakness is unique to Australia as it isn’t evident in the US. Russell Investments’ Asia-Pacific strategist, Graham Harman, believes this is in part due to a “hole” in the dividend stream.

“Around August-September, you get a raft of dividend [payments], and in December the banks are paying dividends,” says Harman. “This leaves you with an air pocket in between the periods.”

Another reason for the seasonal correction is related to an information vacuum as we come out of the full-year reporting season.

“The risk-reward equation for Australian equities deteriorates somewhat in the three months after August,” adds Harman. “Then, December is usually a cracker.”

While November’s track record isn’t great, the real month to fear is this month, according to Harman. The probability of suffering a loss in October may not be as high, but when things go the wrong way, they can really go the wrong way. The graph below shows how volatile returns (as measured in standard deviation) can be for October.

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The positive sentiment people feel in the lead-up to Christmas is one of the probable reasons why the sharemarket does well, and the goodwill tends to last right through to April. This may not be obvious on the first chart, which overplays the weakness in January due to the big losses during the global financial crisis.

However, Harman notes that January generates an average 1.8% return if you look back over the past 40 years.

Small caps tend to follow the same seasonal pattern, and as mentioned in last week’s article (Small caps in the sunshine), I believe the wind will be on the back of the sector through to April.

The latest market shake-up is happy days for those who thought they’ve missed out on our “buy” recommendations since June, with these stocks delivering an average return of about 20%. I believe the best opportunities can be found in the junior resources sector, as this is one of the most, if not the most, underappreciated segments of the market.

That may have sent a shudder down your spine given the cautious outlook many analysts have for commodity prices, with predictions that some metals, like copper, will move to an oversupply situation next year.

However, history has shown that investors should be long commodities when the global economy is expanding. No doubt we still have a number of issues to overcome, including the US cat fight, and growth may look weak compared with the rates achieved in the past. But signs consistently point to an expansion in economic activity for the year ahead.

YTC Resources (YTC)

While there are questions about valuations of the mining majors since they bottomed in June, smaller miners are still looking cheap on fundamentals. This is true for the likes of YTC Resources (YTC), even though first production from its flagship Hera project in New South Wales isn’t expected until the September quarter next year.

However, unlike many of its peers, the Hera gold-base metal project is fully funded through a partnership with Swiss mining giant Glencore International, and stage one of the development will see Hera produce over 50,000 ounces of gold a year for 7.3 years.

Operating costs are forecast at around $400 an ounce of gold after by-products lead and zinc are sold, and there is good expansion potential from stage two of the project that aims to develop a high-grade copper deposit (called Nymagee) near Hera. Stage two of the project is also fully funded.

YTC has jumped 50% since July to 24 cents, but there’s still plenty of room for the stock to re-rate as it heads towards the middle of next year. I can see the stock doubling in value if Hera gets up and running, as forecast.

I have an “outperform” recommendation on YTC.

Tiger Resources (TGS)

Another stock that has also run up strongly is Tiger Resources. The fledgling copper producer is up close to 60% since we rated it “outperform” on July 3, and it shares some similarities with YTC.

First, Tiger is also funded by Glencore and the first phase of its Kipoi project in the Democratic Republic of Congo is going better than originally envisaged, with its plant producing twice the concentrate as planned, and at a cost of just US50 cents a pound.

Stage two of the development could see costs rise, but costs are expected to stay under half of current market price of copper, which is hovering around $US3.30 a pound.

Second, Tiger also has the potential to double in price from here. Analytsts polled on Bloomberg are tipping adjusted net profit to surge 160% to $US27.2 million for 2013 (its financial year is the same as the calendar year) before more than doubling again to $US63.2 million the following year.

This puts the stock on a 2014 price-earnings multiple of a little over three times, and I reiterate my “outperform” call on Tiger.

Beadell Resources (BDR)

A more risky proposition is gold producer Beadell Resources (BDR). It’s not Beadell’s key Duckhead project in Brazil that worries investors. It’s the negative sentiment towards gold.

The precious metal is on track to post its first annual loss since 2000, with the gold price having plunged more than 20% since January to around $US1,300 an ounce.

Sentiment towards gold has been hit by an unexpected lack of inflation despite the easy money policies adopted by developed economies to bolster growth, and an improved global outlook.

Analysts have been slicing their price forecasts for the yellow metal, but even the most bearish analyst surveyed by Bloomberg still expects gold to stay above $US1,000 an ounce for the next few years.

This is good news for Beadell as its operating cash cost should remain below $US485 an ounce. If the iron ore price stays around current levels, it could shave another $US30 to $US50 per ounce off its cost, as its project contains iron ore as well.

Duckhead is expected to produce around 120,000 to 130,000 ounces of gold this calendar year, and around 200,000 ounces in 2014.

The stock has slipped 3% since we rated it an “outperform” on August 28. I think the market will re-rate the stock, which is trading on a one-year forward P/E of around five times, when investors become more confident that gold isn’t about to plunge below $US1,000 an ounce in the coming months.

I reiterate my “outperform” call on the stock.

Think big, go smalls!

Brendon Lau owns shares in YTC and TGS.