2014 A year for small caps

Many equity investors have missed out on the solid sharemarket returns over the last two years after being burnt by the global financial crisis. But it would be a mistake not to get back into stocks in 2014.

Small caps are the place to be this year as they are better placed to deliver returns. The question is, what strategies should investors use given the strong rally we’ve had last year?

While we have highlighted a number of ways to approach emerging stocks in the past, there is one strategy that stands out at this time of the year.

It follows the “Dogs of Dow” theory used by serious investors. It’s almost a yearly ritual to buy the 10 worst performing stocks on the Dow Jones Industrial Average (which conversely translates to the ones with the highest yield given that price and yields move in opposite directions) on the belief that businesses move in cycles, and what is down in one year will rebound in the following 12-months.

Australian investors have good reason to be tempted to look at the biggest laggards on the Uncapped 100 given that a number of pieces of research have shown the “Dogs of Dow” theory works and the fact that laggards look “cheap” in a rising market.

But don’t click on the “buy” button until you read our findings on this strategy, as the rules for the Dow are very different for emerging stocks – and I am not talking about the obvious differences like dividends or earnings growth.

The good news though is that using the one-year performance table as a guide can pay off very handsomely, as long as you remember a few simple truths.

Size and numbers matter

One of the key reasons why the “Dogs of Dow” theory shouldn’t be applied literally to small cap stocks relates to the size of these businesses. Stocks on the Dow are industry giants with very well established businesses. When such stocks fall from grace for the year, it is more often than not driven by cyclical factors.

In contrast, when emerging companies fall out of favour it can often reflect structural issues with their business models or industry. Structural challenges are very much more difficult, and usually takes a lot longer, to address.

The other point is the number of stocks that make up the respective indices. If you bought the 10 biggest dogs, you have effectively purchased a third of the Dow, while doing the same would only net you a 10% exposure for the Uncapped 100 and 5% of the S&P/ASX Small Ordinaries Index.

These factors are why you can often get away with indiscriminately buying the biggest losers from the Dow, but not small caps.

Play both sides

The fact that there is only around a 50% chance that a laggard from the Uncapped 100 in a given year will outperform in the next 12-months means that blindly buying “cheap-looking” stocks will often land you in hot water.

The trick here is to widen your scope and to look at both the 10 worst and 10 best performers for 2014 pocket rockets.

The 10 best performers on the Uncapped 100 have a similar tendency to outperform in the preceding 12-months as the dogs due to the same structural argument outlined above.

While the best-performing blue-chips are often aided by a cyclical tailwind, emerging stocks that top the table often enjoy some form of structural advantage – either being a “technology disruptor”, such as mobile payment company Mint Wireless (MNW) and mobile funds transfer provider eServGlobal (ESV); or an early mover into a new or niche market, such as aerial mapping company Nearmap (NEA).

A structural advantage can cause a small cap to outperform for an extended period, although this doesn’t mean one should shy away from taking profits, as highlighted in James Kirby’s article 10 Things you must do in 2014. After all, small cap stocks almost never move up in a straight line, and having no financial exposure to a stock will allow you to be more objective in determining the chance of the stock entering the next up-cycle or re-rating.

Hooking the big fish

This all sounds like a lot of work, but does the reward justify the risks? Looking for stocks at the worst and best end of the market is like deep-sea fishing – there is no more fertile ground than the two ends of the league table if you are looking to hook a big fish.

History shows that the top and bottom 10 stocks of the Uncapped 100 are five times more volatile than our collection of emerging stocks in the following year, and it doesn’t matter if the stock is at the top or the bottom of the performance table.

Further, nearly every one of these stocks goes on to make big moves in the next 12-months. It’s only a question of whether the move is up or down.

This is why alpha-hunters can’t afford not to put these 20 stocks under the microscope, although I would caution most retail investors to use this tactic sparingly. Looking for stocks at the deep end should be used to supplement your core portfolio strategy given the high-risk nature of buying over- and underachievers.

2014 movers and shakers

This brings us to the more pertinent question. Which stocks on the 2013 league table are likely to go up or down materially this calendar year?

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This isn’t an easy call, especially for the best performing Uncapped 100 stock for 2013. Mint Wireless is up a whopping 1622% and I don’t think we will see anything close to that number this year.

The stock has nearly doubled in price since we rated it as an “outperform” in October and I estimate that it has to a further 17% to climb to reach fair value at around 42 cents. But I would be surprised if Mint Wireless made it into the top 10 again this year, unless we see an accelerated adoption of its service.

The one I am tipping could make a big move in the right direction in 2014 is Universal Biosensors (UBI).

I know it’s a big call given the negativity hanging over the medical device company. The stock is, after all, the worst performer on my current list of “outperform” calls, with a more than 20% fall since I rated it on September 4 last year.

Investors have dropped the stock like a hot potato after management warned last year that the launch of the coagulation testing device it was developing with Siemens would be delayed to the first-half of this calendar year from the end of 2013 due to insufficient patient enrolments for the clinical trial.

This raised questions about the credibility of management and sparked worries that there is a deeper underlying issue with the device. After all, Universal Biosensors seems to be accident prone and has thrown up a number of unpleasant surprises, such as when LifeScan announced a product recall. LifeScan, a Johnson & Johnson subsidiary, jointly developed a glucose testing device with Universal Biosensors.

Universal Biosensors also surprised many with a debt funding announcement just before Christmas for a facility of up to $US25 million with Athyrium Capital Management. The debt carries a 10.5% interest rate and the company will issue a warrant to the lender giving it 4.5 million shares at an exercise price of $1 a share.

However Universal Biosensors’ chief financial officer, Salesh Balak, is urging shareholders to keep the faith as the launch of the Siemens’ product is on track to happen before June and the company will have a more detailed update by the end of this month.

He also stressed that Universal Biosensors isn’t in need of cash. The Athyrium facility is more an insurance policy to ensure the company has enough firepower to complete the development of the Siemens’ device, which will be used by medical professionals, and a self-testing version for patients, which Universal Biosensors plans to take to market on its own through a distributor.

“We know what our expenditure is, but we have no control over our revenue and we could get stuck for some reason, such as the LifeScan recall last year,” says Balak. “The loan is only a risk mitigation exercise.”

LifeScan pays US1 cent to Universal Biosensors for every one-use test strip it sells for its glucose tester. The payment is made every quarter, and the sales update for the three months to December, which will be released next week, is likely to come in ahead of management’s expectations.

WilsonHTM Investment Group analyst, Shane Storey, also believes the stock is looking very cheap around current levels.

“If all goes according to plan over the next two years, the stock can recapture its highs of four years ago [when it was trading above $2 a share],” says Storey. “But the stock is speculative.”

Other stocks in the group of 20 that are likely to make big upward jumps this year are eServGlobal (ESV) and Starpharma Holdings (SPL).

The former has more than doubled in price over 2013, but I believe the market will re-rate the stock further this year as management updates investors on the market adoption of its new HomeSend product.

HomeSend, which allows mobile phone users to transfer cash to each other, is a joint venture between eServGlobal, MasterCard and European telco BICS.

The service currently operates in 50 countries, giving 1.2 billion mobile phone subscribers access to the service. The stock has gained 11% since we upgraded it to “outperform” from “neutral” on December 13.

Starpharma is another of our “outperform” calls from 2013 that is likely to see a significant rise in the coming months if it can clinch a partnership deal with a global pharmaceutical giant as I expect it would.

The biotech’s dendrimer technology, which can make existing drugs more effective, has been kicking goals late last year with Cancer Australia awarding it funding to develop a lung cancer treatment using its technology; and successful tests showing that the dendrimer significantly lowers toxicity in two major cancer drugs, oxaliplatin and docetaxel. You can read more about Starpharma here.

On the flipside, drilling products and services firm Imdex (IMD) could remain on the down and out this year even after its 63% plunge from grace in 2013.

Commentary from drilling companies around the world remains downbeat as miners are shying away from exploration activity and greenfield projects. Miners will instead be more focused on maximising returns from existing mines in 2014.

Of course, all bets are off if the company receives a takeover bid – an event that cannot be discounted given that the sector is ripe for consolidation as we have pointed out in Five small cap trends for 2014.

One 2013 outperformer that is at risk of experiencing a reversal in fortunes is Greencross (GXL). The veterinary services group has grown strongly over the past few years by acquiring independent veterinary practices at good prices.

It recently announced a change in strategy and has expanded into pet supplies. The idea is to provide a one-stop shop for pet owners to buy products and to seek medical services.

I don’t believe shareholders fully appreciate the execution risks involved and the stock is priced for perfection after its 145% rally in 2013. This put the stock on a consensus price earnings multiple of between 35 times and 20 times over the next three years. That’s lofty, even by global standards.

A small misstep in integrating the business is all it takes to trigger a steep slide in the share price, which was trading at $8.04 on Wednesday afternoon. I do not have a rating on Imdex or Greencross.

Think big, go smalls!

* This article is part of the “It's Time” series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.