First profit, first choice for stock pickers

Companies delivering a maiden profit tend to outperform the market.

There are more strategies to invest in small caps than you can shake a stick at. Fortunately, you don’t need an advanced degree to follow one of the most effective methods to picking emerging winners.

The method to the small cap madness that has proven to work well is the “maiden effect”, with Eureka Report back-testing showing that the strategy has yielded an average return of over 38% over a relatively short six-month period.

The “maiden effect” refers to a key milestone in a company’s life cycle when it first becomes profitable.

A company’s maiden profit announcement signals a coming of age all market minnows aspire to in their quest to become a profitable and sustainable enterprise. The vast majority of them start life on the ASX as nothing more than a speculative venture.

The positive impact from delivering a maiden profit is easy to understand. Proving that your business works will earn you a re-rating in the market, whereby the risk premium ascribed by investors to the stock drops and the value goes up (both move in opposite directions); and the company will start attracting bigger institutional investor interest, which would increase demand for the stock.

Getting a handle on the concept is the easy part. The much bigger question is whether it is too late to buy such a stock after management reports its first full-year profit, as many of these stocks have a habit of running hard in the weeks or months before achieving this milestone.

Look at Uncapped 100 stocks like Asian real estate website operator iProperty Group (IPP) and mobile payment solutions provider Mint Wireless (MNW). Shares in iProperty have rallied 142% this calendar year, with analysts tipping its maiden profit to arrive in 2013-14, while Mint has surged a dazzling 16.5 times over the same period.

iProperty is forecast to deliver a $3.3 million net profit in 2014 (its financial year ends in December), while Mint Wireless will swing into the black in 2014-15 to the tune of $5.5 million, according to consensus forecasts.

You might think that trying to buy the stock well before the profit announcement would yield the best outcome. This may not necessarily be the best strategy, especially once you consider the risk involved in trying to predict the future.

What is likely to be a better strategy is to consider buying the stock only once management reveals their first profit for the year, as research done by Eureka Report shows that these stocks tend to continue to outrun the market up to six-months post result, if not beyond.

Looking at the 18 companies that have delivered their first net profit and positive earnings before interest, tax, depreciation and amortisation (EBITDA) in the last three years, we found that the group has lagged the ASX All Ordinaries Index in the 90 days pre-announcement by an average of 2.4%.

This quickly reverses in the wake of their results with the group rallying 3.2% ahead of the broader market on average in the 30-days from the profit announcement. The “maiden effect” becomes even more pronounced at the 90-day and 180-day mark, as shown in the chart above, with the average outperformance to the market reaching 18% and 25%, respectively.

We filtered the stocks on both net profit and EBITDA to ensure that the company has really evolved into a profitable business and that the positive profit number is not due to an accounting treatment.

What is just as remarkable is that the probability of a maiden profit stock generating a positive return is high, with 72% of the group making gains post-result and across the time periods in question. This isn’t an achievement to be taken lightly, as 2011 to 2013 have been challenging times for small cap stocks.

Performance of companies that posted a maiden profit in the past three years

CodeCompanyMaiden profit date90D pre (%)*90D post (%)*Current (%)*
GRB Gage Roads Brewing Co24/08/2011-4.5585.71559.39
MYX Mayne Pharma Group 31/08/201011.11-20.00453.90
NSP NuSep Holdings 17/08/2010-62.50144.44330.56
MNZ Mnemon 31/08/2011-2.86-8.82260.29
DNA Donaco International 31/08/2012-20.0025.00120.36
MWR MGM Wireless 27/08/20103.6428.5083.88
CCF Carbon Conscious 31/08/201012.94-2.8975.74
AHZ Allied Healthcare Group23/08/2010-1.0055.5669.08
BXN Bioxyne 20/08/2010-1.1867.5668.77
BLA Blue Sky Alternative Investmen24/08/20127.140.0052.49
NWT Newsat 16/08/201012.5016.6744.44
PGC Paragon Care 31/08/201040.00-3.577.14
APP APA Financial Services 31/08/20100.000.000.00
EOL Energy One 30/08/201020.0055.56-22.22
AHJ Air Change International 29/08/2011-20.00-62.50-43.75
ACR Acrux 24/08/201014.9415.00-74.00
OTH Onthehouse Holdings 31/08/201216.670.00-82.50
SOM SomnoMed 26/08/2010-33.3320.00-97.00
*Stock performance over the stipulated period pre- and post-announcement of maiden profit
Source: Eureka Report, ASX announcements, Bloomberg

This outperformance appears to be relatively enduring too. If we looked at where these stocks are today, we find the same number (but not necessarily the same stocks over the periods) staying in positive territory, with the group doubling in value on average, which is 59% ahead of the ASX All Ordinaries Index.

As mentioned above, iProperty is a maiden profit hopeful and there could be further upside to the stock, although we are reluctant to upgrade our recommendation from “neutral” just yet for the reasons outlined in the article iProperty at transition point.

We are also keeping our “outperform” call on Mint Wireless, even though it might only reach first profit in 2014-15. As long as the market has confidence that it can achieve its goal of processing $1 billion in transactions a year, the stock will continue to be well supported.

The only other Uncapped 100 stock that is tipped to post first profit in 2013-14 is Nanosonics (NAN). Analysts polled on Bloomberg expect the disinfection device maker to report a maiden net profit of $1.2 million next August.

This expectation is likely to be causing some switching between fellow medical device maker Universal Biosensors (UBI) and Nanosonics, with both stocks diverging sharply since May this year. 

Universal Biosensors is not expected to deliver first profit until sometime after 2014-15, and there is a risk it could take even more time to get there due to delays in a new product launch it is undertaking with Siemens (see Universal Biosensors gets tested).

We have a new “outperform” recommendation on Nanosonics as there is around a 30% upside to its current share price of 83 cents over a 12-month timeframe.

Think big, go smalls!

Additional research for this article was conducted by Simon Dumaresq.

Uncapped 100 - Australia's most interesting small cap stocks

Small cap stocks covered by the Uncapped team
CodeNameRationaleMarket cap ($m)Total return 1-year (%)Sector (GICS)
MTU M2 Telecommunications Group Amazing growth story and well run company. High free float and strong insto support.1,096.0469.03Telecommunication Services
NHF NIB Holdings /AustraliaOnly listed health insurer. Widely held. Good performer.1,040.4425.25Financials
MMS McMillan Shakespeare One of the best performers since the GFC, but ongoing risk of change to FBT rules is hanging over the company.936.773.97Industrials
GEM G8 Education Only listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.909.92120.45Consumer Discretionary
ARP ARB Corp Well covered but good candidate for core holding due to quality management.856.0018.36Consumer Discretionary
MRM Mermaid Marine Australia Its strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.814.2814.74Industrials
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding.804.9354.84Consumer Discretionary
BGA Bega Cheese Corporate interest in Australian food companies makes the cheese maker worth following.744.14161.38Consumer Staples
BDR Beadell Resources Will be a very big FY14 for miner as it has to prove it aims to produce 200,000 ounces of gold a year.709.68-5.03Materials
AUB Austbrokers Holdings The insurance broker is a strong performer. Widely held and well liked by small cap investors.699.8457.48Financials
SRX Sirtex Medical A shining star in the biotech space and one of the best performing stocks in 2012. Great product (liver cancer treatment) and bright outlook.672.749.23Health Care
SGN STW Communications Group One of few companies able to benefit from online shift. Widely held and good insto support.599.6956.20Consumer Discretionary
RFG Retail Food Group Owns a number of well know franchise brands. Widely followed by instos.560.6445.45Consumer Discretionary
SEA Sundance Energy Australia Analysts have a favourable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.540.1052.61Energy
RCR RCR Tomlinson Good first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?501.68102.21Industrials
CWP Cedar Woods Properties Property developer with good ROE and earnings growth track record.494.7561.77Financials
TGR Tassal Group Salmon farmer is finally turning a corner with an improved harvest strategy and growing demand for product.480.54129.69Consumer Staples
AMM Amcom Telecommunications Well covered junior telco but good candidate for core holding.470.1648.81Telecommunication Services
BRU Buru Energy Substantial size but not often covered by press. Widely held with good insto support.454.26-43.40Energy
TOX Tox Free Solutions Widely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.450.2917.59Industrials
CCP Credit Corp Group Strong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.449.3237.38Industrials
ACR Acrux One of the most successful Australian biotechs in recent history. Widely held by instos.441.28-11.02Health Care
NXT NEXTDC The cloud computing company is an IT sector darling. Fairly widely held and followed.438.158.78Telecommunication Services
MYX Mayne Pharma Group Sizeable generic drug maker with interesting board members.431.05178.18Health Care
MYS MyState Well regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.429.7840.02Financials
HZN Horizon Oil One of better regarded small energy stocks that doesn't receive much media attention.429.38-11.97Energy
SLX Silex Systems Its uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.415.42-31.07Information Technology
CCV Cash Converters International Strong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.407.1213.31Consumer Discretionary
TGA Thorn Group One of few retail stocks that is performing well. The Radio Rentals chain owner is also well supported by instos.376.7136.39Consumer Discretionary
MOC Mortgage Choice Has a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.370.1070.84Financials
FGE Forge Group One of the better performers in its industry. Good track record and potential core holding.360.193.44Industrials
NWH NRW Holdings One of the better regarded mining & civil contractors with good track record in delivering on projects.359.77-31.97Industrials
IPP iProperty Group Worth watching as it is trying to be the REA Group of Asia.353.73105.26Information Technology
UXC UXC Company has turned corner and enjoyed re-rating. What's next?310.6713.83Information Technology
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal liner on diabetics.302.2329.17Health Care
BNO Bionomics One of the larger cancer treatment developers in this market.298.81124.39Health Care
RKN Reckon Fierce competition for cloud base accounting software puts it in firing line.289.51-1.44Information Technology
IMF IMF Australia Litigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.277.8521.06Financials
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 275.9240.78Financials
RIC Ridley Corp High corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.266.26-16.27Consumer Staples
NWT Newsat Potential large cap if it can launch its own satellite in 2015.260.15-13.73Telecommunication Services
SPL Starpharma Holdings Noteworthy for its good pipeline of innovations. Well run, widely followed.253.62-47.50Health Care
SHV Select Harvests Noteworthy for turbulent past and exposure to soft commodity market.250.34258.70Consumer Staples
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.240.6219.31Financials
GXL Greencross Acquisitive veterinary group. Good profit growth and share price performance, but gets little press.240.60104.43Health Care
SIV Silver Chef Strong jump in the share price of the equipment financing group has attracted a good following.238.4882.22Industrials
VOC Vocus Communications Telecom stocks are in favour but Vocus is one of the least covered233.8364.61Telecommunication Services
TGS Tiger Resources Future lies in its Kipoi copper mine expansion in the Congo but miner is fully funded with DRC govt holding 40% stake in tenement. Next 12mths will be interesting.224.362.31Materials
MXI MaxiTRANS Industries Transport equipment maker posted good interim result. Has appealing yield and growth.221.7129.22Industrials
CLH Collection House In similar space as Credit Corp. Strong stock performance has attracted a following and the stock appears to be well placed to run further217.9678.12Industrials
NAN Nanosonics A successful medical tech story. Should be close to turning in maiden profit with its disinfection device.216.8358.65Health Care
TFC TFS Corp The sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.213.9189.24Materials
WBB Wide Bay Australia The building society is trying to turn its fortunes around. Also worth watching for its exposure to Queensland housing market, particularly around major resource projects.209.10-10.23Financials
PFL Patties Foods Illiquid stock but has suite of well recognised consumer brands. Defensive yield.196.78-9.91Consumer Staples
DWS DWS Will be a big beneficiary if governments start spending on IT again.193.911.17Information Technology
ACL Alchemia /AustraliaOne of the few biotechs with revenue stream. Good pipeline of oncology treatments.188.126.42Health Care
RCG RCG Corp The footwear retailer is one of the best performing consumer stocks as online competition is not a big threat. Company has a good yield as well.185.0789.48Consumer Discretionary
IFM Infomedia Interesting tech play in the car parts market. Strong share price gain but gets little air play.178.4069.66Information Technology
NEA Nearmap A stellar performer with an Interesting business that offers high quality aerial maps to companies & government.174.611442.86Information Technology
DTL Data#3 Well respected IT company that receives little press coverage.169.371.63Information Technology
HSN Hansen Technologies Operates in a high potential/growth industry but is not covered by press or brokers.168.6024.84Information Technology
SFH Specialty Fashion Group In early stages of turnaround. Can the women's apparel retailer sustain the momentum?163.4045.02Consumer Discretionary
CKF Collins Foods One of the few food franchise listed companies.154.8536.53Consumer Discretionary
ESV Eservglobal Mobile money transfer company that has been gaining traction. Widely held by instos but low press coverage151.9267.12Information Technology
IMD Imdex Drilling company is well supported by instos and should benefit from any rebound in exploration activity.147.33-46.21Materials
BGL BigAir Group The wireless microcap has gained strong following over past year or two but is often overlooked by investors and the press.143.5457.10Telecommunication Services
MCP McPherson's The personal care and household products supplier had been relatively insulated from volatile discretionary spend and online threat, but its latest profit warning shows it's not immune.141.53-6.11Consumer Discretionary
POH Phosphagenics Sizable biotech with a game changing FY14 year ahead. Good insto following but questions of poor audit and governance standard could dog company.137.76-12.90Health Care
MLB Melbourne IT A perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.134.236.96Information Technology
SAR Saracen Mineral Holdings Emerging gold producer that is widely held by instos. Hitting milestones and looks cheap. Key asset is close to gold majors, which makes it a potential takeover target.133.93-50.55Materials
MNW Mint Wireless Huge market potential if the mobile card payment solutions provider can gain market traction. Management aiming for $1 billion in transaction value a year.131.261811.77Information Technology
AZZ Antares Energy Liquid with good insto support. Already in production with exploration upside in Texas.126.22-9.17Energy
AMA AMA Group Good turnaround story but under the automotive services group is radar of most.123.6712.15Consumer Discretionary
LCM LogiCamms Strong price performance and reasonable valuation attracting interest.123.4974.27Industrials
GHC Generation Healthcare REITOne of the more interesting REITs. Income is more defensive than typical property stock and its greenfield expansion gives it earnings growth potential.121.3833.31Financials
REX Regional Express Holdings Well run airline that is overshadowed by Virgin and Qantas.110.09-15.61Industrials
WDS WDS Widely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.104.2128.61Industrials
JIN Jumbo Interactive Innovative small cap facing off industry dominated by giants. Worth watching to see if it can carve out a profitable global business.101.9427.60Consumer Discretionary
DRM Doray Minerals Widely held by instos. One of the more favoured gold explorers by brokers.97.18-19.41Materials
RUL RungePincockMinarco IT company to resource industry. Facing tough operating climate with new CEO trying to restructure and turnaround company.96.8257.47Industrials
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.93.51-53.48Health Care
CAA Capral An aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 89.92-5.00Materials
BOL Boom Logistics Crane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid.87.85-38.33Industrials
AOH Altona Mining Noteworthy copper play with Xstrata pull-out of Roseby project in Australia and the good ramp up of its Finnish project.79.83-46.43Materials
CLV Clover Corp One of the star performers in 2012. Operates in growing but relatively stable niche.78.46-6.92Health Care
LGD Legend Corp Electronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.71.3422.18Information Technology
PEN Peninsula Energy Widely held by instos and large free float. It's the only uranium miner on the list.69.95-45.24Energy
YTC YTC Resources Next 12-mths will be eventful after YTC secured funding for its projects from Glencore.69.6618.18Materials
TAN  Tandou The only direct equity exposure to cotton prices. Also trades water rights and receives little press.66.5713.07Consumer Staples
EML Emerchants Trying to change way corporates and governments disburse cash with its trackable and controllable debit card offering. If company can get $1 billion in loaded value on cards, the stock will surge.66.07430.00Financials
CKL Colorpak The small cap packaging company has grown via acquisitions over past few years.65.6446.70Materials
GXY Galaxy Resources Good upside potential if it can get its problem-prone Jiangsu plant back on track. Won't be easy to right this ship.57.43-82.74Materials
TSM ThinkSmart Potential turnaround story worth keeping eye on.56.0056.82Financials
CUV Clinuvel Pharmaceuticals Interesting skin disorder treatment developer that has done reasonably well over past year55.80-11.52Health Care
OTH Onthehouse Holdings Alternative small cap to online property leader REA Group. It is trying to use more timely housing data as a competitive edge against REA.55.470.14Consumer Discretionary
KOV Korvest The construction products and services supplier has been hit by project delays and deferrals. But its relatively high yield could give it some support.53.590.70Industrials
EBT eBet Potential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.49.80214.13Consumer Discretionary
UML Unity Mining Growing Tassie gold producer with high free float. Valuation looks compelling too.42.12-55.56Materials
NTC NetComm Wireless Under appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.31.53113.04Information Technology
PGC Paragon Care Emerging hospital equipment supplier that has been ignored by market.19.18138.01Health Care
Source: Eureka Report, Bloomberg

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