First profit, first choice for stock pickers

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.

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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.

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.

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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.