Smalls in a sweet spot

Investors who have been holding back from the sharemarket must be feeling a little despondent, as the August reporting season has been one of the best for small caps in years.

While the profit season won’t be known for delivering spectacular surprises on the earnings front, the low expectations and more generous than expected dividend payments were enough to spark the greatest August rally for the S&P/ASX Small Ordinaries Index since 2009, when the market surged after shaking off the global financial crisis.

The small cap benchmark put on 2.6% last month, which is nearly one percentage point ahead of the 10-year average. The S&P/ASX 200 Index also performed well, but the 1.6% gain pales in comparison.

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At last the pendulum is swinging back in favour of small caps. The sector had been a woeful laggard as it fell 8.3% in the red in the last financial year, while the top 200 stock index made a stunning 22.8% run-up in value.

Moreover, this is only the start of the outperformance for smalls as these juniors continue to pull ahead of their larger rivals this month. Barring an unexpected global economic shock, this trend is likely to continue over the next six months, although the easiest gains are gone.

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If you had followed the 15 buy recommendations in Eureka Report from the end of June, you would have generated an average return of about 17.5%, or more than 10% above the Small Ordinaries and the ASX All Ordinaries.

The two “underperform”, or sell, recommendations I had have also panned out well so far. Crane hire group Boom Logistics (BOL) and mining software consulting firm Rungepincockminarco (RUL) have both underperformed the broader market by 5.6% on average.

The only missed opportunity was my “neutral” recommendation on engineering contractor RCR Tomlinson (RCR) on July 10. While I did acknowledge that “there is plenty more upside to its current share price of $2.25 if RCR can turnaround Norfolk’s businesses”, I had underestimated the earnings benefits RCR could squeeze from the struggling takeover target.

With the stock at yesterday’s closing price of $3.40, there isn’t sufficient upside to upgrade my recommendation and I have to regretfully keep it on “neutral”.

The bigger question now is whether there are still opportunities in the Uncapped 100 coming out of the latest reporting season.

The natural place bargain hunters would look is among stocks that have disappointed the market. After all, businesses tend to move in cycles and with management tackling the problem areas, they should be able to produce a better outcome at the next reporting season.

However, looking at companies that have recorded the worst “announcement effect” over the past few reporting seasons, that is only true around 50% of the time. Righting a ship can take longer than one might anticipate, and it is often more difficult than it looks.   

The announcement effect refers to how a stock reacts to the profit announcement relative to the broader market. Companies that post the biggest positive or negative earnings surprise should see their share price outperform or underperform the market on the day of the announcement.

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Separately, it’s not easy finding opportunities among the laggards. Some, like engineering contractor Forge Group (FGE) have quickly regained most, if not all, of their initial losses; while stocks like airline operator Regional Express Holdings (REX) is weighed down by the lack of earnings clarity that is likely to persist for the near-term at least.

Silex Systems (SLX)

But there are three stocks that have caught my eye in the wake of the latest reporting season.

First, there is Silex Systems. The laser technology company underperformed the market by more than 6% when it released its full-year result on August 23.

Its underlying net loss narrowed sharply to $900,000 in 2012-13 from a net loss of $17.9 million in the year before, but investors’ attention was focused elsewhere.

It’s the collapsing uranium price that the stock is having trouble shaking off, with the nuclear fuel falling nearly 30% over the past year to $US34 a pound this week. This marks its lowest level in more than six years and is probably under the cost of production for most uranium miners.

The negative sentiment is spilling over to Silex because it is in the midst of commercialising its technology for enriching uranium. Using its laser, the process is far more efficient than the current centrifugal method used around the world.

Silex has received a $US15 million milestone payment from its joint venture partner, GLE (a consortium made up of industry heavyweights GE, Cameco and Hitachi), but the market is worried that the low uranium price would force GLE to postpone, or worse, abandon plans to build the first commercial plant using the laser in the United States.

The fate of Silex’s share price hangs on this decision, which is due before the end of the calendar year, and I believe this is a good time to be buying the stock if you have a long-term investment horizon.

Firstly, while it is very difficult to predict when uranium prices will recover, experts are almost unanimously forecasting higher demand for uranium over the next three to five years, despite the fallout from Fukushima. Where the uranium price will be over this time frame is more important to the decision for the commercial plant as it will take about that long to build it.

Uranium is also very different from other hard commodities, like iron ore. This is because buyers of the fuel are often happy to pay higher than market price in exchange for security of supply. You can’t just turn off a nuclear power plant because of a fuel shortage.

The other often overlooked aspect of Silex is its solar power plant business. This is a longer-term proposition for Silex, but its chief executive Michael Goldsworthy told Eureka Report that if the company achieves its goal of bringing the cost of power down to 10-12 cents a kilowatt hour, the earnings upside could be as great as its uranium enrichment opportunity.

The stock last traded at $2.55 and I have an “outperform” recommendation on Silex.

Universal Biosensors (UBI)

The medical equipment maker’s fall from grace is another that doesn’t appear linked to its results.

The stock lagged the market by over 6% on its half year result on August 1, and has struggled to recover since.

There was nothing sinister in the profit numbers or outlook from the maker of disposable test strips used in LifeScan’s (which is a Johnson & Johnson company) blood glucose machine.

WilsonHTM Investment Group analyst, Shane Storey, believes that investors may be selling out of Universal Biosensors and jumping into fellow medical equipment maker Nanosonics (NAN), which is up 16% since its results.

This is because Nanosonics is closer to turning in a maiden profit. It should hit that important re-rating milestone sometime this financial year, while Universal Biosensors is not anticipated to cross that line until next year, or the year after.

However, Storey believes there is a near-term catalyst for Universal Biosensors, which could come later this month, and he anticipates that the stock could double in value over the next 12-months.

“We must be very close now to Siemen’s launching Universal Biosensors’ second product,” said Storey. “I am hoping that the news will add a whole new dimension to the way people think about the company.”

Siemens has signed an agreement with Universal Biosensors to use its technology to make a blood coagulation testing device. The deal is similar to the deal with LifeScan and Universal Biosensors believes the coagulation opportunity can generate as much value as glucose.

I have an “outperform” recommendation on the stock.

ThinkSmart (TSM)

I have covered the consumer financing company’s results two weeks ago and the stock has not moved much since.

There were no red flags in its results or outlook, and if anything, investors should be reassured that the embattled company’s turnaround strategy is on track.

Investors shouldn’t read too much into the 7% drop in its share price since the earnings announcement on August 21 as it is probably driven more by profit taking after the stock doubled in value since the start of the calendar year.

Also, the fact that the stock is lightly traded and is only 30 plus cents mean that it doesn’t take much for the stock to register a large percentage movement over a relatively short period of time.

My upbeat assessment of the stock is shared by the few brokers who cover ThinkSmart. They have upgraded their share price target to around 45 cents.

I reiterate my “outperform” recommendation on the stock. 

Think big, go smalls!

Have you acted on any Uncapped 100 recommendations in recent months? I would like to hear about your experience and thoughts (good or bad). You can email me at brendon.lau@uncapped.com.au.

Brendon Lau owns shares in SLX, UBI and TSM.