Key points

• Young consumers are increasingly buying insurance policies online and iSelect has the potential to shake up the lucrative life-insurance industry.
• LifeHealthcare distributes high-end medical devices in Australia and New Zealand and has excellent leverage to an ageing population.
• Shine Corporate is a Brisbane-based law firm and is focused only on the Australian market. The well-run firm has plenty of growth options.

Successful small-cap investing always relies more on “bottom-up” stock picking than top-down market or sector analysis. But it pays to understand powerful trends, find the small caps best placed to benefit, and buy them below their fair value.

Trend analysis is especially important for long-term investors such as Self-Managed Superannuation Funds (SMSFs). Investment Trends research shows more trustees want to allocate a higher proportion of their portfolio to small- and micro-cap stocks.

Three factors are driving a higher allocation of small caps. First, more SMSFs are favouring core/satellite portfolio strategies over traditional asset-allocation approaches. They might use passive funds for large-cap equities and fixed-interest exposure in the portfolio core, and a high-conviction portfolio of small caps as a satellite to lift returns.

The second argument for a higher allocation of small caps in SMSFs is returns. Research shows the Australian small-cap universe remains a fertile ground for achieving “alpha”, or a return greater than that of the benchmark.

Standard & Poor’s SPIVA scorecard consistently shows the majority of small-cap fund managers outperform the Small Ordinaries index.

In contrast, most active Australian large-cap fund managers fail to beat their benchmarks over three and five years. That means their unit holders, on average, are paying high fees to achieve a return less than the index. They would be better off with exchange-traded funds that replicate the index return at lower cost.

The third argument for small caps is leverage to industry “disrupters”. With the S&P/ASX 100 heavily concentrated in banking and resource stocks, SMSFs are looking to small- and mid-cap stocks for exposure to technology-related themes.

Themes to watch

Having decided to allocate more of their portfolios to small-cap stocks, SMSF trustees should consider multi-year or decade trends and the best companies to benefit.

Five trends are influencing my thinking on small caps:

• The unstoppable trend of buying goods and services online;
• Rise and rise of cloud computing;
• New media’s new prospects;
• An obese, ageing population; and
• The rise of the industry consolidator.

1) The unstoppable trend of buying goods and services online – iSelect (ISU)

Source: Yahoo!7 Finance

2) Rise and rise of cloud computing – NEXTDC (NXT)

Cloud computing is still in its infancy in Australia as more companies “lift and shift” their data to the cloud to save costs and improve data storage and management. Smaller tech players such as Rhipe, Covata and micro-cap service provider Bulletproof Group appeal.

But I prefer a different approach to cloud computing. NEXTDC (NXT) is racing to cement a first-mover advantage as an independent data-centre operator with state-of-the-art facilities in Sydney, Melbourne, Brisbane, Perth and Canberra.

It listed on the ASX in late 2010 through a $40 million float at $1 a share, and now trades at $2.29.

NEXTDC is superbly positioned to capitalise as more companies rent space in its facilities: Cisco Systems predicts global data-centre traffic will nearly triple over the next five years.

A lower way to play cloud computing is NEXTDC spin-off, Asia Pacific Data Centre Group (APDC), an Australian Real Estate Investment Trust that owns data centre buildings.

After recent price falls, APDC is trading in line with its latest stated net tangible assets of $1.24 a unit and looks good value – the first time all year. A 7.8% forecast yield is another attraction.

Chart 2: NEXTDC (NXT)

Source: Yahoo!7 Finance

3) New media’s new prospects – iSentia Group (ISD)

Growth in new media companies was an overlooked highlight in the Initial Public Offerings (IPO) boom in the past two years. Outdoor advertising providers oOH! Media and APN Outdoor Group have interesting prospects as more out-of-home advertising signage is converted to digital, and this segment grows its share of total advertising.

Media-monitoring provider iSentia Group (ISD) has been among my favoured small-cap stocks in the past 12 months after it raised $284 million at $2.04 a share in a June 2014 IPO. It peaked at $3.95 this year, before easing to $3.51.

iSentia provides media monitoring, social-media monitoring and analysis, media management and analysis, contract management services around communication strategies, and media-release distribution.

iSentia is not cheap, but the explosion in social media means companies will have to spend more to monitor it and engage more in editorial-based content marketing – an area iSentia is expanding into through recent acquisitions.

Chart 3: iSentia Group (ISD)

Source: Yahoo!7 Finance

4) An obese, ageing population – Lifehealthcare Group (LHC)

Investors who want small-cap exposure to this trend typically consider life-science stocks or, retirement village operators such as the promising Estia Health. I favour established medical-device makers or distributors, and follow two closely.

The first, SomnoMed, was nominated as a “born global” small cap for this report in April. It makes oral devices to treat sleep apnoea, a long-term growth market as higher rates of obesity cause more sleep disorders and breathing problems.

SomnoMed is among the more impressive global-focused Australian small caps. Its three-year annualised total shareholder return is 43%, but it still trades on a revenue multiple below similar companies in the US.

LifeHealthcare Group (LHC) is the other stock. It raised $76.6 million through an IPO on ASX in December 2013 at $2 a share and now trades at $3.17.

LifeHealthcare distributes high-end medical devices in Australia and New Zealand and works closely with surgeons, hospitals, nurses and other medical specialists.

It has excellent leverage to an ageing population, as more people need orthopaedic surgery. As a product distributor, it has less risk than medical-device makers and its relationship with surgeons is more valuable than realised.

Chart 4: Lifehealthcare Group (LHC)

Source: Yahoo!7 Finance

5) Rise of the industry consolidator – Shine Corporate (SHJ)

I’m wary of industry consolidators that grow by acquiring smaller competitors. They usually look great on paper, but can take on too much debt, issue too much overpriced equity, and struggle to implement acquisitions. Then they crash.

The new breed is more attractive. Dental groups 1300 Smiles and Pacific Smiles Group have good, long-term prospects in the highly fragmented dental industry. Pacific Smiles’ strategy to open clinics in shopping centres appeals.
Capitol Health’s work to consolidate medical-imaging practices in Victoria also has merit.

In professional services, Slater & Gordon looks oversold after being attacked by short-sellers this year amid fears over the price paid for its UK acquisitions.

Its business model has more risk after its UK deal, but a forward Price Earnings multiple of less than six times for the dominant personal-injury firm in Australia and now the UK is too low.

Veterinary group Greencross almost received the top nomination in this category on valuation grounds, after price falls. However, recent and unexpected management changes are a headwind for the aggregator of veterinary practices and pet goods retailer.

Instead, I’ll plump for Shine Corporate (SHJ). The Brisbane-based law firm has fallen from $3.36 in March – just as Slater & Gordon’s problems emerged – to $2.25. It may also have been the target of short sellers and has suffered from poor sentiment towards Slater & Gordon.

Unlike Slater & Gordon, Shine is focused only on the Australian market, its acquisitions are modest by comparison, and there is less risk. The well-run firm has plenty of growth options.

Chart 5: Shine Corporate

Source: Yahoo!7 Finance

– Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis 2 Sep 2015.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.