A remarkable rally in small-cap stocks this year has elevated investment risks. Pockets of value remain, but they are getting harder to find as investors chase higher-growth stocks.
The S&P/ASX Small Ordinaries Index, a barometer of stocks ranked 101 to 300 by market capitalisation, has a 26% total return (including dividends) in the year to September 20. The S&P/ASX 100 index has delivered 6% in this period, much of it from dividends.
Investors are paying a bigger valuation premium for small- and mid-cap stocks that deliver above-average growth in a patchy economy. Stocks that are likelier to be “disrupters” than the “disrupted” as they take market share off industry incumbents are in favour.
Emerging industrials are trading on an aggregate Price Earnings (PE) multiple of about 18 times FY17 earnings versus almost 16 times for large-cap industrials (including financial services and property trusts), based on Macquarie Group estimates for stocks it covers.
Small caps historically trade at a discount to large-cap stocks. Their operations are less diverse, management teams are often shallower and balance sheets are generally weaker. Yet investors are paying a rising premium for small caps based on aggregate PE multiples.
Broad-brush valuation comparisons, of course, should be treated with care. Small-cap investing is always about bottom-up company analysis and stock picking, not top-down views on relative index value. If you want index exposure, stick to ASX 100 stocks.
Another problem is the high weighting of the big-four banks and large miners in the ASX 100. Financials accounted for almost 48% of ASX 100 at August 2016. An underperforming banking sector is a huge drag on the ASX 100 and broader sharemarket.
Comparisons aside, finding value in small caps is getting harder. Anecdotally, more large-cap funds are looking further down the market for “alpha” – a return greater than the market return. That means more buyers for top-performing small caps and higher valuations.
Several of my preferred small-cap stocks, nominated for the Switzer Super Report in the past 12 months, have rallied and look fully valued.
They include: NextDC (NXT), Asia Pacific Data Centre Group (AJD), Vista Group International (VGL), SeaLink Travel Group (SLK), Premier Investments (PMV), RCG Corporation (RCG), Nick Scali (NCK), JB Hi-Fi (JBH), Retail Food Group (RFG), Link Administration Holdings (LNK), oOH! Media (OML), RCR Tomlinson (RCR), CBL Corporation (CBL), Rural Funds Group (RFF), Nufarm (NUF), Trade Me Group (TME), Xero (XRO), National Storage REIT (NSR) and Arena REIT (ARF).
Not everything has gone to plan. I overestimated 3P Learning (3PL), Spotless Group Holdings (SPO) and Ainsworth Game Technology (AGI). Shine Corporate (SHJ) and Slater & Gordon (SGH), identified too early last year after savage price falls, were other disappointments.
But the winners have comfortably exceeded the losers, which should be expected in a hot market for small-cap stocks this year. Here are five ideas to consider:
1. Data#3 (DTL)
The technology services provider has rallied from a 52-week low of 95 cents to $1.40 as more signs emerge of a modest improvement in Data3’s core corporate and government markets, and an increase in its market share.
The market might be underestimating the improving quality of Data#3’s revenue. More of it is coming from recurring sources, such as cloud-computing services rather than one-off projects. That, in turn, is lifting the visibility and reliability of its future revenue growth.
Some small-cap fund managers that own Data3 have it trading on a forecast PE of about 14 times next year’s earnings and yielding about 6%, fully franked. The company can lift earnings growth – and the share price – as it increases its share of a slowly improving market.
Source: Yahoo
2. Aventus Retail Property Fund (AVN)
The Australian Real Estate Investment Trust (AREIT) listed on ASX through a $303 million Initial Public Offering (IPO) in October 2015. Aventus traded around the $2 issue price for the first six months before rallying to $2.37 as the market became more comfortable with its prospects.
Aventus is an unusual AREIT by Australian standards. It owns and manages 20 large-format retail centres, mostly on the East Coast. Big-box retailing is a much more common form of REIT in the United States than here, which possibly explains why Aventus was overlooked upon listing.
Large-format properties have good potential as big-name electrical, homeware and other specialty retailers are grouped together in “super centres”. Their scale attracts more customers and helps Aventus generate higher occupancies and performance than privately owned centres.
Aventus’ average weighted lease-expiry profile is rising and it has had a consistency lower vacancy rate than the industry average. Watch Aventus acquire more privately owned centres and lift their valuations through improved operating performance.
Gearing at 35.7% is a touch high, but Aventus’ blue-chip client base and high occupancy rate provide comfort. It stands out in an overvalued AREIT sector.
Source: Yahoo
3. Nick Scali (NCK)
The furniture retailer, a long-time favourite of this column, earns a spot on this list despite its soaring valuation. Nick Scali has a total return of 63% over one year.
The gain is well deserved. Nick Scali leapt more than $1 after its full-year result, released in August. The furniture retailer reported 30% growth in revenue to $203 million and 56% growth in Earnings Before Interest and Tax in FY16.
Like-for-like sales rose 11% in a tough retail environment. Gross margins were slightly higher despite the lower Australian dollar (which lifts Nick Scali’s import costs). Management said strong trading conditions in FY16 had continued into July.
Nick Scali keeps finding ways to beat market expectations and has traits of exceptional companies: high and rising return on equity, no debt and capacity to fund growth internally rather than through debt or equity issuance. The company has plenty of organic growth prospects as it opens more stores and expands into New Zealand.
Nick Scali is not as attractive as it was six months ago on valuation grounds. Price gains might be slower from here, but the company has rising revenue and margins in a challenging market. That’s testament to its management, business model, product and brand.
Source: Yahoo
4. CBL Corporation (CBL)
I first nominated CBL Corporation for the Switzer Super Report in a November 2015 report on small- and mid-cap insurers. It has doubled to $3.50 since that report.
To recap, CBL listed on ASX through a $114 million IPO in October. The New Zealand-based company focuses on identifying profitable, non-traditional insurance lines in local and offshore construction and property industries and is particularly strong in compulsory building insurance in France. Builders take out insurance to protect the homeowner when undertaking renovations, or against the risk of home defects when constructing a property.
CBL recently acquired Securities and Financial Solutions Europe SA, its major product distributor in France. The deal gets them closer to its end customers and reduces the risk of too much product distribution being concentrated through one firm.
CBL’s ratings upgrade from B++ (good) to A- (Excellent) in June reflects the company’s improving capital position and makes it more competitive, particularly in Asia.
Its key management owns more than half of the company, which is invariably a good sign in emerging small-cap stocks. I said in my 2015 Switzer report that “CBL is a small cap to watch”. That view remains firmly in place.
Source: Yahoo
5. ImpediMed (IPD)
I’m always wary of including small-cap biotech stocks in lists such as this. There have been too many disappointments over the years and some biotechs take forever to release news.
I typically prefer medical-device makers, having nominated SomnoMed (SOM) in this report in April 2015 and initially included heart stent maker Reva Medical Inc (RVA) in the Switzer takeover portfolio.
ImpediMed, another medical-device maker, produces equipment that can measure changes in fluid levels in the human body in an accurate, non-invasive way.
Its flagship product, L-Dex, enables early detection of Lymphedema, which affects many cancer patients after chemotherapy. By detecting small amounts of fluid changes, the technology can help healthcare providers better detect and manage chronic disease in patients.
ImpediMed has rallied from a 52-week low of 76 cents to $1.60. Its shares spiked this month after a promising published report demonstrated the impact the L-Dex lymphoedema detection product can have on patients at risk from breast cancer-related lymphoedema.
L-Dex has potential to become a platform technology that measures fluid changes in other parts of the body. ImpediMed is working on a new product that could detect chronic heart disease, an addressable market that is many times larger than lymphoedema.
It is still early days for ImpediMed and much can go wrong with emerging medical-device makers. But the company is targeting a large market, is achieving promising research results and has strong relationships with influential hospitals in the United States.
Like many small device makers, ImpediMed has low research coverage among broking firms. As more firms cover the stock in the next 12 months, its market profile will rise.
Successful medical-device makers have high margins and high valuations multiples: think Cochlear (COH) and ResMed Inc. ImpediMed is a long way from those lofty heights, but looks like one of the more promising emerging Australian medical-device makers in the past few years.
Source: Yahoo
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Sept 21 2016.
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.
