Investors could not get enough of top small- and mid-cap stocks for much of this calendar year. In a sluggish market, they paid up for companies growing faster than the economy.
The S&P/ASX Small Ordinaries index returned 27% (including dividends) over the year to September 2016 – almost three times better than the ASX 100 index in that period.
Small-cap outperformance astonished. Index quirks, such as the higher weighting of resource stocks in the Small Ords, partly explained the higher returns. Small-cap gains followed relatively poor performance from mid-2012 to 2016.
Weight-of-money pushed small-/mid-cap valuations higher. Fund managers that normally dabbled in ASX 100 stocks looked further afield for “alpha” (a return greater than that of the market). Some even changed their investment mandates and invested in microcaps and pre Initial Public Offering (IPO) opportunities.
At the small-cap peak, sentiment more than fundamentals drove aggregate returns. The Small Ords traded at a valuation premium to the ASX 200 index, when it historically trades at a discount because of the general lower quality and liquidity of small stocks.
Small-caps usually do best when risk appetite is rising; not when investors are fearful of global recession and market volatility is persistently high. But such was the asset-price distortion from a backdrop of record-low interest rates and radical monetary policies.
Simply, investors bought large defensive stocks for yield and small-/mid-caps for growth.
That trend started reversing in the fourth quarter as Donald Trump’s surprise United States election win primed the “reflation trade”. Hopes of higher US infrastructure spending and better global economic growth lifted interest-rate and inflation expectations.
The consensus swung to large-cap Australian equities over small ones, and growth stocks over yield. Resource stocks soared and banks lifted. Defensive sectors, such as infrastructure, utilities and listed property trusts, fell. Small-caps retreated.
Fund managers took profits in small- and mid-cap stocks on high Price Earnings (PE) multiple and rotated into undervalued large-cap stocks.
The Small Ords’ one-year return of 15% is now slightly above that of the ASX 200 – a remarkable narrowing given the Small Ords was ahead by a factor of three at one stage this year. Watch the ASX 200 finish ahead of the Small Ords by year’s end.
The Small Ords has already lost 5% this quarter in a rising sharemarket. The ASX 200 is up 3%. Institutional capital is rotating out of price small-/mid-caps into the large-cap rally. Small-caps that had huge rallies are easier to sell.
However, I doubt the sustainability of the “reflation trade” and do not believe it warrants a bull-market in resource stocks and soaring valuations for big miners. Granted, the trade could run well into the New Year and last longer than many commentators expect. But a Trump Presidency – and its effect on the global economy – is rife with uncertainty.
There is a good case to reduce exposure to small-/mid-caps that have rallied. The market is itching to take profits; witness the brutal sell-down of any small-caps that lower their earnings guidance.
Some commentators argue that price falls of 20-30% in popular mid-caps suggests the selling will soon be exhausted. But several top-performing mid-caps doubled or tripled in the past few years, meaning there is there plenty of room for further falls.
The sell-off in small and mid-caps has further to run because fund managers are, collectively, still underweight the resource sector and, to a lesser extent, large-cap industrials. Taking some profits on soaring smaller caps makes sense.
The list below nominates small-caps that have rallied too far, too fast. Each is a quality, well-run company that investors could consider buying at lower prices. Their inclusion is based on valuations that are factoring in too much earnings growth.
1. Webjet (WEB)
Source: Yahoo!7
The travel provider is on the right side of tourism trends as more bookings are made online. But after more than tripling from its 52-week low this year by October, Webjet’s valuation was arguably priced for perfection.
It has fallen from a peak of $12.20 in October to $9.80 – a casualty of the market rotation out of high-priced small-caps into large-caps.
Webjet deserved its re-rating this year. The market had misunderstood the company (which has not always been the best communicator) for years.
Analysts underestimated Webjet’s rapidly improving business-to-business division, currently loss making, but potentially a bigger earnings engine than its consumer business given the operation’s global focus. Webjet expects more than 30% compound annual growth in its business-to-business division over five years.
It’s hard to fault Webjet’s strategy, execution or the size of its online opportunity. And there’s a danger in reading too much into its forecast PE of 24 for FY17 based on consensus forecasts. Some stocks warrant a high PE multiple because of their high expected growth. Webjet is an example.
My concern is the risk of greater competition from online travel giants in the next few years, in a highly price-sensitive market where few companies have sustainable advantages. Much depends on Webjet’s business division beating market estimates.
Some profit taking seems in order given Webjet’s industry risks and valuation.
2. Helloworld (HLO)
Source: Yahoo!7
My column for last week’s Switzer Super Report outlined problems facing bricks-and-mortar travel retailers as online travel competition goes up several notches.
Helloworld (the rebranded JetSet Travelworld) has been a terrific turnaround story. It looked down for the count a few years ago: the brand was tired, larger competitors continued to eat into its market share and its rebranding was fraught with risk.
Helloworld soared from a 52-week high of $1.94 to $4.95, before easing to $3.85.
Acquisitions and better-than-expected earnings growth boosted market confidence in Helloworld’s turnaround prospects and management. Strong growth in inbound and outbound tourism was another tailwind.
At $3.85, Helloworld trades on a forecast PE of about 20 times FY17, based on a consensus of a small group of analysts. That’s a substantial premium for a small-cap company that has no discernible competitive advantage in an intensely competitive, price-driven market.
As online travel giants continue to reshape the global travel industry, it is hard to justify paying big valuations for small-cap, “shopfront” travel retailers.
Helloworld deserved its share-price re-rating: it’s one of the better small-cap turnarounds in the past few years. But it still needs to do more to warrant its valuation.
3. SeaLink Travel Group (SLK)
Source: Yahoo!7
Long-time followers of this column will be aware of my early interest in stocks exposed to the inbound Asian tourism theme. I have written about this trend for years and highlighted the effect of middle-class Asian consumption on Australian tourism.
This megatrend underpinned my previously positive view on the likes of Sydney Airport (SYD), The Star Entertainment Group (SGR), Mantra Group (MTR) and SeaLink Travel Group. The latter, a ferry and small-cruise operator, was a small-cap favourite of mine.
I followed SeaLink during its 2013 Initial Public Offering. It was the type of well-run, understated industrial company that tends to over deliver after listing. The influx of Asian tourism to Sydney would drive demand for SeaLink cruises, and it did.
SeaLink soared from a $1.10 issue price to a 52-week high of $4.85 after a string of impressive profit results. It now trades at $4.35 after recent profit taking.
At that price, SeaLink is on a forward PE of about 16 times FY18, using a consensus of a small group of analysts. Always take care relying on consensus forecasts based on a low number of analyst forecasts, for results can be skewed. But even the trailing (historic) PE of 18 shows SeaLink trades at a premium to the broader market.
Like others on this list, SeaLink deserved its price re-rating. The company has good long-term prospects, but needs to pedal faster to maintain that valuation. Long-term investors might consider taking some profits and buying back at lower prices.
4. Domino’s Pizza Enterprises (DMP)
Source: Yahoo!7
CEO Don Meij could justifiably have a quiet laugh when yet another analyst suggests the pizza group is overvalued. For years, many analysts argued that Domino’s was overvalued, only to miss one of the great rallies from one of Australia’s great companies.
Better judges argued that the market was underestimating Domino’s transformation into a technology company. Its capabilities in food-ordering and delivery technology in the Australian fast-food industry are valuable competitive advantages and a reason why Domino’s is being valued more like a hot tech stock than a low-margin food provider.
A fall from the 52-week high of $80.69 to $66.48 has reduced Domino’s nose bleeding valuation. But even at the current price, Domino’s trades on a forecast PE of 46 times FY17 earnings, according to consensus analyst forecasts.
True believers will stick with Domino’s. Long-term investors could take some profits as the market continues to rotate out of pricey industrials.
Rising competition from Pizza Hut and concerns about higher wage costs for pizza-shop workers could affect Domino’s franchisee profits. Domino’s will yet again overcome its industry challenges, but its valuation, even after recent falls, leaves little room of error.
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at December 14, 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.
