Finding bargains in small-cap land is getting harder. As large-cap fund managers look further down the market for value, many small-cap industrials have been re-rated. But there are opportunities for patient investors who buy during market pullbacks.
The five stocks below were chosen for different reasons. Online educator 3P Learning makes the grade because it looks undervalued. So does litigation funder IMF Bentham after case losses crunched its share price.
Spotless Group Holdings also looks a touch undervalued and its defensive qualities appeal in a volatile market. Veterinary group Greencross appeals after shedding a third of its price. DuluxGroup rounds out the list because its long-term strategic appeal is undervalued.
Here is an overview of the five small- or mid-cap industrial stocks:
1. 3P Learning
The education software firm continues to frustrate investors. It has traits of exceptional companies: low debt, high return on equity, high margins, recurring revenue, a genuine global footprint and good management. It also has fabulous products in Mathletics, used by more than 3 million students worldwide, and Reading Eggs, which it distributes.
But the share price has disappointed. 3PL listed on ASX in July 2014 through a $282 million Initial Public Offering (IPO) at $2.50 a share, in a heavily oversubscribed offer. It briefly traded above the issue in May this year, before slumping to $1.80 as the share market sell-off peaked in September. It is now $2.30.
3PL initially beat prospectus forecasts and its latest earnings result bettered market expectations. Some fund managers are concerned that it is discounting products to gain traction in the US, and its recent acquisitions might have spooked investors.
3PL acquired in September a 23% shareholding in Learnosity Holdings, a Dublin-based provider of software-as-a-service assessment tools for US$19.4 million. That followed its US$5 million investment in March for a 17% stake in Desmos Inc, a US graphic calculator application business.
At $2.30, 3PL trades on a forecast Price Earnings (PE) multiple of 20 times 2015-16 earnings, based on a small number of analysts who cover the stock. That is lower than several software stocks that are not nearly as established or growing as rapidly overseas. Macquarie Equities Research has a 12-month price target of $2.92. 3PL is one to watch.
3P Learning (3PL)
Source: Yahoo!7 Finance, 5 November 2015
2. IMF Bentham
The litigation funder soared from $1.60 in February 2014 to $2.47 a year later. Its descent was just as swift: IMF hit $1.34 last month.
To recap, IMF funds shareholder and consumer class actions – a growing area of legal claims in Australia and offshore. It is a bit like a funds-management business: IMF backs a portfolio of cases, each with different expected settlement timeframes, and spreads risks. It typically earns about 30% of cases settled before trial, sometimes more.
IMF has lost only 6% of cases backed over the 14 years, but four case losses, rare by its standards, was enough to smash the share price. Its portfolio of 39 cases at 30 June 2015 had an estimated claim value of about $2 billion (of which IMF would take a share if all of them were successful). Assuming its long-term case-win rate resumes, IMF looks undervalued.
IMF had $130 million in cash on the balance sheet at June 30, 2015– high for a company capitalised at $246 million. It trades on a forecast PE of about seven times 2015-16 earnings. Four analysts who cover it have a buy recommendation and the median price target is $2.41.
IMF’s earnings and revenue can be lumpy, and litigation funding is a high-stakes game. But it operates in a long-term growth industry as more class actions are pursued, is the dominant litigation funder in Australia, and is growing overseas. IMF is also consistently well run.
IFM Bentham (IMF)
Source: Yahoo!7 Finance, 5 November 2015
3. Spotless Group Holdings
As more companies target high-growth tech markets, Spotless is making solid gains in cleaning and catering. Neither industry is glamorous, but they give Spotless a vital commodity in a volatile market: defensive, visible earnings growth.
Much has been achieved since Private Equity Partners bought the struggling Spotless in 2012, delisted it from ASX, and fixed it. It came back to market in May 2014 through an IPO that raised $994 million at $1.60 a share. Spotless is now $2.13.
Spotless’ maiden full-year result, released in late August, beat revenue and earnings (EBITDA) forecasts in the prospectus by 5-6%. Its profit margins in the Health, Education and Government division bettered market expectation.
Spotless has announced several contract wins or renewals this financial year and looks well placed in the booming healthcare and aged-care sector. The market is underestimating the company’s potential to provide outsourced facility, laundry and linen services to sectors benefiting from huge demographic tailwinds.
Most brokers who cover Spotless have a buy recommendation, but a target price of $2.25, based on a small consensus of brokers, suggests it is fully valued for now.
Spotless can do better than the market expects, buoyed by its healthcare division, contract wins, efficiency gains, and a management team that is driving plenty of operational momentum. A 4-5% expected yield is another attraction.
Spotless Group Holdings (SPO)
Source: Yahoo!7 Finance, 5 November 2015
4. Greencross
The market could not get enough of the veterinary practice and pet-store owner. It soared from $1 in August 2011 to $10.17 in September 2014 as investors applauded its strategy to consolidate the fragmented veterinary industry through acquisitions.
But Greencross was hammered after Jeff David’s surprise resignation as CEO in August, and amid market fears of rising competition in the veterinary industry. National Veterinary Care’s listing on ASX in late July and talk that private equity firms are preparing to roll up practices suggests Greencross might have to pay more to buy assets.
Greencross was always due for a significant pullback after “ten bagger” gains, and I suspect the market had trouble digesting a spate of large acquisitions and its transformation in 2013 into a pet-store owner through the merger with the impressive Petbarn chain.
The acquisition provides cross-selling opportunities between veterinary services and pet goods, demand for which is expected to rise as people spend more on their animals.
The results are starting to show. Greencross delivered a solid 2014-15 result, said it had a positive trading start to this financial year, and that it expected to deliver strong organic-led growth in 2015-16. Bigger benefits from the merger should flow this year.
Seven of nine brokers who cover Greencross have a buy recommendation and the consensus price target is $8.32, analyst forecasts show. That looks a touch bullish for now. But after a period of share-price consolidation, Greencross can grow faster than the market expects.
Greencross (GXL)
Source: Yahoo!7 Finance, 5 November 2015
5. DuluxGroup
Australia’s leading paint maker, and one of the market’s higher-quality mid-cap stocks, is approaching value territory after falling from a 52-week high of $6.88 to $5.88.
Fears that big retailers could sell more private-label paint and reduce DuluxGroup’s shelf space have weighed on the stock. So have concerns of price discounting and irrational market behaviour in low-end paint and more competition from multinationals in the high-end area.
But these fears look overstated. Dulux paint, increasingly fashionable, is a drawcard for its key distribution channel, Bunnings. Dulux backed the right horse in 2013 when it pulled its paint and wood-care products from Woolworths’ Masters chain and concentrated on Bunnings.
Dulux has a strong position in an oligopoly for paint and has cleverly positioned itself at the higher end. Key brands such as Antique White USA are popular among home renovators and a reason why they prefer premium over discount paints.
The home-improvement market shows no signs of slowing as high house prices encourage more people to stay put and renovate, rather than move. Record-low interest rates are another driver of sustained growth in the renovations and refit market. Moreover, Bunnings has plenty of growth ahead of it and Dulux should benefit as the hardware chain extends its lead.
Three of 11 analysts who cover Dulux have a buy recommendation, six a hold, and two have a sell. A median price target of $6.10 suggests Dulux is fully valued for now. The market is underestimating the changing nature of the paint market, as renovators favour premium brands, and Dulux’s potential to drive stronger performance from its Alesco-acquired assets.
Dulux’s exposure to the renovations markets also means it is less volatile than its peers that rely on the more cyclical housing starts, although the Alesco Corporation acquisition in 2013, with its garage doors and building products, added an element of higher cyclicality to the company’s earnings.
DuluxGroup (DLX)
Source: Yahoo!7 Finance, 5 November 2015
– Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at 5 Nov 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.
