It’s A Small Cap World After All

This story features SUNLAND GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: SDG

– Stockbrokers have updated their thoughts and views on ASX-listed small cap stocks
– It is FNArena's observation that lists of potential outperformers show a lack of mining stocks
– Mining service providers are expected to do well as global capex spend is on the rise
 

By Greg Peel

The Australian All Ordinaries index comprises all those stocks listed on the ASX which satisfy a minimum threshold of market capitalisation and liquidity and its components number around 500. By contrast, the Standard & Poor's ASX 200 comprises the top 200 companies in the All Ords by market cap and typically represents around 80% of the All Ords. The ASX 200 is the index mostly used as a benchmark for index-tracking funds.

S&P also publishes smaller and larger basket indices, from top 20 through to the top 300. If we take the ASX 300 and subtract from it the ASX 200, the 100 stocks left make up what is known as the “Small Ords” – a basket of 100 small to medium stocks by market cap. The Small Ords and its two major sub-indices – the Small Industrials and Small Resources – are popular benchmarks for those interested in “small cap” investment.

Small caps by their definition have a lower “beta” which means, to use a highly technical definition, they are more free to do their own thing rather than be shackled by the general market influences of the lumbering top 200. Small caps can thus provide outperformance.

And thus, of course, they can also provide underperformance or, more scarily, “outperformance on the downside”. Often in times of panic, such as in a GFC, investors jettison their small holdings first in a rush to cash before deigning to part with their blue chips.

Small caps are thus more popular as investments in times of bull markets, or perhaps recoveries from bear markets. From the March 2009 low to today, the ASX 200 has rallied 55% while the Small Ords has rallied 58%. In calendar 2011, the ASX 200 is up 16% and the Small Ords is up 21%.

One must always be cognisant nevertheless that the components of the Small Ords will change much more often than the components of the top 100, whether for good reasons (eg takeover, or market cap increase) or bad (market cap reduction).

Citi notes, for example, that the March index changes saw the iron ore stock component of the Small Ords drop to 3.6% from 6.1%. This might seem strange at first glance when one considers how well iron ore prices have been doing, and how well iron ore stocks have been performing, but remember we're talking promotion as well as relegation here. In March, Atlas Iron ((AGO)) was promoted to the ASX 200, leaving an iron ore hole in the Small Ords. Previously, iron ore had represented 15% of the Small Ords, now it is only 8%.

On the flipside, real estate investment trusts Valad ((VPG)), Sunland ((SDG)) and Servcorp ((SRV)) were relegated out of the Small Ords in March while ING Industrial ((IIF)) disappeared due to takeover. REITs have now fallen to under 5% of the Small Ords from over 7%.

The big mover up in the Small Ords from March was the Commercial & Professional Services sector (think mining services, recruitment companies etc) which jumped to 7% from 5.4%, mostly on the admission of Campbell Bros ((CPB)).

When changes are made to the index, those fund managers who offer a Small Ords tracking fund must change accordingly. Citi thus warns, for example, there may yet be more selling in REITs as funds are rejigged to accommodate the changes. In theory there should also be selling in Atlas Iron as well, but then this will be countered by funds tracking the ASX 200 which now need to buy Atlas.

(Just as a quick aside, everyone is astounded just how well QR National ((QRN)) has been doing since a disappointing listing while at the same time Asciano ((AIO)) – it's NSW lookalike – has not, and given the analyst world was pretty down on the stock from the get-go. A simple explanation is that QRN enters the top 20, let alone the 200, so every fund in the world tracking Australian blue chips is forced to buy it.)

So the moral of the tale here is be wary of thinking the Small Ords is the “best” of the small caps. Just like English football, your second division team which swept all before it last season will now end up in first division and thus a whole new ball game.

One does not have to track the Small Ords to play in small caps, of course. Investors are also free to pick and choose.

Citi analysts suggest their “bottom up” valuations imply a total return for the Small Ords of 14.5% for the year ahead. Small Industrials have outperformed the Small Resources for two of the last three months and are now outperforming on a 2011 to date basis. Previously there were some big wins from small miners but that story appears to have run its course for now, with investors taking a breather from Resources and searching for performance in some of the “forgotten” Industrials, Citi notes.

Across the Small sub-sectors, Citi's best 12-month forecast returns are in capital goods (23.5%), consumer staples (22.3%) and financials ex-REITs (22.0%) in the Industrials and gold (37.5%) in the Resources.

Citi has just added biotech company QRxPharma ((QRX)) and painting and building maintenance company Programmed Maintenance ((PRG)) to its list of Top Buys in Industrials which otherwise includes Alesco ((ALS)), Navitas ((NVT)), Southern Cross ((SXL)), and Premier Investments ((PRV)).

Citi has reinforced its Buy call on coal miner Resource Generation ((RES)) within its Resources list which also includes Medusa Mining ((MML)), OceanaGold ((OGC)), Gindalbie Metals ((GBG)) and Grange Resources ((GRR)).

Stockbrokers Moelis & Co covers 84 small to mid-cap industrial companies in a coverage universe it calls the XTop100 Industrials. Given this universe consists of stocks not in the top 100, it is a higher cap weighting than the Small Ords which includes stocks not in the top 200.

This “index” delivered around 19% earnings growth in the first half FY11, notes Moelis. There was little change to growth expectations for both FY11 and FY12, but only on a net basis. Those stocks showing upward momentum in the first half received upward earnings growth forecasts, and vice versa. Indeed there was a big variation in performance amongst sectors.

The big winners were those companies in mining services and in IT services & recruitment. The losers were mostly those exposed to the consumer or to interest rate rises, being retail, housing, and some telco companies.

In terms of individual stocks, those “standouts” which surprised to the upside in 1H11 and/or scored earnings upgrades were Boom Logistics ((BOL)), Chandler Macleod ((CMG)), Carsales.com ((CRZ)), Decmil Group ((DCG)), Data3 ((DTL)), FlexiGroup ((FXL)), Imdex ((IMD)), NRW Holdings ((NWH)), Super Retail Group ((SUL)), and Talent2 International ((TWO)).

On the negative side in terms of results and outlook were Customers ((CUS)), Hills Holdings ((HIL)), Industrea ((IDL)), iSOFT ((ISF)), Pacific Brands ((PBG)), Seek ((SEK)), Transpacific Industries ((TPI)), The Reject Shop ((TRS)) and Webjet ((WEB)).

Between the two, Moelis has selected a group of what the stockbroker now sees as attractive risk/reward “turnaround” opportunities at various stages of execution. They are Ausenco ((AAX)), Alesco ((ALS)), Boom, Capral ((CAA)), Fantastic Holdings ((FAN)), Oakton ((OKN)), Skilled Group ((SKE)), Wotif ((WTF)) and UXC Ltd ((UXC)).

Looking ahead on a sector basis, Moelis suggests that in theory consumer-exposed stocks should start to show more positive earnings growth from the second half FY11. A consumer “bounce-back” has been a common theme among analysts for the past couple of years but it still hasn't happened. Moelis simply points out that it was in the second half FY10 that consumer stocks hit their depths following the “stimulated” second half FY09, and as such earnings comparisons this half will be a lot kinder.

Yet the simple reality is that the consumer has not bounced back and does not look like bouncing back anytime soon, as Moelis notes. Savings have replaced once high levels of household debt, and it is for this reason the RBA is not moving interest rates at present. If consumers were more inclined to spend, then rate rises would stymie that anyway. It's a bit of a lose-lose in retail at present.

By contrast, companies exposed to resource sector capex, whether it be mining services for example, or recruitment in a sector suffering from skills shortage, have done well to date and there is little reason why they should not continue to do so for the next 6-12 months, Moelis believes.

I noted earlier in this article that the ASX 200 had risen 55% since the March '09 low while the Small Ords has posted 58%. Interestingly, the Moelis XTop100 Industrials has also risen 55% but the Small Industrials has jumped 75%. This result, says Moelis, represents recognition of a robust earnings recovery across a number of segments and a decline in global market risk aversion.

The Small Industrials forward price/earnings multiple peaked at 18.5x in 2007 and fell to 9.5x in March 2009. Its ten-year average is 14.9x and the current multiple is 13.6x. On that basis, Moelis believes Small Industrial valuations are “still far from demanding, at a still relatively early stage of the domestic/global economic recovery when compared to historical averages”.

The Industrials theme is also being played out by Credit Suisse, given the analysts include in their “top five picks” in the small-cap space (by total shareholder return) STW Communications ((SGN)), Mirabela Nickel ((MBN)), Henderson Group ((HGG)), Navitas and Campbell Bros. That's only one Resource stock in five.

Credit Suisse's wider “top pick” list includes BT Investment Management ((BTT)), Alesco, Cabcharge ((CAB)), Programmed Maintenance, SAI Global ((SAI)), SMS Management & Technology ((SMX)), ARB Corp ((ARP)), Domino's Pizza ((DMP)), Flight Centre ((FLT)), McPherson's ((MCP)), The Reject Shop, Specialty Fashion ((SPH)), Austar ((AUN)), Carsales.com, Aston Resources ((AZT)), Kula Gold ((KGD)), TPG Telecom ((TPM)) and Virgin Blue ((VBA)).

Of that list of 18, only two are Resource stocks. Credit Suisse is clearly also looking for some knock-down value in retailers.

To cap off, so to speak, and to again reinforce the mining services thesis, note that Goldman Sachs has initiated coverage on mining equipment rental company Emeco Holdings ((EHL)) with a Buy rating on an expected total shareholder return over 12 months of 41%.

Click to view our Glossary of Financial Terms