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Mid-cap stocks to consider

This article appeared in the October 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

The best place to spot these types of growth companies is in the small to medium industrial sector. These tend to be under-researched and are growing at a faster rate than their peers.

Photo of Geoff Wilson By Geoff Wilson, Wilson Asset Management

It has been about five years since the Global Financial Crisis hit and the challenges are clearly not over yet. I believe we are only halfway through a decade of deleveraging - governments and consumers paying off debt.

In the coming years, growth will be lower than experienced in the past and with that will come lower price-to-earnings (PE) multiples for companies. In this low-growth environment there has been a focus on defensive shares and high-yielding investments over the past year. It's still tough out there.

(Editor's note: To learn more about ASX-listed small and mid-size companies, watch the current series of ASX Corporate Profile videos).

Wilson Asset Management meets more than 1000 companies each year, providing extensive insight into the economic environment. Many companies have seen little or no impact from the Reserve Bank's interest rate cuts in the past 12 months, and a majority of outlook statements from companies during the recent reporting season highlighted a tough operating environment and continued volatility.

Since the results, equity analysts have downgraded FY13 earnings estimates for a significant number of companies, averaging 4 per cent across the market.

Macquarie expects earnings growth of 5.7 per cent for FY13, but we believe this is too optimistic. We forecast close to zero earnings growth for FY13. That is not to say that all companies will experience these low levels; some will grow quite rapidly despite the economic environment.

Searching for growth

In the Research Driven part of the Wilson Asset Management portfolio we look for companies growing at one to two times their Price Earnings (PE) multiple and have a catalyst that is going to cause a re-rating of their share price in the near future. Put another way, if a company's PE is 10, it needs to grow its earnings or profits per share at 15-20 per cent per annum for us to consider buying it.

(Editor's note: To learn more about PE ratios, read Michael Kemp's article in this issue).

We don't buy unless we can identify a catalyst or event that will change the valuation by the market. That catalyst might be the appointment of a new chief executive, a divestment of an under-performing part of the business, or entry into a new market.

We believe the best place to find these types of growth companies is in the small to medium industrial sector. These tend to be under-researched and are growing at a faster rate than their peers.

Those we currently like include Breville Group Limited (BRG) and Flexigroup Limited (FXL). They also have had catalysts - in Breville's case, expanding its US business. These are examples of small companies growing rapidly despite the difficult conditions faced by many of their larger competitors.

Low interest rates to drive M&A activity

Larger companies tend to find it harder to grow at the same high rate as their smaller rivals. They are generally more exposed to the economic headwinds currently buffeting the global economy. This may lead them to embark on a trail of acquiring smaller faster-growing rivals in order to effectively buy growth for their own businesses.

Low interest rates provide relatively cheap debt funding options for potential mergers and acquisitions, and in the next 12 to 18 months I expect to see an increased level of M&A activity. This will be more evident if we get one or two further interest rate cuts, and we expect the Reserve Bank to cut rates before the end of 2012, bringing them back to GFC levels.

Growth at the right price

When we look for small-cap growth companies we are also looking for shares that represent good value - we want to buy growth but at a relatively cheap price. This is why we use the metric of growth at one to two times PE. Because small companies tend to grow faster than large ones, it makes sense for investors to have exposure to a diversified portfolio of small-cap growth companies.

A listed investment company (LIC), such as WAM Research Ltd (WAX), can provide that. If you want to invest directly and have the time to conduct your own research, the two companies mentioned, BRG and FXL are a good starting point.

The new rolling 12-month highs and lows [published in some newspapers] can also be a good fishing ground for ideas. Another place is the announcements page on the ASX website.

The time is now

A great African proverb says, "The best time to plant a tree was 20 years ago, the second best time is now." I take some poetic licence with this and swap "plant a tree" for "invest". It doesn't matter where we are in the cycle, you will always find some companies growing strongly. They are in the sweet spot of the cycle for how they make money and so can exploit that. Investing in these companies can benefit your overall portfolio, whether you choose to invest through a LIC, or invest directly.

About the author

Geoff Wilson is the Chairman of Wilson Asset Management, a leading small-cap investor.

From ASX

Listed Investment Companies provides a wealth of information on LICs. Use ASX Market Update information to review LIC premiums and discounts to NTA since 2004. View the monthly sector update to see overall LIC performance. Examine quarterly performance returns to gauge a LIC's investment performance against others.

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