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Six star small stocks

This article appeared in the March 2013 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.

Investing in smaller companies is often perceived as risky, because they can have a lower market capitalisation, higher volatility and less liquidity. However, exposure to up-and-coming businesses can help achieve long-term outperformance, if you know what to look for, and understand the risks. ELIO D'AMATO reports.

Photo of Elio D'Amato By Elio D'Amato, Lincoln

Mention the words small or mid when describing a company on the sharemarket and many investors conjure up images of speculative short-term stocks showing poor fundamental qualities, where the "easy come, easy go" philosophy to share investing holds true.

However, retail investors cannot ignore this end of the market because it is by far the most populous area of the exchange. Of the 1880 companies currently trading on ASX, fewer than 10 per cent have a market capitalisation above $1 billion. In fact, BHP Billiton's ASX market capitalisation equals that of the 1684 (89.6 per cent) smallest companies on ASX.

It has been a tough 12 months for the small to mid-cap investor. Of the companies with a market capitalisation below $1 billion, the average return was +3.9 per cent, a disappointing effort compared to the ASX All Ordinaries Index (XAO), which rose 19.3 per cent.

More concerning is that if you look at the median, or middle, performance for mid-to-small-cap companies with a market capitalisation of less than $1 billion, the return drops to -20.9 per cent. This means the trend for the past year in small-cap stocks has been negative returns.

3 year market performance of the S&P/ASX Small Ordinaries, S&P/ASX Mid Cap 50 and All Ordinaries index

3 year market performance of the S&P/ASX Small Ordinaries, S&P/ASX Mid Cap 50 and All Ordinaries index - from March 2010 to January 2013

Source: Lincoln Stock Doctor - Data at 19 February 2013

With returns like this, it is easy for the retail investor to simply ignore these companies as high risk.

But a number of academic studies have proven that over the long run, smaller-cap companies outperform the broader market on a risk/return basis. This is known as the "small company effect" and reasons attributed to this phenomenon include:

  • Information uncertainty. Lack of information amounts to relatively higher risk and potentially greater opportunity to exploit market mispricing
  • Transaction costs. Small-cap stocks generally involve wider bid-ask spreads and are subject to larger market impacts from trades. This dissuades investors from trading frequently
  • Illiquidity. Small-cap stocks are relatively illiquid and some studies propose that their excess returns can perhaps be explained simply as compensation for this illiquidity.

But every company has its very beginnings, even before listing, starting out as a small-cap once in its lifetime. Therefore, there are clearly gains to be had in getting in early in a company's life as there may be tremendous growth opportunities. At Lincoln we propose that a small "great" business is more likely to become a great big business one day. However, as any quick examination of "penny-dreadfuls" will attest, this area is a minefield as there are many companies that never make it.

Using our Lincoln Financial Health score, the numbers look worrying. Of all the companies in the small-to-mid-cap area, 79 per cent are exposed to unacceptable levels of financial risk, according to Lincoln analysis. The reason for this bad statistic can be wide and varied. They highlight the possible risks of these sectors where you may be called upon to throw more capital into such businesses, or worse still, called upon to talk to the administrators. (Editor's note: the high proportion of resource stocks yet to make profit adds to overall financial risk in the small-cap stock universe).

Financial Health of companies below $1 billion market capitalisation

Financial Health of companies below $1 billion market capitalisation

Source: Lincoln

Contrary to common belief, there are small-cap companies that exhibit strong fundamentals. By this we mean they are profitable companies that have a strong balance sheet with a sound gearing structure in place.

The good news from the above graph is that 21 per cent are acceptable and therefore may prove to be an opportunity for the savvy investor willing to take on a little bit more volatility risk in their portfolio. The question then becomes how to identify the weak from the strong and ultimately which small or mid-cap company to select.

Steps to identify a quality small/mid-cap opportunity

  • Because of the potential pitfalls that can befall investors in smaller companies, at Lincoln we first look at a company's financial health by looking at the profitability, debt balances and cash flow levels. Identifying companies with a consistent history of profit-making and sufficient liquidity to meet its operational and debt requirements is essential for investors, particularly in smaller businesses, as generally they contain non-diversified single income streams that can fluctuate.
  • Assess management's historical performance by looking at ratios such as return on assets (ROA), return on equity (ROE), earnings per share (EPS) growth and revenue growth. An investor must ensure they are growing, and within industry averages or better, considering the additional risks involved compared to their larger peers.
  • Examine share price value. Often smaller companies do not have valuations attached to them. In such instances refer to a company's price-earnings (PE) ratio and, as a rough rule of thumb, if it is less than the industry average it indicates potential for share price appreciation. Where PE is greater than the industry average, a PEG ratio (PE/EPS Growth) of less than 1 may be used to determine if the premium is justified given the level of earnings growth.
  • Determine the liquidity of the stock. Many small-caps can be highly illiquid companies and you may find it difficult to sell in the future. Generally speaking, make sure your exposure is one where you have an exit strategy if need be. A good rule of thumb is a "daily average traded volume" around five times your exposure. Notably, the longer your time horizon and confidence in the company, the less of an issue liquidity represents.
  • Consider the share price trend or market sentiment. Focus on companies with a positive trend in share price.
  • Finally, and perhaps most importantly, understand the business of the company. Know what it does as well as the potential opportunities and threats that could affect its future earnings. Watch the company announcements and media releases to ensure there have been no negative developments.

Keep your mine detector on at all times

In summary, investing in smaller to mid-size companies on the sharemarket is often perceived as being risky relative to large companies because they have a lower market capitalisation, higher volatility and can have poor liquidity. However, investors should not be dissuaded from investing in such companies, because the weight of historical evidence suggests an exposure to up-and-coming businesses is key in achieving long-term outperformance.

Simple steps of ensuring your smaller companies are growing, profitable, reasonably priced and have strong long-term prospects will put you in the best position to enjoy the opportunities that investing in these companies can provide.

First and foremost, never forget the most important rule, which is to ensure your businesses are financially healthy. Investing in only the healthiest of smaller companies will reduce the likelihood of nasty surprises in the sharemarket and in small caps. While the fields look green with opportunity, there can be nasty surprises for those who do not take sound and solid steps.

(Editor's note: Do not read the following commentary as stock recommendations. Do further research of your own or talk to your financial adviser before acting on the themes and ideas in this article).

Six examples of financially healthy small/mid-cap companies, according to Lincoln analysis:

Code Name Price ($) Market Cap. ($mil) Comments
AUB Austbrokers Holdings Limited 8.84 508.9 AUB operates as a network of insurance broking and financial services firms in Australia. The company should benefit from hardening in the premium cycle and is likely to continue to increase earnings through further bolt-on acquisitions that are expected to make positive contributions straight away.
FGE Forge Group Limited 6.18 534 FGE is a financially healthy civil construction services business with a specific focus on servicing the mining sector. More recently, the company has moved into the power plant construction industry and this Lincoln Stock Doctor Star Stock looks set to grow, having reported strong interim financial results and providing solid full-year profit guidance.
GEM G8 Education Limited 1.715 229 GEM is a Lincoln Stock Doctor Star Stock and Lincoln preferred income stock. It operates in the childcare industry with the majority of its operations in Queensland. A rise in two-income households has seen a growth in demand for childcare services. A large proportion of GEM’s income is stable as it comes direct from government, which assists families by reimbursing half of all childcare expenses. GEM is well positioned to capture growth in this industry. It is also forecasted to pay a grossed-up dividend of 5.83 per cent.
MIO Miclyn Express Offshore Solutions Limited 2.49 697 Lincoln Stock Doctor Star Stock, vessel services and charter business MIO, is well placed to continue its strong growth trend with operations in Australia and South-East Asia. This is a trend we believe will continue as capital expenditure in the offshore oil and gas industry is set to soar in coming years.
NST Northern Star Resources Limited 0.93 382 NST is a gold producer focused on the Paulsens underground gold project in WA. NST is scheduled to commence mining high-grade ore this year and possesses an attractive exploration profile following its joint-venture arrangement with Fortescue Metals Group Limited (FMG). Despite recent weakness it is expected to see its star shine again soon.
SRX Sirtex Medical Limited 10.44 548 SRX is a financially healthy biotechnology and medical device company that manufactures and distributes SIR-Spheres microspheres, a radioactive treatment for inoperable liver cancer. Dosage sales will continue to increase as its treatment gains awareness in the global oncology community. Major clinical trials are under way with results due in 2015, which are likely to underpin the company’s long-term future growth.

Source: Lincoln Stock Doctor. Prices at market close 19 February 2013

About the author

Elio D'Amato is chief executive of Lincoln, a leading Australian share researcher and investor.

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