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Use these five filters to help identify the most promising small and mid-cap ASX-listed stocks.
By Karl Siegling, Cadence Capital
I look for five key attributes to identify outstanding small and mid-cap stocks, which are outside the ASX top 100, by market capitalisation:
- Strong earnings growth and attractive valuation
- A strong balance sheet with cash
- A management team with a record of success
- Liquidity in the shares
- A share price chart in uptrend.
First, to compensate for the risk of investing in a small company, there must be strong forecast earnings growth over your investment time horizon. The company's valuation must be compelling enough to see scope for valuation expansion and thus a rising share price. As well as strong earnings growth, there needs to be solid operating and free cash flow. (Editor's note: Simply put, free cash flow is operating cash flow minus capital expenditure, or the money left to distribute to shareholders after the company's asset base has been maintained or expanded.)
Second, the small-cap company must have a strong balance sheet to provide capital for growth and minimise the risk of a dilutive equity raising in the event of economic slowdown or business shock. (For example, a placement where shares are offered at a large discount to the prevailing share price to raise capital). A company with cash on its balance sheet is better than one with debt, especially if no value is being ascribed to the cash. (Small exploration companies, for example, sometimes have a market capitalisation that is less than the cash on the balance sheet).
Third, the management team needs a strong track record of previous success in growing a business. It must have clearly articulated its strategy to the market in an easily understandable form, so we can identify the value proposition the business is offering. Ideally, management should own a large portion of the company's shares, to ensure its interests are strongly aligned with shareholders.
Fourth, the small-cap company must have reasonable share liquidity so it is possible to enter or exit a stock within a reasonable timeframe. (Liquidity is a measure of the ability to buy or sell assets easily and with little impact on price). Alternatively a stock with less liquidity needs to compensate owners with a greater return. This is especially important at the moment as large-cap stocks have done as well as small and mid-cap stocks, without the liquidity risk. (That is, shares in large-cap stocks typically trade more frequently and are easier to buy and sell without as much impact on the price).
Finally, the share price chart must be in an uptrend (showing a series of higher price-highs over a longer period). The Cadence process is based on both fundamental and technical analysis. We buy stocks both with solid fundamentals and showing upwards share price momentum. We follow the motto: "Buy assets that are going up, sell assets that are going down". This is easy to say but not always necessarily easy to implement. No amount of fundamental analysis is any good if the end result is buying a stock that is going down in value.
Cadence's top small and mid-cap stock holdings
The filters above help Cadence identify stocks to buy. Here are 10 in our fund that meet these requirements:
- RHG Limited (RHG). Operates in the funding and servicing of residential mortgages. The loan book is in run-off. Cadence believes this stock will be delisted after a sale in the short term.
- Retail Food Group (RFG). Australian retail franchisor and brand manager. Operates several franchise systems, including Donut King, Brumby's Bakeries, Michel's Patisserie and Crust Gourmet Pizza. Strong earnings growth and good operating cash flow. The successful acquisition profile, combined with Australia's insatiable appetite for junk food as we move towards being the most obese nation in the world, should help the RFG valuation.
- Flexigroup (FXL). Non-bank financial services provider offering consumer credit and small and medium-size enterprise (SME) credit products. Has carved out a niche financing SMEs where the big banks have not been lending money. Once these SME loans are packaged up into a portfolio of mortgages, there are many wholesale lenders to this business.
- McMillan Shakespeare (MMS). Offers salary packaging and fleet management services. The recent share-price sell-off represented an excellent buying opportunity. Regulatory risk (that the government could remove salary-packaging tax concessions) has affected MMS for the third time since listing at 50 cents and each time the stock has bounced back bigger and stronger.
- iiNet Limited (IIN). Leading internet service provider (ISP) in Australia with a good earnings profile and good cash flow characteristics. Telecommunications companies have tended to drift into and out of favour over the past 10 years.
- Sunland Group (SDG). Property development and construction. A company with a very large franking credits account balance and in a recovery phase after a terrible period during the GFC.
- Abacus Property Group (ABP). Property funds management and development. A very well-run business with a large wealthy shareholder who appears to manage their investment as if it were a private business - a good sign.
- Freelancer Ltd (FLN). Job outsourcing website and marketplace. An early-stage "destructive technology business" that is attempting to auction services over the internet, as eBay does with goods. Recently listed on ASX after an Initial Public Offering
- Reckon (RKN). Accounting software provider for small business and home office users. Reckon continues to deliver good, strong operating cash flow and free cash flow as its business model migrates online. Certainly the lowest valued software company of the three main players - MYOB, Reckon and more recently Xero (whose valuation is 10 times greater than RKN despite never having earned any cash flow).
- Ingenia Group (INA). Owns and develops residential living communities. This is a very good turnaround story that has some organic earnings growth and also growth through acquisition. Management has a strong track record of delivering since the recovery.
In terms of large-cap stocks, Macquarie Group is in the Cadence portfolio. It hit $16 briefly after the 2008 GFC and we started accumulating it at around $23. Macquarie is starting to see a strong uptick in the earnings cycle and on this recovery should also get rerated. Macquarie has the added benefit of 65 per cent of earnings being offshore, and is a global business.
About the author
Karl Siegling is Managing Director and Portfolio Manager at Cadence Capital Ltd (ASX Code: CDM), a listed investment company. Learn more about the Cadence investment philosophy or visit the Cadence website.
ASX online courses cover shares, interest-rate securities, warrants and instalments, exchange traded funds, options and futures. The shares course has 11 modules, each taking 10 to 15 minutes to complete. Topics covered include: What is share; How to invest; Risk and benefits of shares; What to consider in an investment; and How to buy and sell shares. Simple summaries and quizzes in each module make learning fast, easy and enjoyable.
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