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3 small and mid-cap stocks with big prospects

Photo of Julian Beaumont, Bennelong Australian Equity Partners By Julian Beaumont, Bennelong Australian Equity Partners

min read

Many smaller-companies have good potential for business growth and returns.

Many investors appreciate that Australia’s sharemarket is heavily concentrated, best illustrated by its large exposure to banks and resources. The relatively homogenous big four banks account for almost 30 per cent of the market’s total value and about half of all dividends distributed.

However, what is not well understood is that beyond the top 20 stocks our market is nicely diversified. This should present opportunities, particularly for retail investors, in companies with a wide range of investment attributes.

In the first seven months of 2016, the ASX 20 dramatically underperformed all other market-cap bands. In August, the tide turned and the top-20 large caps outperformed, particularly against the ex-100 stocks.

Index Membership Returns
  1/1/16 – 31/7/16 1/8/16 – 31/1/17 1/1/16 – 31/1/17
1-20 1.6% 6.4% 8.1%
21-50 17.3% -0.7% 16.6%
51-100 18.3% -0.5% 17.8%
101-200 15.5% -5.2% 9.5%
201-300 17.7% -5.2% 11.6%

Source: BAEP, IRESS

Of course, by far the major driver of the relative performance of the ASX 20 are the banks, which account for almost half of its total value (equating to the figure above of almost 30 per cent of the overall market). The sector’s influence was exaggerated last year, as the banks zigged early on when the rest of the market zagged, and vice versa in the back half.

Early on, investors grew concerned by the potential for slowing credit growth, rising bad debt charges, margin pressure and increasing prudential capital requirements. These concerns abated later in the year, earnings expectations lifted and the banks recovered to post quite good returns.

Most important, however, was Trump’s election win, which came with a more positive macro and regulatory narrative that gave a shot in the arm to banks globally.

Another very large exposure within the ASX 20 is to blue chips, which are mature and predominantly domestically orientated oligopolies. They comprise most of the ASX 20 and include the big four banks, Telstra, Wesfarmers, Woolworths, IAG, Suncorp, AMP, Transurban and Scentre.

These stocks are time-tested, relatively safe and pay high dividends, and investors perceive them as generally low risk. On the other hand, they are generally growth constrained, not least because they are full in terms of their market share, and must rely on their industry and the broader economy to eke out any growth.

Their growth problem was evident in the 2016 financial year, in which the plodders faced the headwinds of a sluggish domestic economy and increasing competition, and when earnings per share for the ASX 20 declined by 13 per cent.

Beyond large-caps for growth

Given a then-weak outlook among large caps, many investors looked elsewhere to get their fix of growth, which they found mostly among mid-cap names.

From August, however, as the 2016 financial results came in and the macro narrative started to turn increasingly positive, growth was thought to have become more readily available elsewhere.

Most growth stocks, many of which had become market darlings and been pushed to lofty valuations, were sold off. This was exaggerated among companies reporting operational issues, such as Aconex, Bellamy’s, Vocus Communications and iSentia. However, it also hit those that did not, including Domino’s Pizza, BWX and Reliance Worldwide, and this presented opportunities.

The sale of these generally small and mid-cap growth names funded a rotation back into banks and the resources sector, which was recovering along with commodity prices.

The small and mid-cap miners benefited most, particularly at the start of 2016. They have far greater leverage to commodity prices because of generally higher-cost mines and often higher gearing levels.

Indeed, the market’s best performers over the past year have almost all been ex-20 mining stocks. In the ASX 20, blue chips BHP and Rio Tinto have far less leverage, were accordingly sold down less in the sector’s downtrend in prior years, and therefore had less upside from the recovery. It reflects the lower risk/lower return proposition that characterises the ASX 20.

Concentration within the large caps

The market moves highlight the dependence of the ASX 20 on just a few exposures, particularly the banks and blue chips.

They also highlight a dependence on exogenous factors, best exemplified by the dramatic outperformance of the ASX 20 following Trump’s election win. This exposes investors to economic, political and other unpredictable factors.

At present, the Trump-infused macro narrative is positive, but that could easily change.

Opportunities in the ex-20 space

There are far richer opportunities among ex-20 stocks, which provide the opportunity to diversify. For example, only among the ex-20 stocks can investors genuinely get exposure to:

The US residential housing cycle through a stock such as Reliance Worldwide.

Entrepreneurial owner-managers such as BWX’s CEO, John Humble, who is a major shareholder in the company.

Ageing and other demographic trends, which underpin the growth in demand for Ramsay Health Care’s hospital services.

Companies that are consolidating industries through acquisitions, such as Burson Group.

Different business models, such as the franchise system of Domino’s.

It is not just diversification on offer, but the prospect of stronger long-term returns that accompany growing businesses. This compares to the growth-constrained top 20 stocks, half of which have not provided capital growth over the past decade.

All the ex-20 companies listed above have set their own agenda for growth. Whether through opening new stores, building in new countries, taking market share or investing behind strong industry growth, these companies can grow regardless of what Trump tweets, or the Reserve Bank’s next move, or unemployment data.

Looking back over the decades, the best-return stocks for any given year are almost always small or mid-caps. This should tell us where they are likely to be in the future. Of course, this comes with a caveat: with the offer of higher returns usually comes greater risk.

For balance, it should be noted that the worst performers are also generally small or mid-cap stocks. It is more common for smaller-cap stocks to run into operational and other troubles, and for their shares to halve or worse. Look at the recent share price charts of Aconex, Bellamy’s, Vocus Communications and iSentia.

It is important to do your homework and accept the potential for risk in any stock in your portfolio. However, because small-caps attract less investor attention, the rewards for effort are typically much greater.

It is not always the case that ex-20 stocks are riskier. In our view, a stock like Ramsay Health Care is more “blue chip” than top-20 stocks BHP, Telstra and Brambles. Indeed, the share prices of Telstra and Brambles have fallen around 30 per cent from highs last year despite the more recent outperformance of the ASX 20.

Three current opportunities

Last year’s moves have left opportunities evenly balanced across the market, in small, mid and large caps. Recently we have found opportunity within the indiscriminate sell-down of growth stocks, particularly among those currently seeing strong operational momentum and whose long-term outlook remains intact. A few examples are:

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

  • BWX, a genuine small-cap worth less than $500 million, saw its shares decline almost 30 per cent in the back half of last year. The company owns the Sukin range of skincare and personal care products, with strong momentum in its Australian business, and exciting growth opportunities in the UK, Canada, China and elsewhere. Besides being caught up in the growth sell-off, it also suffered by association with Bellamy’s problems, notwithstanding limited relevance. We increased our holding. The company reported very strong half-year earnings, pushing its shares higher by 20 per cent from recent lows.
  • Domino’s Pizza Enterprises has also seen its shares decline by 30 per cent from its highs of last August. In February, the company reported a solid result and upgraded full-year earnings growth guidance to 32.5 per cent. (From 30 per cent prior, which itself was an upgrade announced at its AGM in November from its initial guidance last August of 25 per cent). Nevertheless, the shares came under further pressure, which we believe was because of negative media attention around franchisee activities, short selling, and valuation concerns reflecting only a short-term view of its prospects. The company has visible and compelling long-term growth prospects, particularly within its European business, and the current share price weakness presents an attractive opportunity for long-term investors.
  • Reliance Worldwide is a manufacturer of plumbing fittings and other products that only listed last year. It is a high-quality business that has enjoyed consistent long-term growth, but its shares are off 20 per cent since last August. In its February result, the company reported earnings growth of 18 per cent and confirmed full-year earnings guidance ahead of the prospectus issued at the time of its listing. Its innovative SharkBite fittings continue to take market share from traditional products, and are now stocked in two large US hardware chains, Home Depot and Lowe’s. Reliance’s long-term prospects look strong as it continues to take market share and grows elsewhere around the world.

About the author

Julian Beaumont is Investment Director, Bennelong Australian Equity Partners (a Bennelong Funds Management boutique).

Follow: @Bennelongfunds

From ASX

Bennelong Funds Management is a foundation member of mFunds. mFunds are unlisted managed funds you can invest in through ASX’s mFund Settlement Service

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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