The best of the small-cap bunch Author: Henry Byrne Date: 24/08/2005 Words: 1561 Source: AFR Publication: The Financial Review Section: Smart Investor Page: 30
Small companies have had a roller-coaster ride in 2005. Having fallen foul of investors in April, the shares of many of these companies have bounced back in recent months. The S&P/ASX Small Ordinaries Index has gained more than 20 per cent since it fell to a calendar-year low of 2127.6 points on May 17. As the reporting season builds to a crescendo this week, Smart Investor's Henry Byrne spoke to Eley Griffiths' Brian Eley, Paradice Cooper's Matt Riordan and Perennial Value Management's Grant Oshry about their outlook for small companies. One of the trends of the reporting season to date has been the recovery of small-cap stocks, such as Pacifica and Crane Group, which were sold off heavily during the "confession session" in March and April. While many of these companies have reported profits in line with expectations and enjoyed an uplift in their share prices, they are still trading below their calendar year highs. How do you view these companies at present and do you see any value here?
Brian Eley: In general stocks that have recovered off intra-year lows are being given the benefit of the doubt in a strong market where many investors are short of good ideas. Most of these will be severely punished if they transgress again.
With Pacifica, the market has responded to some cautious optimism from management that its operating environment is stabilising and might even improve. We feel it is too early to make such a call and believe that supply of automotive components to large car companies is a structurally challenged market.
Matt Riordan: We've since seen a partial unwinding of this sell-off as there's been a realisation that it's not the end of the world and the economy, while soft in patches, remains reasonable.
In the case of Crane, while the headline growth wasn't stunning it was an excellent result in that management delivered an operational turnaround despite the fact that the environment in the building sector had moved against them. The company still looks to be good value on the basis that it remains cheap and provides good yield support despite being at the bottom of its earnings cycle.
Grant Oshry: While the likes of Crane, GUD and Pacifica have recently outperformed subsequent to their profit downgrades, for the 12 months to date on a relative basis they are still significantly underperforming the Small Ords Accumulation Index.
They are not out of the woods yet. Crane Group is in the early stages of turning around their Tradelink business while Pacifica has to contend with high input costs and a financially stretched customer, General Motors. Also, I do not believe that the transparency is there to trigger a substantial re-rating in these stocks, given where they are currently priced.
The general performance gap between small- and large-cap stocks has narrowed recently, shown by a 19 per cent gain of the small ordinaries index in the past three months against a 13 per cent gain on the benchmark S&P/ASX 200 index. Do you think the divide between smaller and larger stocks will widen or narrow from here?Oshry: With the ASX 200 hitting record highs on a daily basis, it is fair to say that risk appetite has increased, which has been a key driver behind the narrowing of the gap between large and small caps in recent weeks.
I am of the view that the gap will not get much narrower from here as the risk going forward is more weighted towards this differential increasing.
Riordan: We continue to see strength in those sectors that are exposed to non-residential construction and the resources sector. Companies exposed to retail and housing have experienced a tough time over the past six months, but we think that once we move past the tough comparatives of 2004 and the benefits of tax cuts start to take effect we should see the earnings environment for these companies start to improve towards the end of this year.
Eley: The valuation differential between small and large caps is about right given the outlook and would not expect any major divergence either way from here.What are the key risks for small-cap stocks?
Riordan: The last time that small caps had an extended period of weakness was after the tech wreck. At the time tech and telco companies had reached 30 per cent of the small ordinaries index and when these stocks imploded it dragged down the sector.
We currently have a similar situation where resource stocks have performed strongly and now represent over 20 per cent of the index. There are also a series of other companies that provide services and equipment to this sector. If resources were to have a major stumble it would certainly drag down the overall performance of small caps.
Eley: As always it is the domestic profit cycle. If domestic profits come under pressure over the next 12 months we will see investors retreat up the market cap ladder and favour large caps over small caps.
Oshry: I would say that the domestic economy is the biggest risk to small caps. It's fair to say that margin erosion as a result of higher input costs coupled with a tight labour market will impact all companies alike. As a general comment, a company with a bigger, stronger balance sheet may be able to sustain and absorb some of this compression more so than a small or mid-cap company. Which three companies with a market cap under $500 million do you favour at present?
Eley: iiNet is Australia's third-largest internet service provider with approximately 600,000 subscribers. It is rolling out its own broadband infrastructure and is set to do very well from the development of this market.
Investor Group is a very well-run company offering accounting services and financial planning advice. It has successfully consolidated a significant segment of its market, generating strong profit growth in the process.
OM Holdings is a metals trader and soon to be manganese producer. The manganese market has remained positive and the company will see a material uplift in its profitability once the Bootu Creek mine is open.
Oshry: IRESS delivers live financial information to financial market participants and is almost a monopoly in Australia, giving it real pricing power. Cash flow generation is outstanding and returns are impressive.
Hastie is the largest installer of commercial heating ventilation and air-conditioning systems in Australasia . . . Its earnings are relatively defensive, underpinned by ongoing organic growth and it has a quality management team.
Vision Systems designs and manufactures high-tech video surveillance and early warning fire detection equipment . . . The company is starting to gain traction and significant upside exists as the business mix changes from fire and security to medical diagnostics.
Riordan: Hastie is trading on a cheap multiple, has good exposure to the non-residential construction cycle and provides a solid dividend yield. The company also operates in a fragmented market and will be able to benefit from making acquisitions at attractive multiples.
While Colorado has experienced a difficult trading environment of late, the stock remains cheap and is one of the best managed companies in the sector.
The company also has more than $60 million in cash on the balance sheet which is available for potential acquisitions or capital management initiatives. The market is currently giving them no credit for this.
Investor Group operates a highly successful model that combines accounting firms and financial planners. The leverage that this model produces has seen strong earnings growth over the last few years which we expect to continue moving forward.
Which smaller companies, yet to report, are you expecting strong results from?Oshry: Penrice Soda is the sole manufacturer of soda ash, predominantly used in the manufacture of glass, and sodium bicarbonate in Australia supplying 74 per cent and 88 per cent, respectively, of these products into the domestic market. At current prices, this stock trades on a price-earnings ratio of 10 times 2006 earnings and offers a gross yield of 9 per cent.
WorleyParsons is another contender to deliver an impressive scorecard given the demand for their services coinciding with the new contracts they have won.Riordan: Hastie should do well, as they've already released their nine-month figures which were running ahead of prospectus. Smorgon should have a good result, as OneSteel did, driven by having achieved price increase on its products while benefiting from falling input prices. If overseas comparatives are anything to go by, WorleyParsons should also have a very strong result.
Eley: We are expecting strong results from Coates Hire, Cabcharge, Sydney Futures Exchange and IRESS Market Technologies.Which smaller companies, yet to report, are you expecting weaker results from?
Oshry: Globe and Kresta are two companies that could disappoint. Having said this, both companies revised their forecast prior to reporting season and Globe has a new holder on their register, so anything is possible. However, whether the magnitude of their recent profit downgrades are sufficient remains to be seen.
Riordan: We'd be wary of some of the perceived earnings certainty stocks. Following the April shakeout a lot of money flowed into these types of stocks and some of them are now priced for perfection. If these stocks don't live up to their high expectations they could struggle.
Eley: We are cautious of Housewares, Miller's Retail and Nylex.
* Brian Eley is a portfolio manager with Eley Griffiths.
* Matt Riordan is a portfolio manager with Paradice Cooper.
* Grant Oshry is an analyst and dealer with Perennial Value Management.
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