Small caps - companies outside the top 100 - can offer good value to brave investors, reports Barbara Drury.
A growing appetite for risk and a hunt for value have sent adventurous investors deep into the heart of the sharemarket's small cap sector over the past six months, with some stunning results.
Over the past three months the Small Ordinaries Index has jumped 11 per cent, easily outpacing the overall market and the top 100, up 5.4 per cent and 5 per cent respectively.
As a sign of the times, a small cap fund also topped Morningstar's retail managed fund performance tables for the June quarter. Equity Trustees' Small Companies Fund produced total returns of 12.58 per cent in the June quarter before going on to return a massive 44 per cent in the year to July.
In recent weeks scores of small cap stocks have hit new 12-month highs, as many of them report better than forecast earnings for the latest financial year. Automotive parts supplier Pacifica Group, Sunbeam appliance-maker GUD Holdings and Crane Group are just a few small caps reporting better than expected results. The question is will the recent stellar performance of many small caps be sustained, or is the catch-up nearly complete?
Cavil Singh, the head of broking investment services at Godfrey Pembroke, says the low price-earnings (P/E) ratios of small caps, combined with high yields and a sound economy, mean investors are prepared to wear the additional risk of companies outside the top 100.
Small caps normally trade at about a 10 per cent discount to large caps to reflect the added risk. With the average industrial small cap P/E at 12.5 times and the average large cap P/E at 14 times, Singh says small caps are fair value. However, small caps have slightly better yields than the big end of the market (4.6 per cent compared with 4.2) and higher earnings per share growth (15 per cent compared with 11.8).
Paul Jenkins, the managing director of Jenkins Investment Management, also believes the relative value of small caps has gone from being attractive three months ago to just OK today. He adds, though, that strong demand from retail and institutional investors, combined with few new share issues and a strong economy, is supporting the sector. Taking a long-term historical perspective, Tom Cottam, the head of investment research at van Eyk Research, says small caps are still relatively undervalued.
Research here and overseas shows that small companies on average outperform large companies over the long term. However, over the past six years, during the sharemarket boom and subsequent flight from risk, small caps have trailed by almost 5 per cent a year. Cottam says the picture becomes clearer when you separate the small cap growth stocks, which he believes are still very attractive, from value stocks, which are now only fair value.
Stephen Hiscock, whose boutique firm manages the Equity Trustees small cap fund, also adopts a conservative focus on quality companies with solid earnings growth rather than hunting for bargains.
Perpetual Funds Management's portfolio manager, Matt Williams, agrees that value is getting harder to find. He says companies exposed to the housing sector, including Gunns, Reece Australia and Crane Group, have performed particularly well but are no longer bargains at 10 to 14 times earnings.
"Consumer spending and the housing sector are still going well, but that doesn't mean stock [prices] will continue to go up," he warns. He urges investors to be selective (see right).
Small caps to watch
Small cap companies are generally classified as anything outside the top 100 market leaders. That leaves investors with more than 1000 companies to choose from, ranging from household names to start-ups and penny dreadful miners, and giving them plenty of room to hang themselves.
Harvey Kalman, the general manager of Equity Trustees Funds Management, recommends investors have no more than 5 to 20 per cent of a balanced portfolio invested in small caps. Hence, the best way for personal investors to gain exposure to the sector with some diversification is probably through a managed fund.
Equity Trustees's Small Companies Fund has been a bullet performer since it was established in June 2001, with a total return of 22 per cent in the year to June and 44 per cent the previous year. For a small cap manager with a longer track record, Morningstar gives its top rating to only two small cap retail funds still open for investment: Perpetual's Investor Choice Smaller Companies Share and Colonial First State Developing Companies. ASSIRT also gives its top rating to these two, plus AMP's Small Companies Fund and Perpetual's Smaller Companies Fund.
Stephen Hiscock, the manager of the Equity Trustees fund, attributes much of his success last year to a defensive move into gold and oil stocks. This year he is maintaining a modest weighting to gold stocks as a protective measure against world markets spiralling down, but otherwise leans towards quality growth companies.
The fund's top 10 holdings include McPherson's, Sirtex Medical, internet service provider iiNet and Oxiana.
Tom Cottam, of van Eyk Research, also prefers growth to value stocks. For example, van Eyk believes Colorado Group and Sigma Pharmaceuticals are dynamic growth companies with a solid earnings record and future growth prospects that still look cheap.
Value is harder to find, but Cottam says boatmaker Austal is a potential turnaround stock and will look cheap if it picks up new orders.
For an asset play, Cottam says the computer company Kaz Group is trading below book value and, while it could be argued that it is inferior value to quality stocks such as Colorado, its price is moderately attractive.
Cavil Singh, the head of broking investment services at Godfrey Pembroke, likes automotive parts supplier Ion; Iress Market Technology, which has a near monopoly on the supply of data to the finance industry; and Worley Group. All three have 2004 prospective earnings per share growth of 10 per cent, a fully franked dividend yield of about 4.5 per cent and a price-earnings ratio of between nine and 13 times.
Singh also likes Record Investments, the structured finance specialist chaired by ex-Macquarie Bank boss Tony Berg. It is sitting on a prospective PE of 17 times, EPS growth of 28 per cent and a fully franked dividend yield of 4.6 per cent.
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