There's gold in some small cap shares. Oil, too. John Dagge reports on where to find profitable shares at $2 or even less.
The biggest profits have come from some of the smallest shares over the past year or so.
The best little stocks in town, especially those in resources, have left the blue chips in their wake. Among managed funds, small cap funds dominate the top 10 performers.
Since US President George Bush landed on the deck of the USS Abraham Lincoln under a "Mission Accomplished" banner in May last year the index of the 100 largest companies trading on the stock exchange has risen 19.1 per cent.
But the index of the smallest stocks has put on 31 per cent.
The so-called small cap funds account for half of the 10 best performing retail funds and take out the top three positions.
Leading the way is the Credit Suisse's Australian small companies fund, which has put on 65.8 per cent over the past 12 months and 18.7 per cent over the past three years.
ING's small companies growth fund has returned 59.7 per cent over the past 12 months but only 0.2 per cent over the past three years, while the Smallco Investment fund has put on 56.1 per cent over the past year and 8.5 per cent over the past three.
"The performance of small caps was extraordinary over the last financial year," Stephen Van Eyk, head of research house Van Eyk, said.
"Back at the start of the last financial year the P/E from small caps was less than the markets, so the earnings you needed to generate a return were very small, and at the same time the forecasts were huge. The effect was that at this time last year we felt small caps were 100 per cent cheap."
A strong domestic economy (small caps generally have a high domestic focus so their earnings benefit greatly from a strong housing cycle and consumer spending), soaring Australian dollar (many small caps are domestic importers meaning a higher dollar lowers their costs) and better liquidity in the market all fuelled the small end of the market's rise.
Booming commodity prices also add a positive distortion to the small ordinaries index given that this sector dominates the index.
Exiting from several years of disappointing results from blue-chip funds, normally nervous mum and dad investors have begun to dip their toes into this end of the market.
"There has been a general increase in the risk appetite in the market; people have been more willing to look beyond the big blue chips," Deutsche Asset Management Australian small companies portfolio fund manager Sinclair Currie said.
History is, however, a poor guide to future earnings and investors sitting on the sidelines are asking themselves if they've missed the boat.
Most market watchers agree that the easy money is now gone from the small cap sector.
"The valuation gap between small caps and large caps was wide 15 months ago and that gap has now narrowed," ING's Australian Equities portfolio manager Mark East said.
However, East said opportunities for handsome returns among the small caps still existed. It's just that stock selection was getting trickier.
"Overall, the Small Ordinaries probably will track the broader market," he said. "But there will be stock specific opportunities in small caps that will provide enhanced returns."
Those opportunities were most likely to be found in the non-residential construction and resource sectors.
"We would expect to see earnings upgrades in non-residential construction over the next 12 months for stocks exposed to this sector," East said. "Small resources should also continue to perform well if global growth and the expectations that China will be a large consumer of commodities remain intact."
Phillip Shamieh, general manager of the Investment Wise tip sheet, said there was little doubt the next 12 months would be a more volatile trading environment.
But with volatility came opportunity. "Over the next 12 months we can expect to see increased volatility so overperformance will be driven by individual stocks and earnings," Shamieh said.
"Rather than gains coming across the board, one must be able to identify individual stocks that are performing and we've always been able to do this."
Shamieh said the oil, gold, biotech and agribusiness sectors were looking strong for the next 12 months.
"Commodity prices will still drive all related resource stocks, in particular oil, base metals and gold, which we expect all to go higher," he said.
There are good stocks that trade for $2 or less.
For example, Investment Wise has buy recommendations on resource stocks Austral Coal, Union Capital, Nexus Energy, Gallery Gold, ship builder Austal and agribusiness firm Timbercorp.
With a potential tightening of the economy led by the downturn in the housing cycle, Currie said, investors should target companies which earned their profits from non-discretionary consumer income.
"That is, companies that offer goods or services that you have to buy even if things tighten," he said.
Deutsche is targeting the business services and commercial services sectors along with health care and IT business services sectors.
Angus Geddes, of tip sheet Fat Prophets, is less bullish on the speculative end of the market and said investors should consider reducing their exposure to small caps in favour of large cap oil stocks.
"Overall, we're very comfortable with the gold sector, it has had a decent pullback in the past six months and we see that stabilising and then rallying again," he said.
"We also think we're going to see a very strong profit reporting season from the oil sector and that will flow through to large cap oil stocks."
By the way, $2 stocks aren't always small companies either.
Geddes said the best value among small caps would be found in "turn-around situations".
These can be once-large, well-known companies that have fallen on hard times.
"Stocks like Austar, Burns Philp, Village Roadshow and Tower have really been knocked around in the past few years and we think they will mend," Geddes said.
Other market analysts, such as Van Eyk, say the risks no longer justify the rewards and that it is time to move out of the small end of town.
"If you've made some money, now is the time to take some profits and reduce your exposure," Van Eyk said.
"When you're buying a small company you're taking two risks a market downturn and the company actually collapsing. With the big companies you're not actually worried that they will go broke.
"Because you're taking a greater risk with small caps you need greater growth and we're saying the risk doesn't pay off for the growth you're likely to get.
"The only advantage is in a technical sense, that having exposure to small caps gives you some diversification in your portfolio."
However, Shamieh said that even in market downturns small caps still provided plenty of lucrative opportunities.
"It's worth noting that even in 2001 and 2002 there were more than 80 stocks each year that went up 50 per cent or more," he said. "It confirms that, at the end of the day, it all comes down to stock picking."
Small caps had exited from their earnings forecast period in strong shape, Currie said.
"We've got through that May and June period where, under the new disclosure rules, companies are required to disclose an earnings downgrade and most companies are happy with the earnings environment. So we can go into the new period with a lot of confidence."
Going small: separating the wheat from the chaff
THERE are numerous pros and cons to investing in small stocks.
With 1100 of the 1400 companies listed on the Australian Stock Exchange considered to have small capitalisation, there are opportunities to get in early before the institutions take notice.
When they do you can reap handsome rewards because their large buying pushes the price up or the small company becomes the focus of a takeover.
"But this additional reward also brings added risk as the story is often not proven and may not ever be," ABN AMRO Morgans retail business strategy manager Rebecca Sullivan said.
"Because there are many small caps it is hard to get reliable and well-researched information. This means you are often going it alone, so you need some analytical skills and sometimes a bit of sheer luck."
Small cap stocks can also be thinly traded, which means if a major shareholder sells out, it's probably going to have a negative impact on price despite the fundamentals of the business not changing.
Sullivan said successful small cap investors often bought based on asset value to get a greater level of security.
"For example, if assets are worth more than their share price, then it is an opportunity," she said.
Phillip Shamieh, general manager of the Investment Wise tip sheet, said there were six characteristics of outperforming stocks:
A turnaround in earnings or profit.
A sound management team that has a strategy in place for any downturn in the economy.
The company is usually a market leader in its industry or has a strong research and development team.
It has a competitive advantage or differentiation.
It is still in the growth stages of its business cycle.
It has recently traded at a high and is now trading at a low.
Shamieh said: "We focus on the small to mid-cap sector of the market because small companies are still in the growth stage of their business cycle and this is where the greatest investment opportunities lie."
