Is it time to buy small-cap industrial stocks after a brutal sell-off that has wiped up to a third off some of the market’s best emerging companies in a few months?
That question is testing value investors who know the best time to buy high-quality companies is during corrections that are more to do with market sentiment than fundamentals. Or put another way, to buy when everyone else is selling.
To recap, small- and mid-cap industrials boomed for much of 2016 as fund managers paid up for companies growing faster than the economy.
Fund managers that focused on large-cap stocks looked further down the share market for growth and to lessen portfolio underperformance from investing in ASX 100 stocks. Some investment managers even changed their mandates to invest in pre-float opportunities.
This weight of money drove small-cap industrials to a significant premium over ASX 100 companies. By September 2016, small caps had returned 27% over one year (including dividends) – about three times more than the ASX 100 over the same period.
It was madness.
Sure enough, fund managers started to take profits in small caps at elevated prices and rotate into undervalued banks, resources and big industrials. Donald Trump’s United States election win quickened the rotation into large-cap cyclical and other growth stocks.
The gap between large- and small-cap performance soon eroded. The S&P/ASX 100 index’s 21.6% total return over 12 months compares with 22.2% for the Small Ordinaries. Were it not for rallying small resource stocks, the ASX 100 would be in front.
Even market darlings were caught in the carnage. Domino’s Pizza Enterprises (DMP) has fallen almost 20% from its 52-week high. REA Group (REA) is down 14%, Carsales.com (CAR) is off 19%, TPG Telecom (TPM) and Blackmores (BKL) are down 45% from their high.
The big unknown is whether this rotation from small-cap to large-cap stocks has run its course – and if rapidly improving value in smaller industrials lures fresh capital.
My sense is the rotation has a few more months to run. Investor surveys suggest fund managers collectively are still underweight banks and resource stocks. But a base might be forming in several of the market’s higher-quality small caps that have tumbled.
Rapid market swings from one investment theme to another invariably provide opportunities for patient portfolio investors. Still, value investors in small caps should watch and wait for better value as the market reassesses Trump’s impact on global growth in the next few weeks and months.
Although I’m bullish on equities in 2017, small caps have further to fall before they start to recover. Watch for highest-quality small caps to form a base over the next few months, before recovering lost ground, as fund managers nibble at value.
Here are four small caps that stand out at the current price:
1. Catapult Group International (CAT)
The impressive maker of wearable sport technology for elite athletes raised $12 million and listed on ASX in December 2014. Its 55-cent share peaked at $4.29 last year before falling to $2.57.
Chart 1: Catapult
Catapult has terrific growth prospects, but its stock ran too hard, too fast as hype grew. The price fell when Catapult issued FY17 guidance of 21-30% revenue growth. The market wanted more, even though most companies would kill for such sales growth.
Value is returning. Catapult is a genuinely global technology business that sells a high-margin product with recurring revenue. Major sporting codes and clubs use its technology to extract real-time data on their athletes and feed it into their sports-science programs.
The business has good cash flow, no debt and strong intellectual property. Active investors should wait for Catapult shares to form a base before buying.
2. IDP Education (IEL)
I nominated IDP Education for this report in a feature on education stocks in August at $4.40.
IDP rallied to $4.99, then fell to $3.92 amid the broader small-cap selloff.
Chart 2: IDP
My positive view on IDP is unchanged. As I wrote in August: “IDP is superbly leveraged to long-term growth in international education in Australia through its international student-placement services and English-language testing services. IDP co-owns IELTS, one of the world’s leading English-language tests, as well as English-language schools in South East Asia. These are terrific, well-established businesses.”
IDP’s recent acquisition of digital-marketing and online student-recruitment company Hotcourses is smart. The business attracts online traffic, should complement IDP’s student-placement division and be earnings-per-share accretive.
Macquarie Equities’ $4.67 price target over 12 months suggests IDP is undervalued at the current price. IDP is another well-run small cap that has been hammered more because of market sentiment than any fundamental reason.
3. IPH (IPH)
Investors could not get enough of the intellectual-property adviser when it listed on ASX in November 2014.
After raising $169 million at $2.10 a share, IPH soared to $9.26 in early January 2016, making it one of the market’s best floats in a decade.
Chart 3: IPH
Source: Yahoo Finance
IPH wholly owns Spruson & Ferguson, a leading intellectual-property services firm with operations in more than 25 countries and over a century of history. IPH’s early success led the way for the smaller Xenith IP Group float in 2015 and QANTM Intellectual Property float in 2016. Like IPH, both stocks have been sold off in the past six months.
IPH slumped to $5.09 after reporting a weaker-than-expected FY16 result in August 2016. Although net profit grew 50% on FY15, the market needed more growth to justify IPH’s nosebleeding valuation at its share-price peak.
The sale of $150 million in shares in November that came out of escrow, by the firms’ senior partners, weighed on IPH and was a timely reminder of why it pays to watch IPOs closely around escrow dates when share restrictions are lifted and early investors can sell.
Four of seven brokers that cover IPH have a buy recommendation and three have a hold, per consensus forecasts. A median price target of $6.97 suggests IPH is good value.
IPH has an excellent position in an intellectual-property advice market that will continue to grow as more companies seek to protect their technology, particularly in Asia. The company has a better business model than many traditional law firms and a forecast Price Earnings multiple of 16 in FY18 (using the consensus) is not excessive given IPH’s growth outlook.
4. iSentia Group (ISD)
The media-monitoring group starred after raising $294 million through an IPO in June 2014, its $2.04 issued shares hurtling to a $4.77 peak.
Chart 4: iSentia
Source: Yahoo Finance
Then reality set in. iSentia’s profit downgrade in November sparked a 26% share-price drop. A disappointing first-half performance from its content-marketing business spooked investors and led to commentary that the company had strayed beyond its core competency.
iSentia paid $48 million for the King Content business in 2015 and saw content marketing – a type of advertising based on paid-for editorial – as a natural evolution of its business.
iSentia had run too far to its peak, but the savage fall to $2.65 seems an overreaction. Simply, a $2 million half-year loss in the content-marketing business led to more than $170 million wiped off the market capitalisation. Moreover, content marketing is only a small part of iSentia’s overall business and, in theory, its valuation.
Investors were itching for a reason to take profits in iSentia in a jittery market for small-cap industrials. They got it with the first sniff of bad news (even though it was not so bad).
iSentia remains a leading firm in the attractive media-monitoring and analysis business. Growth in social media and corporate publishing is driving corporate demand for market intelligence in this area. The company is an interesting take on digital-media trends.
iSentia’s strong business model based on recurring revenues – and appealing growth prospects in Asia – are other attractions. The stock looks to be forming a share-price base after its heavy sell-off. Investors will watch if iSentia can hold support above $2.50, consolidate its recent price losses and wait for the market to regain its senses.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without considering your objectives, financial situation or needs. Before acting on the information in this article you should consider its appropriateness, regarding your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at January 18, 2017.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.