Value should be hard to find as the share market tests its record high. But there’s plenty of value for bargain hunters; the challenge is finding a re-rating catalyst for battered stocks.
Small- and mid-cap stocks are an example. For every soaring tech stock, many others are languishing on almost GFC-like valuation multiples. Small industrial stocks leveraged to Australia’s slowing economy have been forgotten in the momentum-investing craze.
The S&P/ASX Small Ordinaries Index, a barometer of stocks ranked 101 to 300 by market capitalisation, has a total return (including dividends) of 5.6% over one year. The S&P/ASX 100’s total return is almost 15%.
Over three years, the Small Ords has returned 9% annually versus 12.6% for the ASX 100, S&P Dow Jones Indices data shows. The underperformance of small-cap stocks versus their large-cap peers began in 2012 and the gap has barely closed.
That is unusual in a bull market. Typically, small caps outperform when risk appetite rises and funds flow to growth stocks. Not this time. Outside the star tech stocks and parts of the resource sector, there is waning interest in small caps.
Several factors explain this divergence. Record-low interest rates and the prospect of more cuts to come are pushing investors into large-cap stocks for franked yield. Income seekers gravitate to household-name dividend payers rather than small caps.
The boom in Exchange Traded Funds (ETFs) is another factor. Algorithmic trading strategies are thought to be pushing small- and mid-cap stocks with strong momentum higher and discarding the rest. ETF buying and selling is indiscriminate because it seeks to replicate an index.
The closure of several small-cap asset managers in the past few years and declining stockbroking coverage of small caps partly explains the performance divergence with large caps. Simply, fewer investors are analysing small caps, exacerbating pricing inefficiencies.
That’s good or bad depending on your perspective. I’m seeing more opportunities in neglected small-cap stocks than I have for years. It makes no sense that some are trading on valuation multiples that have not changed in a year, despite solid operating progress.
Private equity has spotted the opportunity. Witness the rising number of takeovers of small-cap minnows by local or international private-equity firms. GBST Holdings, Wellcom Group, Credible Labs, Chalmers and Navitas each had takeover bids this year.
This market is also sensing value in neglected small caps.
The Small Ords index slightly outperformed the ASX 100 in the past quarter. After years of underperformance, the Small Ords’ recent gains are significant and perhaps a sign that too many small caps have fallen too far.
However, caution is needed with talk of a small-cap recovery. Small-cap companies tend to be more leveraged to the Australian economy relative to their large peers that typically have a higher proportion of offshore exposure. The Australian economy is limping along, so there’s little joy for cyclical small-cap industrials that are heavily exposed to the domestic economy.
But every stock has its price. Valuation multiples for many small-cap industrials suggest the market is pricing in too much bad news. That’s an opportunity for experienced investors who understand the benefits and risks of investing in small- and mid-cap stocks.
Here are 5 that offer value at current prices:
1. AUB Group (AUB)
The insurance broker has had a disappointing 12 months with a total return of -13%. Over five years, the average annualised gain is 6.2%, Morningstar data shows. AUB, a former market darling, badly disappointed as the market lost confidence in its strategy and execution.
AUB performed below expectation in FY19: adjusted net profit rose 4.1% to $46.4 million. Costs from fraud in the firm’s Canberra office and a challenging NSW Workers Compensation market dampened performance and offset solid gains in insurance and underwriting.
At $11.02, AUB is on a forward Price Earnings (PE) multiple of about 19 times, consensus estimates show. Listed rival Steadfast Group is on a forward PE of 26. That’s a large gap and a sign that better value might exist in AUB as its recovery plays out in the next few years.
2. Domain Holdings Australia (DHG)
The online property advertising firm has given shareholders a wild ride since its 2017 Initial Public Offering (IPO). After trading above $3.50 after listing, Domain sunk to $2.07 in early 2019, after management changes and amid expectations of a property slowdown.
Domain has recovered to $3.22, as the market looks to an improving property market, courtesy of falling interest rates. Rising auction clearance rates bode well for higher property turnover (off a 20-year housing turnover low) – and thus more advertising on Domain.
My hesitation with Domain during the IPO was its growth prospects outside of Sydney and Melbourne. Domain benefited from exposure in its then parent company’s (Fairfax Media) Sydney Morning Herald and The Age. Unlike REA Group, which had national exposure through News Corp publications, Domain did not have as much cross-promotion in other states.
Nine Entertainment Company’s takeover of Fairfax, which gave it majority ownership of Domain, gives the property portal serious national exposure via prime time TV. Witness the marketing synergies between Domain and Nine’s hit reality renovation show The Block.
I expect at least two more interest-rate cuts in the next 12 months and an ongoing recovery in the property market, albeit less heated this time around. That’s good for Domain.
Domain Australia Holdings
3. Shine Corporate (SHJ)
Listed law firms were all the rage a few years ago until Slater & Gordon’s near-death experience after its disastrous UK acquisition. Brisbane-based Shine Corporate was caught in the carnage, falling from $3.33 in mid-2015 to 77 cents.
The market questioned the business model and accounting practices of listed law firms, even though Shine avoided some of the mistakes made by larger rival Slater & Gordon.
Shine’s FY19 performance met market guidance: underlying earnings (EBITDAI) rose 1.6% to $38.3 million. The company expects earnings to rise 10% in FY20, suggesting a pick-up in growth.
Shine in June 2019 announced the settlement of a shareholder class action against it, related to alleged continuous disclosure breaches over its FY14 and FY15 results. Settlement of the $250 million class action, the terms of which were confidential, removes a headwind for Shine.
For all the short-term challenges, Shine has a good position in a long-term growth market and room to expand through acquisition of smaller firms. Gross operating cash flow continues to rise and Shine has implemented some good innovations in online claims for motor-vehicle injury and is expanding its family law practice.
At 77 cents, Shine is on a trailing PE of 9.7 times and yielding almost 5%. The national law firm could take time to recover but value is there for patient investors.
4. Ardent Leisure Group (ALG)
Few small caps have been more on the nose than Ardent Leisure, operator of Dreamworld and other theme parks and US entertainment centre chain Main Event.
Ardent shares went into free fall after the 2016 accident at Dreamworld that killed four people. Attendance at Dreamworld and other Gold Coast theme parks suffered, as concerns grew about the maintenance and safety of rides, and consumers chose other entertainment.
The market also worried that growth in Main Event, one of Ardent’s best-performing businesses, was slowing. Bad news seemingly appeared at every turn for Ardent.
Ardent streamlined its operations through divestment of the marinas and bowling businesses. Main Event is the key for Ardent, accounting for 85% of FY19 revenue.
The theme-park business is recovering but taking longer to resume growth than expected, thanks to Coronial Inquest hearings and delays in new attractions.
I’m not convinced the Gold Coast theme parks, particularly Dreamworld, will return to their former glory. The attractions look tired and competition from eco-tourism on the Gold Coast is growing. Kids these days seem to get more excitement via their iPad or smartphone than on another rollercoaster ride at a theme park for the tenth time.
Beneath the gloom, Ardent lifted revenue from continuing operations by 14.4% over the previous year. Morningstar values Ardent at $2 a share, double its current price. The research house concedes the pace of Ardent’s recovery is uncertain but argues that the assumptions in its forecasts are conservative compared to the company’s historic growth rates.
I suspect the market has given up on Ardent and is overlooking its stabilisation. The Main Event business should benefit from management rejuvenation, a lower Australian dollar relative to the Greenback and continued organic growth through new centre openings.
5. Pact Group Holdings (PGH)
The packaging group has had a terrible 12 months, falling from a 52-week high of $4.10 to $2.23. Over three years, the average annual return is -26%.
Like other packaging groups, Pact struggled with higher energy and raw-material costs that crimped profit margins and it lost market share in the key food, beverage and dairy segments. A stretched balance sheet that took Pact close to its debt covenants was another concern.
Pact said packaging pricing improved in the second half and resin costs fell, enabling it to recover some of the pricing lags from earlier periods.
Operationally, Pact looks to be stabilising but the valuation is not factoring in any turnaround. At $2.26, Pact is on a forward PE multiple of about 10 times, consensus forecasts show.
An average share-price target of $3.88, based on the consensus of six broking firms (too small a sample to rely on) suggests Pact is significantly undervalued.
I’m not as bullish but expect a recovery to unfold slowly in Pact, as its profitability improves and market concerns about its debt levels ease, as debt is refinanced or an asset sale creates balance-sheet breathing space.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy regarding your objectives, financial situation and needs. Do further research of your own and/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 24 September 2019.