Australian Small Cap Stocks – How to Peg a Winner

If you take a gander at recent index figures for the ASX, you’ll notice a couple of sectors are clear stand out performers. The usual suspect, resources, is making ridiculous gains all the time. But, as a sector, Australian small cap stocks are currently enjoying their own expansionary phase.

The overall Aussie share market is up 11% so far this year, which is pretty handy. But Australian small caps (as a sector) are currently sitting on a 4½ month return of 15%. They’re beating the market by 4%.

In fact, if you’d invested in small caps one year ago today, you would have made 13% more than the market over the past twelve months (see Figure below). That’s the type of exceptional gain that fund managers charge limbs for, yet it can be obtained as easily as sticking money in an index. How is this so?

 

Australia is in the middle of a big bull market. Aussie stocks have gone up in eleven of the last twelve years. That makes Australia the world’s most consistent bull market of the decade. And bull markets are where smaller companies thrive the most.

On an individual basis, small cap companies can be the most profitable opportunities going around. Small companies can grow revenue quickly. And small companies that do that can even turn into big companies. Shareholders who get on the growth train early can be richly rewarded. If you’d bought Microsoft stock 20 years ago, today you’d have $500 for every dollar invested in Bill Gates and his once-fanciful company. That’s a 36% compounding return each year for two decades.

But on an individual basis, it’s not as simple as throwing money at stocks and watching them explode in value. How do we spot a company likely to out-perform?

Identifying winning small caps at the company level is a notoriously difficult task. Knowing how to find winners depends a little on what you’re looking for. The easiest way to begin panning for Australian small cap gold is to divide the sector into two main categories: small cap growth and small cap value stocks. These are two different animals, as you’ll see…

Let’s deal with growth first. And let’s say that you’re analysing mining shares. With resource prices high, new companies are being formed all the time, looking for a piece of the profit. But there’s a small problem with a new company…it’s new!

The downside of a new company is that you simply don’t know much about it. It has no operating history. You can’t judge the management’s historic performance because there IS no historic performance (although it’s a good idea to check up and see if the people running the company have experience somewhere else.) In the mining business, you’d also run the risk of buying a company with unproven assets. Does it really have gold, zinc, or copper? Or is it just trying to cash in on the boom?

The upside is obvious. New companies can grow very quickly. A new idea or a new product in a new niche market can translate into growth in future earnings. The advantage of investing in small cap growth is that most of the earnings haven’t happened yet. Investors willing to take a punt on a growth story could see the stock price rise when the earnings start to roll in.

One of the best quantitative methods for identifying growth potential in relation to the stock price is the PEG ratio. It tells you how much you’re paying for the amount of growth the company is likely to experience. The lower the PEG ratio is, the cheaper the company is now for the earnings it will have later. For example, a hypothetical new mining company might have a PEG ratio of 5 compared to the industry average of 10. That means it’s cheaper than most for the chance of above average growth.

Picking small cap growth stocks is all about correctly assessing future earnings. Small cap value, on the other hand, is about finding a company with current value. Specifically, value that the market has ignored.

Because there are so many small caps - literally thousands of companies that analysts at investment banks would never think to cover - there are hundreds of overlooked stocks. More importantly, there are dozens of quality companies that may be undervalued.

When you find an undervalued share, it’s like buying fine quality goods at bargain basement prices. Often, you can expect your investment to increase quickly when the market realises what you’ve realised.

The downside to hunting for Australian small cap value is that it’s hard work. You really have to dig deep and investigate thoroughly. There is usually limited data available (i.e. only a few periods), and data can be less reliable if only over a short time-span.

To spot value, the price-to-earnings (or P/E) ratio is a great measure. Similar to the PEG, it gives you an indication of how cheap or expensive the company is relative to its earnings power. The difference is that a standard P/E ratio deals with trailing earnings (or sometimes earnings for the next twelve months.) While projections can change, these forward earnings estimates are more accurate than the projections for earnings two, three, or five years out. The further out in time you try to predict earnings growth, the more room for error.

Historically, most stocks sell for about nine times future earnings. During a bull market, investors are comfortable enough with the prospects for the future that paying nine times a company’s current earnings is not that risky. You are assuming the company will grow. And it’s the growth you are paying for now. Small-cap stocks tend to command higher P/E ratios because the growth expectations are higher.

Is there such a thing as a P/E ratio that’s too high? Yes! When a stock is trading at 30, 40, or 50 times earnings, it may signal that the stock is already trading more on potential than real earnings. To tell the difference between a stock that’s over-valued and one that has real potential, you need more than P/E ratios. But they are a good start.

Al Robinson
for The Daily Reckoning Australia

Australian Small Cap Stocks - How to Peg a Winner, 4.2 out of 10 based on 5 ratings

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Related Articles:

• None Found