The Motley Fool

Here’s why the current earnings season is a defining moment for small and microcap stocks

This article is written by Boyd Peters. He manages Investor Services and Shareholder communications for listed investment company Contango MicroCap Limited (ASX: CTN). This article is for information purposes only.

For the first time since 2011 the small and microcap sector is poised outperform large cap indices. If earnings season delivers results “in-line with expectations” the small part of the market may perform strongly.

The last few years have been difficult for small companies with the Small and Emerging Companies Index (“Microcap”) under-performing large cap indices.

Chart 1 shows the differential in the rolling 12 month performance between the Large and Microcap sectors between 2005 and early 2013.

Periods where red was above the line were times where microcaps outperformed large caps, and vice versa. The chart does not indicate positive or negative returns- purely differential. We see who was the “faster horse in the race”.

CHART1

Chart 1: Source: Contango MicroCap Limited

In early 2013 small cap valuations were compelling, as shown in Table 1 below. Many cyclical investors observed the extreme performance disparity between large and small indices and rotated into these stocks.

FY14 Valuations(as at 25.02.13) S&P/ ASX 100 Small Ordinaries
Price/ Earnings    13.6x 10.5x
EPS growth 12.4% 24.7%
Dividend Yield   4.7% 3.8%
Return on Equity 14.3% 12.0%

Table 1: As at 25.02.2013

Source: Contango Asset Management Limited

Table 2 shows that investors in small and micros enjoyed positive returns, in line with the valuations inferred 12 months earlier.

  12 month return
ASX Small Ords Accum Index 13.1%
S&P/ASX Emerging Co’s Accum Index 14.7%

Table 2: As at 30.06.2014

Source: Contango Asset Management Limited

However, investing is also a relative game meaning that investors should know how this performance compared to the large cap sector.

Those investors who in early 2013 rotated into smalls on the back of lower P/Es and higher earnings growth would have done well to understand the role relative valuations and momentum play.

To observe how this expressed itself we extend Chart 1 forward to August 2014.

CHART2

Chart 2: Source: Contango MicroCap Limited

Chart 2 shows that notwithstanding the compelling fundamentals and subsequent returns from the small and microcap sector, the relative underperformance to large caps grew further, peaking at a -52.6% on 30 April 2013.

Is now the time?

Investors may ponder if now is the time to rebalance into smaller companies in the belief that they will now outperform large caps.

Chart 3 looks at the actual performance of the large and microcap indexes from which the differential was extrapolated. For the first time since 2011 microcaps are generating a positive 12-month rolling return and nearly outperforming their large cap counterparts.

 

CHART3

Chart 3: Source: Contango MicroCap Limited

For the first time since 2011 the Micro’s Index is delivering positive rolling annual returns. Table 3 shows the one-year forward valuations across the sectors. The general consensus as we enter earnings season is that valuations were “reasonable”.

FY14 Valuations(as at 07.08.143) S&P/ ASX 100 Small Ordinaries   CTN [“Micros”]
PE (x) 14.9 15.5 12.6
EPS growth (%) 4.8 25.4 36.6
Yield (%) 4.7 3.8 3.6
Return on Equity (%) 16.1 13.5 16.2

Table 2: As at 07.08.2014. Source: Contango Asset Management Limited

To sustain and then extend the positive returns the market requires the current valuations (fundamentals) in smalls and micros to meet expectations.

All eyes on this earnings season

August 2014 shapes as a significant period for the microcap sector as investors are poring over results to see if valuations are being confirmed. Positive or even in-line outcomes could see a bounce in small and microcap stocks.

Looking to FY15, microcap fund manager Contango MicroCap Limited anticipates solid growth as the economy transitions from mining investment to non-mining investment and consumption. In this environment, it prefers companies that have solid growth profiles and high free cash flow yields while avoiding low growth defensives and pure yield companies, seeing select opportunities within the microcap space.

Some of the larger positions in the CTN investment portfolio include Cedar Woods Properties Limited (ASX: CWP), Villa World FPO (ASX: VLW), Village Roadshow Ltd (ASX: VRL), iProperty Group Ltd (ASX: IPP), Mayne Pharma Group Ltd (ASX: MYX) and Prime Media Group Limited (ASX: PRT).

The small cap sector typically outperforms large caps when risk appetite is strong. Whilst that might not describe the current environment, investors can find select opportunities within the small cap space. That is particularly the case for well managed, small industrial companies with strong EPS growth prospects and solid balance sheets.

In most cases investors can remain cautious about small companies exposed to the mining sector, particularly if they are early-stage or carrying high debt levels. In a stronger growth environment, when bond yields and commodity prices are typically rising, investors can look to increase exposure to mining stocks. As with large cap investing, investors can look for the right combination of high quality and attractive valuation at the right point in the business cycle.

Note: In Table 2 listed microcap CTN’s investment portfolio is used as a proxy for the fundamentals of the microcap sector as the weights of the stocks within the S&P/ASX Emerging Companies Accumulation Index are not known.

Are you looking for some of The Motley Fool's best small-cap ideas?

Oil and copper continue to be in high-demand -- and their popularity doesn’t look to be slowing. We've uncovered three companies poised to benefit from the rising prices of these commodities. Get our brand-new report -- "3 'Under-the-Radar' Resources Companies That Could Win Big" -- FREE!

Disclaimer: This article was written for The Motley Fool for information purposes only. There may be errors in the data generated and the author is not licensed to provide financial advice. Microcaps may not be a suitable for all investors. Investors should consult professional financial advice before making any investment decision. Article authorised by Bruce Jackson. Bruce Jackson has an interest in Contango MicroCap Limited.

NEW. Five Cheap and Good Stocks to Buy in 2019…

Our Motley Fool experts have just released a brand new FREE report, detailing 5 dirt cheap shares that you can buy today.

One stock is an Australian internet darling with a rock solid reputation and an exciting new business line that promises years (or even decades) of growth… while trading at an ultra-low price…

Another is a diversified conglomerate trading near a 52-week low all while offering a 2.8% fully franked yield…

Plus 3 more cheap bets that could position you to profit over the next 12 months!

See for yourself now. Simply click the link below to scoop up your FREE copy and discover all 5 shares. But you will want to hurry – this free report is available for a brief time only.

CLICK HERE FOR YOUR FREE REPORT!