This is the time of the year to be looking at dogs. Not the canine kind but stocks that are lagging the market by a country mile.
It is almost a "must-do" for any serious investor and it follows the "Dogs of Dow" theory, which is premised on this year's biggest laggards being the strongest performers in the new financial year.
The Dogs of Dow looks at the biggest losers on the US stock benchmark, the Dow Jones Industrial Average, and history has shown that these dogs have a tendency to outrun the market in the following 12 months.
The key reason for this is because of business cycles. Industries that face a cyclical downtrend can often bounce back in the following period.
Applying this to small cap stocks can be trickier as their underperformance is often linked to company specific drivers – meaning the headwinds facing a small cap stock can be more structural than cyclical.
However, there are three small cap dogs that I think will race ahead in 2015-16.
The first is child care facilities operator G8 Education Ltd (ASX: GEM) following its 20% plus fall over the past year.
I have stayed away from G8 Education in the past because I was unwilling to pay a premium for what is essentially a "roll-up" business – meaning a company that grows by acquiring smaller rivals.
While management has proven to be smart acquirers and there are some benefits to scale, service businesses tend to only enjoy modest synergies from acquiring competing businesses.
Further, G8 Education really offers no competitive advantage. Any other child care operator with access to capital can do what the company is doing, and that's what is happening. All the more reason I would not pay a premium for the business.
But G8 Education is now trading at far more attractive valuations with the stock fetching a 2015-16 consensus price-earnings (P/E) multiple of 12x and is forecast to yield around 10% with its franking credit.
The second dog I like is leisure facilities operator Ardent Leisure Group (ASX: AAD) after the stock shed nearly a quarter of its value because of an unexpected management change and declining sales at its fitness centre division.
However, there are signs of a turnaround in that division and its key US entertainment centres are still growing strongly.
It's new and untested chief executive poses downside risks but I think that is more than reflected in the current share price with the stock trading on a 2015-16 forecast 13.7x P/E, which is close to the bottom of the stock's five-year P/E range.
What's more, the stock is tipped to yield around 7% in the new financial year, and that makes the stock particularly appealing given its US dollar exposure and leverage to the boom in overseas tourists visiting Australia.
The last dog is the riskiest of the three and my early bullish call on Specialty Fashion Group Ltd. (ASX: SFH) has yet to be proven right.
The big thorn in the side of the apparel retailer is the problematic Rivers chain it acquired in 2013. Getting that business up to scratch is proving to be more difficult than initially thought.
However, I think we will see an improvement in Rivers when Specialty Fashion reports its full year results in August and I expect its core brands to continue to perform strongly in the current half.
Make no mistake, this is still a speculative call, but I think Specialty Fashion's valuation following its close to 30% plunge over the past year is getting hard to ignore.
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