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This small cap underperformer is finally starting to win back investors

One of the most prominent fallen angels in the small cap sector is winning back the market!

The G8 Education Ltd (ASX: GEM) share price jumped 0.7% to an eight-month high of $2.86 this morning as Morgan Stanley upgraded the stock to “overweight” from “equal-weight”.

Its outperformance stands in contrast to the 0.3% drop in the S&P/ASX 200 (Index:^AXJO) (ASX: XJO) index at the time of writing.

The broker upgrade comes on the back of the childcare centre operator’s trading update at its annual general meeting and isn’t premised on a big profit increase as Morgan Stanley has only increased the company’s earnings per share (EPS) forecast by 5%.

It’s based more on confidence that earnings for the embattled company won’t crash again with the sector hit by multiple headwinds over the past year.

These are namely an oversupply of childcare places, changes in childcare rebates and wage issues with childcare workers staging strikes earlier in the year.

But these headwinds seem to be abating. G8’s trading update from last week indicated that occupancy rates are starting to recover, and Morgan Stanley noted similar commentary from other childcare companies like Goodstart and Think Childcare Ltd (ASX: TNK).

There were already signs of a recovery earlier in the year but Morgan Stanley wasn’t convinced it was sustainable till now.

However, the industry’s era of capacity expansion has come to an end (at least for now) with difficulty in accessing capital due to tightening credit conditions.

The change to the way families receive rebates has also largely been accepted by the public while G8’s initiatives to improve staff retention and business performance should be starting to pay-off.

“We have conviction we are at an inflection point,” said Morgan Stanley who has increased its price target on the stock to $3.25 from $2.30 a share.

“FY18 are trough earnings, so expect GEM’s trading multiples to expand, anticipating an extended period of EPSg [EPS growth]. We feel this is warranted as capital is still leaving the industry as banks tighten access to credit.”

The Banking Royal Commission which exacerbated the tighter credit conditions isn’t great for the growth of the big banks like Commonwealth Bank of Australia (ASX: CBA) or Westpac Banking Corp (ASX: WBC), but it’s made all the difference to sentiment towards G8.

G8 isn’t the only notable riser on the market today. The Baby Bunting Group Ltd (ASX: BBN) share price, the Appen Ltd (ASX: APX) share price and the A2 Milk Company Ltd (ASX: A2M) are also outrunning the market this morning.

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Motley Fool contributor BrenLau owns shares of Baby Bunting and Westpac Banking. The Motley Fool Australia owns shares of A2 Milk and Appen Ltd. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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