Why UBS says go overweight on small caps like Appen and Nanosonics

ASX small cap industrial stocks haven't been this cheap in seven years even though the sector has underperformed the S&P/ASX 200 (Index:^AXJO) (ASX:XJO).

Brendon Lau

Brendon’s passion for shares started by accident in 2003 and he has worked in various roles around capital markets ever since as a trader, stock analyst and markets reporter with the Australian Financial Review. Most of his wealth has come from share investing than any other asset class, and that has given him the financial freedom not to work full-time, if he chooses to. Brendon is a medium to long-term investor who aims to hold positions for a year or longer and is focused on fundamental analysis, although he will occasionally use technical indicators to time his entries and exits. Brendon has an MBA from Melbourne Business School and is RG 146 certified. He lives in Melbourne with his wife, three kids and two dogs.

Published September 7, 2019 2:48 pm AEST

The reporting season has been tougher on small caps than the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) stocks but this could be the time to be going overweight on emerging ASX stocks, according to UBS.

The broker noted that FY19 earnings per share (EPS) contracted by 7% at the smaller end of the market, particularly among resource stocks which fell 24%.

Small industrials excluding financials weren't great either as that retreated 4%, while financials managed to buck the trend to inch 1% higher.

Worst August in six years

Similar to their larger peers, FY20 forecasts for small industrials were revised downwards by circa 3% – making this the worst August reporting season in six years for the group in terms of EPS downgrades.

"Weaker EPS revisions meant the market reaction to the small cap reporting season was softer than the large caps," said UBS.

"The typical small cap (ASX 101-200 basis) Industrial result prompted -0.4% relative share price reactions on the day of the result, in contrast to the large caps, where companies that reported bounced 0.6% more than the market."

Small caps silver-lining

But small cap investors shouldn't get discouraged. As hard as it is to believe, there is a pretty large silver lining to all this bad news as the underperformance of small industrial stocks means the group is now trading at its biggest price-earnings (P/E) discount since 2012!

"Higher PE discounts are correlated with outperformance by the small caps in the next 12 months," explained UBS.

"Our modelling suggests the level of the PE discount today means that small caps could outperform large caps over the next year by c.3%."

Small cap buys and sells

But the broker warned against indiscriminate buying of the sector even though it's feeling bullish about the sector's outlook in 2020.

If you are looking for small caps with the best potential to outperform, UBS is nominating the Appen Ltd (ASX: APX) share price, the Imdex Limited (ASX: IMD) share price, the Myer Holdings Ltd (ASX: MYR) share price, the Nanosonics Ltd. (ASX: NAN) share price and the NRW Holdings Limited (ASX: NWH) share price.

On the flipside, the broker is wary of the GUD Holdings Limited (ASX: GUD) share price, the Japara Healthcare Ltd (ASX: JHC) share price, the Mayne Pharma Group Ltd (ASX: MYX) share price and the Speedcast International Ltd (ASX: SDA) share price.

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