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

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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Brendon Lau has no position in any of the stocks mentioned. Connect with him on Twitter @brenlau.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Nanosonics Limited. The Motley Fool Australia owns shares of Appen Ltd. The Motley Fool Australia has recommended Nanosonics Limited. 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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