Small Caps | Nov 07 2013
-Take note of specialty retailer rents
-Dividend yield still key to industrials
-Attitude to base metals improves
-Focus on small capex, low cost resources
By Eva Brocklehurst
Looking for leverage in specialty retailers? Citi has targeted stocks best exposed to failing retail rents. Small cap specialty retailers stand to benefit most from this situation in coming years and that means OrotonGroup ((ORL)), Premier Investments ((PMV)) and Specialty Fashion ((SFH)). The broker contends the upside will take time, but over the next three years rents should fall as a share of sales for these companies. The prospect for rent reductions is greatest for Premier Investments and Specialty Fashion Group. Citi has a Buy rating on Specialty Fashion, which trades at a substantial discount to discretionary retail peers with better internally generated earnings growth.
In terms of cyclical leverage, small resources have given back some gains so far this month but remain material outperformers so far for FY14. Whilst Citi retains a preference for industrials, particularly those with some cyclical leverage, there is opportunity for increasing exposure to small resources as the global growth cycle improves, and because of the earnings downgrades over the past 12 months. The broker estimates that small resources have undergone earnings cuts of around 30% over the past 12 months, gold and iron ore stocks in particular. What is encouraging is that estimates for small resources have not changed as much over the past few months and this could suggest earnings are nearing their nadir. An exception may be gold, where the price risk for the precious metal remains heightened.
The broker is struggling to find value in small industrials and accepts that the dividend yield continues to look attractive relative to alternatives for income production. Therefore, this sector should enjoy support despite offering limited capital growth opportunities. On a risk adjusted based the broker includes SAI Global ((SAI)), G8 Education ((GEM)) and Amcom ((AMM)) in the list of preferred small cap industrials.
UBS observes a recent resurgence in capital raising among the small-medium cap stocks and it's largely been in resources. As many as 14 base and precious metal companies have announced, or completed, an equity raising above $5m. In the last week this has included Panoramic Resources ((PAN)), Sirius Resources ((SIR)), Tiger Resources ((TIG)), Medusa Mining ((MML)) and Cudeco ((CDU)). The broker found from discussions with clients that attitudes have changed slightly towards base metals. This has been supported by changing market dynamics in nickel, with a potential ban on Indonesian ore exports expected to support nickel prices into 2014. Additionally, interest in copper is robust, with clients less concerned about previous forecasts for significant surplus, amid an improving outlook for demand from China, US and Europe.
Emerging from the Diggers And Dealers conference, the broker found sentiment was better than expected and it's good news for the small caps. Investors have been continuing to ask about companies with potential to supply new low cost production with moderate capex requirements.Very few clients showed interest in companies with large development projects, where the proposed expenditure is a multiple of the company's market capitalisation. Sentiment towards the gold space remains almost universally negative but a number of deals have been completed recently in this sector, suggesting that interest could be picking up. With the ongoing volatility in the underlying commodity price UBS believes clients should look at the low-cost producers for exposure and avoid the marginal players.
The recent surge of capital raising is likely to continue for the next month as producers and explorers with advanced projects take advantage of the current investor sentiment ahead of the Christmas holidays, which typically results in limited market access. Within UBS' metals coverage, companies that have weak or near zero free cash flow due to either low margins and sales or high capex include Newcrest Mining ((NCM)), Lynas Corp ((LYC)), Perseus Mining ((PRU)) and Discovery Metals ((DML)), although Discovery has recently announced a re-capitalisation program with the Singapore's Blumont Group. The broker is not suggesting these will be raising equity, rather they exhibit at least one of the characteristics usually seen prior to an equity raising.
JP Morgan notes the best and worst performers this month were mixed in terms of sector but most of those underperforming were doing so because of "confessions" at AGMs and trading updates. The best performer was FKP Property ((FKP)), up 51%, which announced an underwritten 5-for-9 accelerated non-renounceable pro-rata entitlement offer. Net proceeds will be used for a substantial reduction in debt. Emeco Holdings ((EHL)) recovered some ground after amending two financial covenants under its $450m senior debt facility, providing flexibility and more balance sheet certainty. Australian Pharmaceuticals ((API)) delivered a FY13 result which forecast continued improvement in earnings.
The worst performers were headed by Cash Converters ((CCV)), which announced that trading conditions were subdued as the transition to a new regulatory regime in Australia impacted customer credit behaviour. Sales for the second worst performer, Acrux ((ACR)),were down around 15% in the first quarter. Maxitrans ((MXI)) provided profit guidance at the AGM of $10-11m for the first half, down from $13m in the prior corresponding half
The Small Ordinaries is currently trading on a one-year forward price/earnings ratio of 14.5 times which is, according to JP Morgan, a 23% premium to its 5-year average The Small Industrials index is trading on a 1-year forward PE of 15.5 times, a 33% premium. This premium has increased markedly over the last five months from just 12%. The Small Resources index has a 1-year forward PE of 11.4 times, or a 9% discount to its 5-year average. This gap has widened over the last couple of months although JP Morgan observes it is a long way from the 39% discount witnessed in June 2013.
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