Small Cap stocks are showing stability in volatile market11.03.2015

Market Overview: Small Cap stocks relatively stable.

The first thing to say is that there has not been much weakness at all in Under the Radar Report’s stocks. The big selling is occurring at the big end of town because those stocks have been pushed up too far because of the hunt for yield and earnings certainty. The small cap stocks we have been tipping are either very cheap; and/or their earnings are not reliant upon general economic conditions.

One Small Cap stock that's Shooting like a Star in the food sector.

In Thursday’s Under the Radar Report we have a small cap stock that seemingly ticks all the boxes: it has a great niche in the food sector; it’s distributing throughout Australia; and it’s just moved into the giant Chinese market.

There are two big risks which we highlight, but if ever there was a momentum play, this is it.

SEVEN Small Cap Stock Buying Opportunities

We also come up with SEVEN buying opportunities in ASX listed small cap stocks at different ends of the risk spectrum. We don’t shy away from the fact that with some of these stocks, there is an element of binary risk. What we do look for however, is a strong balance sheet: little debt and a lot of cash. If things do go awry, it’s a measure of protection.

Reporting season, or should it be yield season?

Investors of bigger ASX listed companies are not looking at the detail behind the profit numbers, they are looking at the dividend. Seriously, they should change the name of “earnings season” to “yield season”.

What happens when interest rates do eventually rise again?

When the hunt for yield ends, or put another way, when interest rates start rising again, the returns from these dividends will be wiped out by capital losses. As one of Under the Radar Report’s investment columnists and portfolio manager Andrew Brown says: “If a company’s long term growth rate is below 5 per cent, unless you think there is a big cyclical upturn coming, it doesn’t make any sense to be paying a PE of 16 or more.”

In case you are wondering, he’s talking about the likes of Telstra, CBA, Coles supermarket owner Wesfarmers and Woolworths.

You should take note that in the recently ended profit reporting season there have been signs that investors are getting nervous about the ability for companies to keep paying out big dividends. After all, many have payout ratios of 100 per cent. All their profits go into paying the dividend, and none into investing for the future, which is necessary if you want to grow any business.

Big Bank Case Study

A case in point is CBA, which met its numbers, delivering an 8 per cent rise in its cash profit, and increased its dividend, which impressed the analysts at the time. But since then its shares have come off a couple of per cent because of the realisation that its dividend growth has been in no small part fuelled by unsustainably low bad debts.

Investors suffering from Dividend Addiction

Small caps have largely been left alone amid this dividend addiction, but investors have proven willing to pay almost extortionate prices for what looks like certainty of earnings. This is at the very upper end of the sector, and it would be more accurate to call these companies “mid-caps”. These include owner REA and Dominos Pizza, which have market caps of $3.1 billion and $6.5 billion respectively and have forecast PEs well in excess of 30 times.

Investors are trading momentum

When you are paying these prices for industrial companies like these, you are trading momentum. You have to be careful that it doesn’t disappoint, otherwise your investment will be shredded. Just this week the shares in the internet service provider iiNet plummeted 11 per cent in one day last month after it delivered a flat interim profit. Its shares are down almost 25 per cent in the past three months, but are still more than double their level three years ago. The point is to be careful paying up a stock which has massive expectations baked into its price.

For the record, the market is priced on a forward PE of about 14 times, which suggests growth in the region of 9 per cent. This isn’t as relevant as the forward dividend yield of 4.2 per cent, which is way above the current 10 year bond rate of 2.54 per cent, and even further above if you include franking credits. The real problem is that the payout ratio is about 71 per cent based on these figures, which is far too high to produce long-term profit growth.

Why should you invest in small caps?

Many small cap stocks are simply not covered by analysts, and in-depth research can make all the difference to your portfolio. Under the Radar report fills the gap in market analysis by providing research and analysis on more than 100 small listed companies.

Get unique research on fast growing small cap stocks. It’s much easier for a small company to double or triple in size than for a big one and every portfolio should hold small caps for growth.

Find out which small cap shares to buy and receive instant access to all our small cap research. We help you filter through all the listed small cap stocks and provide you with quality research on the small caps we cover.

Plus, the weekly report will be emailed out to you every Thursday morning.

Written by Richard Hemming.

Richard is Editor of Under the Radar Report, Australia’s leading independent research provider on fast growing ASX listed small cap stocks.

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About the Author

Richard Hemming

Investment analyst and Editor of Under the Radar Report

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