Under the Radar Report: Small Caps has produced an average return of 240% on our small cap food stocks, with notable successes including Bellamy’s, Capilano Honey, Freedom Foods and Tassal. We look at whether the drought provides a buying opportunity for any of our favoured small caps.
SMALL CAPS: ALWAYS LOOKING TO HARVEST RETURNS
Being a student of investment markets means that almost everything you hear translates back to, you guessed it, the markets. The other morning at the surf club, I was able to call it research when one of my friends told me that he was trying to buy his neighbour’s property, “up the valley” in Dunedoo, Central New South Wales.
Back in the 1980s a farming family could survive on 400 acres of land; now it’s 2,000 acres, he told me, before ordering 50 sit-ups. Or was it push-ups? Probably both. He did play for the NSW Blues back in the day.
Over the years, we have written a great deal about agriculture and the ASX companies that make a living from it, but that conversation got me thinking, does the drought provide a buying opportunity in any of our favoured small caps?
UNDER THE RADAR REPORT: SMALL CAP’S APPROACH AT LOOKING TO MAKE MONEY FROM AGRICULTURE
First, it’s worth looking at Under the Radar’s strategy in selecting agriculture small cap stocks. One approach has been to look at those small caps that produce largely generic or commoditised products and services but have broad diversification, both by this measure and geographically. We’ve had a lot of success with small cap Elders (ELD) because we purchased when the company was under duress from an unwieldy capital structure, but these days we like small cap Ruralco (RHL), which looks to be good value. More on this small cap stock below.
Another approach has been to look for well managed small cap companies doing their thing with a highly specialised focus. This is where we’ve had most success. I’m talking about the ASX listed small cap almond harvester, Select Harvests (SHV), the salmon and seafood distributor Tassal (TGR), the honey marketing group Capilano Honey (CZZ) and even on the marketing side, the baby formula distributor Bellamy’s (BAL). Our greatest success in the sector comes from a combination of the two. Freedom Foods (FNP) was founded by the Perich brothers and remains controlled by them. The company has created an impressive niche in health and wellness branded food manufacture.
This second approach really isn’t overly influenced by the vagaries of Australia’s climate. Certainly not as much you would think. There is cyclicality but this is dependent on specific factors, many of which are not related to the current drought.
THE SPECIFICS OF ALMOND PRODUCTION IN AUSTRALIA
For example, the almond price upon which Select Harvest’s stock price depends, is influenced by droughts, just not the ones in Australia. About 80 per cent of the world’s almonds come from California, which has been afflicted by lengthy droughts, the latest of which began in 2012 and ended last year. Select does suffer from factors relating to its almond harvests, but these relate to very specific conditions in its 19,000 acres of orchards located in Malley (Victoria), Riverland (South Australia) and Riverina (NSW).
SMALL CAPS: THE KEY TO MAKING MONEY
The key to making money from these small caps has been to purchase when things go wrong or there is a cyclical downturn and sentiment turns bearish. In many cases, their advantage is a relatively low cost of production, which means you can literally reap the rewards when conditions improve. No agriculture based stock is “set and forget”.
WHERE THE DROUGHT IS MOST RELEVANT
The current Australian drought is much more relevant for the diversified producers. Although, as with everything on the land, it’s not simple. When there is no rain, farmers don’t use as much fertiliser volume, which is often supplied from rural outlets and agencies owned by the likes of Ruralco. Then there is the weird effect of no rain on cattle prices, which initially causes them to fall, as farmers de-stock. Meanwhile feed prices climb because of the water needed to produce hay. Then after the drought breaks, cattle prices can climb. We particularly like it that Ruralco also sells water services, which provide a contra-cyclical impact.
However, the effect of the drought has hurt Ruralco more than any other stock, which includes its competitor Elders. Ruralco’s stock is down almost 15 per cent since the start of the year, while Elders’ is slightly up.
In the past month, both stocks have been hit by a one-two punch of disappointing news. First Elders and then Ruralco quantified the impact of the ongoing drought on their operating performance for the second half pf their financial years, which end in September.
When Elders released its news, on 6 July, investors were surprised to hear that the drought would impact, and sold off both companies, and Ruralco did not recover despite its announcement later that month being less negative, reporting that its full year result to the end of September could still (at best) be up about 10 per cent on last year.
SMALL CAPS DEPEND ON VALUATION PRINCIPLES
Ruralco does look better value, trading on a forecast PE ratio of 10 times and a dividend yield of 5.6 per cent, which compares to Elder’s PE and yield of 14 times and 2.5 per cent. Having overcome its capital structure nightmare, Elders’ management has been almost faultless in its execution, while Ruralco has had problems in a number of business units.
Successful investing in both small caps and the larger companies too involves trusting in management’s abilities to deal with tough times. If Ruralco’s management is successful, there is more potential for future reward from the current drought, which everyone hopes will break soon.