7 Steps to Picking Small Cap Stocks

Richard Hemming


Making money over the long-term is being able to take advantage of short-term share price gyrations. The most important component of your future returns is the price you pay for any investment. Recently we have seen many buying opportunities. These are buying opportunities you can't afford to miss, because everything moves quickly in the world of ASX Small Caps.  

1. Cash is King

✓ How much cash/debt compared to last year?

✓ Changes to working capital?

✓ Net investment expenditure?

✓ What is the company doing with its excess cash?

The big effect that COVID-19 has had is to expose the vulnerability of companies’ balance sheets. Put another way, they didn’t have enough cash and debt facilities to weather bad conditions. A virus that was almost unknown at this time last year has produced really, really bad conditions. Consequently, many companies were forced to raise equity to compensate for the cash burn they’ve experienced, while others opportunistically used the period as an opportunity to raise capital for acquisition or otherwise. On the other hand, it’s worth mentioning that some of our favourite companies have taken the opportunity to grow their business organically, raising debt through existing facilities and limiting equity issues.

What has been the impact of COVID-19 on cash flow and has management successfully constrained capital expenditure? What does this mean for the sustainability of growth?

At the big end of town, the bigger a company’s debt the bigger the problem for the banks. This isn’t the case for Small Caps where the bank’s profitability isn’t much affected. But it is important when there is debt; to understand its terms and when it needs to be renewed. If free cash flow is not going towards debt reduction, something will have to give. Whether a request for more funds from shareholders is done on good terms or bad will largely depend on the reason given for those funds, which in turn relies on underlying fundamentals – the interaction between the profit and loss; the cash flow statement and the balance sheet.

2. Sales Growth

✓ Is the company growing sales?

✓ Why are those sales growing – volume or price rises?

✓ If it isn’t, what is driving earnings growth?

Sales growth will be more interesting because of the COVID-19 related interruption. What we want to see is a resumption of sales growth. If a company doesn’t have a prospect of growing its top line year on year, the key is identifying how it can grow. If it does, the key is to quantify the factors behind the sales growth. In a service business, this may be achieved through more efficient operation, or by an increase in staff or infrastructure. In a manufacturing business revenue increases should be achieved from either increased volumes or higher selling prices. Management’s commentary on the sources of growth should be clear and unambiguous.

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3. Margins Matter

✓ The higher the gross margin, the bigger the impact from lower sales.

✓ What are the company’s input costs?

✓ How affected are they by currency movements?

✓ What is the proportion of fixed costs to overall costs?

✓ What is the level of government support and how long can this last?

This is a period in which losses may have blown out. How much have these costs been contained by government handouts such as JobKeeper, is one key. For Small Caps we suspect it won’t be as big an issue as for the big end of town and at the other end of the spectrum, small business. The question is the extent to which the company is reverting to profitability, if at all. This comes back to sales: the factors behind it and the cost structures associated with it should be reflected in both gross profit margins and net profit margins. Gross margins should expand when prices are rising faster than the input costs that go into creating the products and services.

Underpinning this is our eternal search for operating leverage, as a company’s sales and margins should be growing, and the fixed operating costs of the infrastructure and corporate assets necessary to deliver the outcomes should reduce as a proportion of sales over time, increasing net margins. Margins matter. The goal should be to understand what are the factors behind changes in margins and whether these are likely to be sustained or increased.

4. Be wary of what’s “Underlying”

✓ What are the headline profits versus the so-called underlying?

✓ What has the company declared to be exceptional or one off in prior periods versus in the current period?

✓ What are the effect of accounting changes?

These results are going to require some creativity and then some from investors trying to work out the maintainable profits of companies. We are always trying to work out what the real business is doing, but companies make life very difficult and some are definitely worse than others. Expenses companies put above the line (costs incurred in making the product/providing the service i.e. cost of goods sold (COGS) versus those below (relating to operating the business) will need to be scrutinised carefully. The company will claim that some above and below the line costs are exceptional items.

Red flags are often hidden in the exceptional items, which the company considers not part of its normal operations, or one-off in nature. Examples include gains and losses on asset sales, restructuring costs, as well as write-offs of intangible items when a board has reviewed the cash flows from those assets and decided that they are insufficient to support the assets’ carrying values in the accounts. This will be a particularly important factor in the coming results season.

Companies exclude these items to come up with their “underlying earnings”, which is meant to reflect the performance of their ongoing operations. This is an issue when these one offs recur from one result to the next. Outside of us ignoring management’s definition, this becomes an issue of its credibility.

5. Outlook Comments

✓ What is the tone of the outlook comments?

✓ Is the company looking to make acquisitions?

✓ Does the company have a track record of underestimating or overestimating future profit growth?

The outlook comment has never been more important because the numbers will be so hard to read. What we’ll be looking for, which will be in short supply, are specific numbers that the company is expecting to deliver or report, but also the tone and information about investment plans and strategic direction which the outlook should deliver. Beyond this, how well has the company adapted to the COVID-19 world and can this continue if no vaccine is found.

Company reports need to be read with a healthy dose of scepticism. The annual report is always interesting and provides colour to the audited financial statements, which are an important constraint on management’s ability to delude itself and investors.

6. Share price reactions

✓ Has the share price been trending up or down prior to the announcement?

✓ Was there a sharp reaction on the day of the announcement?

The market has been on a wild ride during the pandemic but each stock price chart tells a different story. Subscribers are sometimes surprised by the reaction of share prices to market moving news like results and prospects. This is a variation of the old adage to buy the rumour and sell the news, which has worked very well through this crisis. The stock market is always looking for growth, and accelerating growth at that. Decelerating growth will often cause a big problem for growth stocks, because valuations are based on higher growth for longer. The bottom line is to avoid owning too many stocks that are so expensive that they are vulnerable to any disappointment of other investors’ expectations.

As fundamental investors, we look forward to results which in some cases (if we are right) should confirm our optimism that a company’s results are underrepresented in the current share price.

7. Dividends

✓ Is the company changing its dividend policy?

Ultimately, management’s confidence is reflected in the dividend declared. If a dividend was declared and not paid, that used to be an absolutely terminal act. Think of the Queensland based financial services company MFS. Its stock was going gangbusters until early in 2008 when it fell 70% in one day after it announced that a previously declared dividend would not be paid and that an enormous rights issue was coming. MFS went into administration within weeks. But no more. Almost every company in that 3 to 4 week period from the beginning of March had to pull their payments at the last minute. Now that the uncertainty has lifted, some businesses are doing better than expected, and especially where management has a large shareholding, there has been a natural tendency to resume dividend pay-outs sooner rather than later. Some have paid in late FY20, some in early FY21.

But dividend payment behaviour in this environment may be different. If management want a free pass on paying a relatively high dividend, and to go for growth by increasing investment from earnings, now would be a good time. We’ll explore dividends further as companies report

How is sell different from take profits?

Interpreting our “Take Profits” rating will depend on how much stock you own of the Small Cap in question. If you don’t own much it might mean selling the whole lot to bank profits; while if you own more, it might be a question of just selling a few because the market isn’t liquid in that stock (not many buyers and sellers reflected in a big bid/offer spread). Sometimes you can be lucky enough to take your costs out and let the rest of your holding run for free. Your personal tax situation will also dictate your actions

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About the Author

Richard Hemming

Richard Hemming (r.hemming@undertheradarreport.com.au) is an independent analyst who edits www.undertheradarreport.com.au, which provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (AFSL: 409518). The author does not own shares in any of the stocks mentioned.

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