Big gains on small improvements

The AGM season must seem like a horror film for many investors. Seemingly every time a senior executive opens his or her mouth at one of these annual general meetings, there is a profit downgrade.

Companies both big and small are being hit by either an underwhelming sales line due to depressed activity, or by lower profit margins as businesses all attempt to reduce costs at the same time.

The high profile downgrades at the big end of town have been builder James Hardie’s 35 per cent fall in its first half profit, chemicals producer Orica’s $367 million write-down. QBE seems to be in an endless cycle of profit warnings, Incitec Pivot says the soaring gas price is effecting production, while Origin Energy, which you would think is in a good position with the escalating price of electricity, flagged flat earnings.

Big and small are getting hit

At the smaller end it’s also been pretty miserable. Shares in market darling Webjet slumped after it warned of “very low growth levels”. In mining services, equipment leasing group Emeco said hiring rates were much lower than expected, and dairy products manufacturer Warrnambool Cheese is being hit by a pincer movement of low Australian dollar prices for its milk and declining profit margins due to intense competition.

One fund manager told Under the Radar, in an air of despair: “This is what happens when you become one of the most expensive countries in the world to do business”.

Oh, and it doesn’t help that the high Australian dollar (promoting importing), structural industry changes (the internet), the depressed housing market, and rents that are very high by world standards, are all making life difficult for industrial companies, and in particular manufacturers and retailers. No it does not!

A stock picker’s market

But then, almost in the same breath, he added: “All you can do is pick stocks that are going better than the others.” Inspirational stuff for his unit holders, we are sure.

For what it’s worth, Radar believes he’s right: stock picking is always the way to make money, but we also think that depressed current earnings are a good thing for a stock price, especially (surprise surprise) in small caps.

Not only do many of the companies Radar looks at offer decent yields of 5 per cent plus, but their earnings are forecast to grow at a faster rate than the economy because they are not constrained by it. Most, if not all of the industrial companies we tip, are gaining market share at a fast rate – you just have to read our issue out yesterday to see this.

Look out for the mining minnows!

But in a twist, Radar believes that the place where the fastest growth will occur is the small cap resources companies that have secured a path to production through adequate funding. These companies are out there and they will be the big beneficiaries if commodities prices show any sign of life in the next 12 months.

In some cases, Radar is spotting these companies trading at big discounts to the replacement value of their production plants!

I hear what you’re saying: What about all the doom and gloom in Europe? Isn’t America, still the world’s biggest economy, going to fall off the fiscal cliff? Isn’t China’s growth coming off?

Radar has two words for you: priced in.

As another fund manager said, on the demand side, “if these economies muddle through, it won’t take much in terms of growth to see commodities prices maintain their current levels because there is so much despair out there.”

On the supply side, Radar hopes not to sound like a stock broker here, but it’s actually a positive to see the big resource giants like BHP Billiton and Rio Tinto pulling or delaying big projects. This means that the supply of commodities such as iron ore and coal will remain tight for years to come.

Long before the stock broking analysts raise their commodity price assumptions and increase their net present values (NPVs) for the miners, it will be reflected in the share prices. And the big returns will be in the little miners. In the words of yet another small cap fund manager:

“The smaller miners are producers with enormous leverage. You’re talking about a 10-bagger if commodities move up and the production issues get sorted out.”

And yes, 10-bagger implies a ten-fold gain.

Click here to access the fortnightly newsletter Under the Radar Report: Small Caps, edited by Richard Hemming. Visit here for more Under the Radar articles.

The original release of this article first appeared on the website of Hangzhou Night Net.

Comments are closed.