Small-caps punching above their weight

Wednesday, September 7th, 2016

As the dust settles on yet another eventful reporting season, we believe it is important to take some time to pause and reflect on markets and our portfolio positioning. As a natural and ongoing extension of this process, we examine a range of companies that we believe are well positioned to grow in the years to come.

In a world with a scarcity of genuine growth, we see significant long term opportunity in a range of well-managed, financially strong, small cap companies.

Though simplistic in nature, one of the most powerful concepts of equity investing is ultimately share prices follow earnings growth. For those companies that can reinvest and compound at high rates of return, the prize of substantial investment returns awaits. That is, of course, provided you pay an appropriate price for this growth profile.

What is interesting about this relationship is that at a market index level, prices have broadly increased at a time that earnings growth has stagnated. Indeed, as highlighted below, forecast earnings per share continue to recede. In effect, investors are simply paying higher prices for a stagnant or reducing earnings stream. Reflective of the thirst for yield and particularly in the large caps, is the payment of higher dividends funded by what we believe are inflated payout ratios, something we do not see as being sustainable.

Forecast EPS and Forward P/E Ratios
Figure 1: Forecast EPS and Forward P/E Ratios
Source: RBA Chart Pack

It is important to recognise that the ASX100 is the key driver of the aggregated earnings trends illustrated above, which appear to be tepid at best. This is because the ASX indices are weighted by market cap, where companies only receive a large weighting as a result of their size and liquidity, not because of their quality.

Once you get past the ASX100 however, buried within the vast noise of a 2200 company index are more than a handful of companies that are producing double digit growth in earnings. What’s even more interesting is that in our view, many are available at far more attractive valuations.

 

Nick Scali Limited (NCK)

If one were to pick a company that exemplifies a high quality, self-funded growth profile, it would be Nick Scali (NCK). CEO Anthony Scali has done a wonderful job executing the ongoing store roll out of the core Nick Scali brand across Australia over the past decade. Since 2012, earnings have nearly tripled while the equity base has approximately doubled. This highlights a company that is achieving improving returns on incremental equity, in turn resulting in an expanding ROE profile. What fascinates us is that from listing in 2004 to this day NCK has not issued one further share in the company.

NCK continues to screen well on all the key metrics: ROE is high, the balance sheet is in a strong net cash position, cash flow is strong and exceeds reported profit while we also believe the company has bright future prospects. We are forecasting approximately 10% growth in earnings per share over the medium term and as such believe NCK offers a sound mix of growth potential and fully franked income.

NCK Historical Performance.
Figure 2: NCK Historical Performance.
Source: NCK FY2016 Results Presentation.

 

APN Property Group (APD)

We have also introduced APD to clients over the past 12 to 18 months and management continue to execute well in a sector that has enjoyed significant tailwinds. For the uninitiated, APD is a specialist real estate investment manager with $2.2bn of funds under management.

There are a number of reasons why we like APD. Following the lucrative sale of the Generation Healthcare (GHC) management rights and co-investment stake for $92.6m, the group is well positioned with a strong net cash balance sheet. This led management to declare a special fully franked dividend of 10 cents per share at the recent full year result (a fantastic outcome for holders who especially value franking credits).

Beyond this, we see various other avenues to achieve growth in its AREIT Securities Funds division, syndicates business and its listed AREIT, Industria (IDR). APD also confirmed recent media speculation that it is reviewing the possibility of launching a long WALE petrol station REIT. Should this occur at the scale being touted, we believe this would be a material positive for earnings

APD FY2016 Earnings Growth and Net Income Breakdown
Figure 3: APD FY2016 Earnings Growth and Net Income Breakdown
Source: APD FY2016 Results Presentation

 

Collins Foods (CKF)

The core business of Collins Foods (CKF) is the operation of a large and growing network of KFC restaurants across Australia. In our view, CKF is well placed to grow its KFC network both organically through greenfield development and by acquisition over the coming years. Collins Foods’ KFC network of 191 stores is up nearly 20% on 2014 and we believe the company can increase this towards 250 over the coming 3 to 5 years. When combined with moderate growth in same store sales, we believe CKF can potentially grow earnings at about 10% per annum over the medium term. Further, given the strong cash generation of the business, CKF has the ability to self-fund the majority of this growth.

CKF screens well in terms of its key metrics, highlighted by an improving ROE profile and strengthening balance sheet. When coupled with a discount to intrinsic value and a P/E of just 12.9x, we believe CKF is a promising longer term opportunity.

 

Folkestone Limited (FLK)

Folkestone is an emerging asset manager and property development company. FLK is well placed with an established platform that encompasses the management of a listed AREIT (FET), income focused property syndicates and a substantial multi-sector development pipeline.

Led by a high quality management team that own a substantial stake in the business, we believe FLK can deliver strong growth in earnings per share over the coming 3 years (35%+ CAGR). With a strong net cash balance sheet and a growing network of capital providers, the company also has the financial capacity to execute on the growing pipeline of opportunity. FLK currently trades broadly in line with net asset value, which in our view materially undervalues the funds management business.

FLK Business Overview
Figure 4. FLK Business Overview
Source. FLK FY2016 REsults Presentation

 

IMF Bentham (IMF)

IMF Bentham (IMF) continues to build operational momentum as the company seeks to further grow its investment portfolio while also diversifying by jurisdiction. Recent results suggest management are executing well, with IMF’s investment portfolio now standing at a record $3.44bn. We continue to like the evolving strategy of diversifying by geography, which acts to mitigate concentration risks. IMF has a substantial investment portfolio in North America, which at $1.6bn now accounts for 46.5% of IMF’s total portfolio.

The company remains well placed with a strong balance sheet. As at 30 June 2016, IMF had net cash of $63m. Management noted that a substantial amount of cash has been received since balance date, so IMF’s net cash balance at the time of writing is likely closer to $100m. This provides IMF with the financial strength to continue investing for growth over the medium term.

As illustrated above, despite being smaller in size, we are finding attractive smaller cap companies that we believe:

  • Are quality businesses that have some competitive advantage or are emerging leaders within a specific niche
  • Have a capable and highly aligned management team
  • Have strong, generally net cash balance sheets
  • Are increasingly profitable
  • Have genuine growth in a world where reasonably-priced growth is scarce
  • Can be bought at appropriate prices

Looking ahead

We firmly believe better growth outcomes can be achieved by looking beyond the conventional sphere of the big banks, BHP, Telstra and the major retailers. The team at Clime continue to undertake detailed analysis on those most interesting listed and pre-IPO opportunities and we look forward to sharing further thoughts with you in the future.

Clime Asset Management holds ASX:NCK, ASX:APD, ASX:CKF, ASX:FLK, ASX:IMF in the model portfolio.

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