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When CIMB-GK Research launched its Singapore Small Cap Monitor last month, William Tng — one of the project’s key analysts — thought the research product would mostly be targeted at individual investors. But, the interest from the market has proved to be much broader than that.
“We’ve even had requests from institutional clients for this piece of work,” Tng tells The Edge Singapore in a recent interview. After the steep rise in heavyweight stocks over the past year that has lifted the headline Straits Times Index 59.2%, investors who are still confident that the market will stay buoyant are now diversifying into small-cap stocks that have yet to recover from the battering they took during the global financial crisis, he explains. “Bluechips typically lead a rally and so, right now, valuations may not be so attractive. At this stage of the market, investors tend to look at the laggards, and these are typically the smalland mid-cap stocks,” he says.
Small-cap stocks are, of course, more volatile than heavyweight blue-chips. In the first place, the market for their shares isn’t as broad or deep. That makes them susceptible to wide swings when investors try to get in or out. The lack of a broad investor following also makes analysts reluctant to spend time and effort covering them. “This means there is often no strong research coverage and investors may not know what is going on in the company,” Tng says. “Also, these are small companies. So, their profits tend to be quite small too — maybe in the range of one or two million. In a currency crisis, or a financial crisis like the one we just had, they can’t take a big hit.”
However, investors with the stomach for higher risks might find the higher returns from small-caps attractive now. “Some companies have been sold down and are now significantly below their book or cash values,” Tng says. “This provides some margin of safety.” But, investors ought to make sure that the company’s underlying business is also showing signs of recovery before jumping in, he adds. “So, if it’s loss-making, they need to come back to making a profit. There must be some kind of earnings-recovery story, whether in the quarterly reporting or from the industry.”
Gearing is another important metric to consider when handicapping small-cap companies. All things being equal, a company in a net-cash position is likely to be in a better position than a debt-laden company to cope with the ebb and flow of business cycles and maintain its dividend payouts.
Finally, Tng says, investors ought to spread their investment across a portfolio of smallcaps instead of focusing on one or two names. “Unless you have immense confidence in the company — maybe you’ve worked there before or you work in the industry — it’s not that wise to have 100% of your investment in one company.” Small-cap investing, he says, is about building a portfolio of maybe 10 stocks. Out of those 10, nine may fall flat, with the remaining one doing spectacularly. “Even a company like Microsoft started out as a small-cap once. That’s how you make your return,” he says.
OFFSHORE OPPORTUNITIES
For ideas on how to build a small-cap portfolio, Tng has three sectors or themes that are looking particularly strong at the moment. The first is the oil-and-gas (O&G) sector, which is benefiting from positive fundamentals. “The O&G companies have been delivering. We now have higher oil prices, which means strong demand for exploration and production,” he says. When picking stocks in this sector, Tng says looking at order wins is key.
One stock that has been delivering on this measure is CSE Global, which installs IT, communications and other electronic systems on rigs. The company has been steadily winning contracts and its year-to-date order wins of $163 million are now 30% of CIMB-GK’s $550 million target for the year. The stock is currently trading at nine times CIMB-GK’s estimate of its FY2011 earnings, which Tng says is relatively undemanding, given its three-year compounded annual growth rate of 16% in its earnings. He also likes that the company has been steadily diversifying out of the O&G sector and into the healthcare industry.
Rotary Engineering is another company that has been winning new contracts recently. It provides various engineering, procurement and construction services to the O&G as well as petrochemical industries. A key catalyst in the near future could be the US$10 billion ($13.7 billion) refinery project in Saudi Arabia that Rotary is bidding to be part of. If Rotary secures this project, its earnings per share could rise 28% in FY2012. Even without the win, however, the stock is backed by net cash per share of 22 cents, versus its current share price of $1.15.
Another O&G play that Tng likes is Swiber Holdings, which provides a wide range of services to the offshore industry, including transporting and installing subsea pipelines and chartering out offshore support vessels. He says Swiber is a laggard among most of its offshore and marine peers, with a price-to-earnings ratio (PER) of eight times CIMB-GK’s FY2011 estimate, a 38% discount to the sector’s rolling forward mean PER of 13 times.