Poised For Recovery? Ten Beaten Down Small Caps That Might Rock In 2019

By Tim Boreham | More Articles by Tim Boreham

As is always the case in a shabby market, investors have taken an indiscriminate approach to bailing out of small to medium cap stocks, rather than basing their actions on specific news.

With so many investment babies being thrown out with the murky bathwater, do opportunities abound for the fearless, especially given the market’s positive start to the year?

Amid a chorus of cicadas and the heady aroma of Aeroguard, Criterion selflessly devoted his summer to pinpointing ten opportunities among beaten-down stocks that may well deliver in 2019.

We caution that like the bargain Rolex bought at a Phuket bazaar, some may be cheap for a reason.

This year’s notable Biggest Loser to date is the fruit and vegetable grower Costa Group (CGC, $5.16), which has downgraded its expected interim (December half) earnings from a double-digit percent increase to a flat result.

Ripe for revenge, investors wiped 39 percent off Costa’s valuation, although the stock has partly recovered. The key culprits were those maligned hipster millennials who aren’t smearing their wholegrain sourdough dough with avocado in the same way they were.

Given the property correction, perhaps they are saving up to buy a house?

The company also cites subdued demand for tomatoes and berries, which means a punnet of blueberries fetches around $2.50-3 compared with $3-3.50 12 months ago.

Management insists the decline is no structural; in other words, it’s the result of temporary oversupplies that afflict any agricultural commodity from time to time.

The company also expects revenue and earnings growth from its recent forays into China (blueberries, raspberries and blackberries) and Morocco (blueberries).

If that’s right, like an immature orchard Costa shares offer longer-term value. But it looks like demand for avocadoes have peaked, having grown at an annual 6 percent over the last decade.

To better align with the growing seasons, Costa has just changed its reporting to the calendar year rather than June 30. Management still expects to achieve double-digit gains for calendar 2019 but this implies a heroic performance in the key January to June period.

Turning to the grey-nomad demographic, the recreational vehicle sector is booming, but the Perth based Fleetwood (FWD, $1.96) now looks a smarter company after it disposed of its loss-making caravan business.

This means management can now focus on its modular accommodation business, which taps into strong infrastructure spending.

Management cites strong government demand for mobile buildings for miens prisons and schools. Fleetwood also operates the Searipple Village in Karratha for Rio Tinto since 2012, with the miner in December extending its contract by a year.

Fleetwood last year expanded into the eastern seaboard market with the $34m purchase of the Sydney based Modular Building Systems and the $10m purchase of the Melbourne based caravan plumbing and electrical supplier Northern RV. These were funded by a $60m rights raising.

As Wise-owl’s Simon Herrmann notes, the acquisitions are revenue and earnings per share positive and the raising was well supported by institutional holders.

Post the acquisitions and divestments, Fleetwood is operating on a run rate of $330m of revenue, generating earnings before interest and tax of $31m.

Despite the progress, the shares are well off their February 2017 high of $3.

For those with a bent for more permanent accommodation, shares in Queensland based home builder Villa World (VLW, $1.81) have lost 36 percent of their value over the last year.

In December Villa World withdrew its guidance of current year earnings of $40 million and didn’t provide any update. That’s as ominous as a black cat walking under a ladder on Friday the 13th.

The company had stuck by that guidance at its mid-November AGM, which shows just how much the residential housing market has deteriorated. Villa World’s problem, in particular, is the reduced availability of finance for home buyers.

There’s always an ‘however’, however, and the company still expects to report a first profit of $16-17m next month, with an eight cents a share franked dividend.

Assuming a full year profit of $29m and a 12.5c a share full-year div – as broker Baillieu does – and Villa World is trading on a multiple of seven times earnings and on a 7.4 percent yield.

But what about the children?

Childcare centres have proven popular with investors because of their defensive characteristics; although in early 2018 the industry was suffering from oversupply issues in some locations.

This capacity problem seems to be abating, while the federal government’s revised childcare subsidy scheme came into effect in July. Under the revised arrangements, more parents are winners than losers.

Industry leader G8 Childcare (GEM, $2.96) has been the ‘go to’ stock, but for investors wary about the company’s $1.3bn market capitalisation there are two smaller alternatives.

Think Childcare (TNK, $1.45) operates 55 centres, mainly in Victoria. The occupancy issues saw Think shares slide some 50 per cent from their January 2017 highs. But in a November update, Think affirmed calendar 2018 earnings expectations of $4.75-5.25m (earnings per share of 10-11c).

Mayfield Childcare (MFD, 96c) points to a net profit of $4.4m for calendar 2018 and expects to delight investors with a 9.2 cents per share dividend, implying a 10 percent -plus. Mayfield shares have lost 30 percent of their value since peaking in February 2018.

While the childcare sector touts it defensive credentials, the printing game is far from assured given the pace of the digital revolution. But every stock has its price and those with an elevated speculative appetite might consider PMP Group (PMP, 18c), the country’s biggest commercial printer following the merger with the Hannan family’s IPMG in February 2017.

PMP has a history of delivering misery to shareholders, with the stock trading at five-year lows. But the market might not have twigged on to a few fundamental changes, notably lower debt and the fact that the merger reduced the number of players in the hotly-fought retail catalogue sector from three to two.

PMP last year generated EBITDA of $40.6m on turnover of $734m. But complex adjustments resulted in a bottom line loss of $43.8m compared with a $126m deficit previously.

A point of intrigue is that the Hannans, which account for 7 percent of the register eventually might privatise the company, which now has a measly $90m market capitalisation.

Banks shares are not usually seen as speculative, although some might argue the shares in the Big Four are just that given last year’s value erosion. A quirkier exponent of the sector is the PNG-based Kina Securities (KSL, $1.03c), which operates in a suspect economy but has capital backing and credit quality levels that would put our Four Pillars to shame.

In June last year, Kina acquired the retail assets of the ANZ Bank for $10m, increasing its share of the lending market from 5.8 percent to 8.8 percent.

Kina also has the advantage of not having been hauled before a royal commission.

Kina reported a June half net profit of 20.6m kina ($8.6m) and paid a 4c a share dividend.

Kina’s net interest margin stood at 8.1 percent, compared with 2 percent for the Big Four banks in the 2017-18 year. Kina’s return on equity of 16 percent overshadowed the Aussie banks 12.5 percent, while Kina’s capital adequacy ratio of 29 percent is almost twice that of the Four Pillars.

The bank describes the PNG economy as resilient, “despite tighter private sector lending and lower employment growth compared with recent years.”

Elsewhere, shares in well-run vocational education provider Redhill Education (RDH, $2.60) ran hard in early 2017, but have retreated since October. A case of back to remedial class, despite management’s solid earnings outlook which should at least earn it an A for effort.

Eden Innovation (EDE, 6.7c) had made good progress in commercialising its concrete technology in the US, targeting the road and bridge building sector. The company reported calendar 2018 sales of just over $1m, more than double the previous run rate. Eden shares, meanwhile are trading at less than half of their valuation of a year ago.

In the $50bn a year defence sector, Xtek (XTE, 46c) remains a stock to watch as it wins more contracts pertaining to military drones and ballistic plates and helmets. Once again, Xtek shares have sagged despite the company’s expectation of current year revenues of up to $26m, compared with $17.3m in 2017-18.

Tim Boreham

About Tim Boreham

Tim Boreham edits The New Criterion. Many readers will remember Boreham as author of the Criterion column in The Australian newspaper, for well over a decade. He also has more than three decades' experience of business reporting across three major publications.

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