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Australia is one of the most highly concentrated stock markets in the world. The big four banks, the big global miners in BHP Billiton and Rio Tinto, and Telstra and Woolworths, are researched extremely closely, and grab the lion’s share of investment on the Australian Stock Exchange (ASX).

The rest of the Top 20, and Top 50, are also very well-researched. But outside the S&P/ASX 200 – the top 200 companies by market capitalisation, or market value – the interest starts to lessen. Given that there are almost 2200 listed companies on the ASX, that means a lot of companies don’t get much interest from broking analysts and fund managers.

This means that there is scope on the Australian market for “information arbitrage”: learning more about a company than anyone else. In Australia, small-cap companies can fly under the radar of the big investors, who concentrate on the Top 200.

But this is a good thing for retail investors, because if a small-cap (or micro-cap) stock starts to put major runs on the board, it starts to get noticed by bigger investors. Its price/earnings ratio (P/E) gets re-rated higher, and this can mean very juicy returns for those who ‘found’ the stock first. This leverage is why all investors should have exposure to small-cap stocks to boost returns…but the caveat is that there is more risk associated with small-caps than with the tried and tested blue-chips, which have very long track records of profitability.

Thebull.com.au has canvassed a range of investors to ask ‘what is your favourite small-cap, and why?’

Kicking us off is Mike Hawkins, chief investment officer at Evans & Partners, who likes hazardous waste management solutions business Tox Free Solutions (TOX, $204.4 million). Perth-based Tox Free provides remediation and recycling solutions for contaminated soils, water treatment and hazardous waste treatment. The company operates two treatment facilities at Port Hedland and Kwinana.

Last year, Tox Free bought the Barry Brothers business from Programmed Maintenance Services, which both moved the company into the sewer and high-pressure water cleaning and waste-water recycling and reclamation areas of the market, and diversified it geographically, into the eastern seaboard states and South Australia.

“Tox Free’s base of serving the resources industry in Western Australia makes it a resources volume story, but through the Barry Brothers acquisition its national footprint is coming together. Waste management is the key theme and we think that puts the company in an excellent position, given that environmental and waste-management benchmarks only likely to get more onerous,” says Hawkins.

“Also, the fact that its major competitor, Transpacific Industries, is showing signs of being capital-constrained is an added plus. Over the next five years we see plenty of opportunities for Tox Free, and in particular, the contract wins it has had over the last 18 months should kick in the 2010/11 year, where we expect to see earnings rising by up to 50 per cent. We have Tox Free trading on 13.2 times 2010/11 earnings,” says Hawkins.

Sebastian Evans, who manages the NAOS Small Companies Fund, likes medical stgice maker Nanosonics (NAN, $135.5 million), which is stgeloping a novel disinfection technology, with the lead product a point-of-care ultrasound probe disinfection unit. Nanosonics is Evans’ fund’s biggest holding.

“At present, ultrasound probes are disinfected with corrosive chemicals that are only about 80 per cent efficient,” says Evans. “Nanosonics’ biocide technology is much more efficient and environmentally friendly. It has approval in Australia and Europe and is being assessed at the moment by the Food & Drug Administration (FDA) in the USA.”

Evans says Nanosonics has no competitor, and he believes its product will eventually be legislated as the only option for disinfection and sterilisation. While Nanosonics is not profitable at present, Evans believes it will be profitable within 12 months, and says it could earn 20-30 cents a year, down the track.

Also in biotech, Angus Bligh, head of private client services at broking firm Wilson HTM, is impressed by medical stgice stgeloper Universal Biosensors (UBI, $231.2 million), although he cautions that the company will not be profitable for a year or two.

UBI is stgeloping a range of in vitro diagnostic tests for point-of-care use under its Verio platform technology, which uses a novel electrochemical cell. The lead product is the One Touch Verio blood glucose monitoring system, which went on sale in January in The Netherlands in its European launch. One Touch Verio allows diabetics to self-monitor their blood glucose levels.

The company’s partner in the stgelopment of One Touch Verio is LifeScan Inc., a subsidiary of US healthcare giant Johnson & Johnson. The relationship with LifeScan dates from 2001.

“The partnership between UBI and Johnson & Johnson in the blood-glucose field is very strong,” says Bligh. “JNJ has announced its intention to increase its market share in the self-monitoring blood glucose market, and the Verio technology will be the platform to drive that growth.

“The next six months promise to deliver significant news flow from UBI, including launch into the rest of Europe, FDA approval, launch in the US and a commercialisation deal for a point-of-care test for C-reactive protein, or prothrombin. “UBI is not a stock for widows and orphans; it’s a high-risk, high-reward play,” says Bligh.

Simon Guzowski, senior portfolio manager in the funds management division at Beresfords Financial Planning, is a fan of small-appliance distributor Breville (BRG, $274.6 million).

The Breville share price has risen by 25 per cent since a takeover bid by competitor GUD was stymied by the competition regulator in February. Guzowski says Breville is “coming off a few rough years,” but he says it has done well in its penetration of the US market (which it entered in 2003) and is now generating half of its earnings outside Australia.

Breville operates in Australia, New Zealand, the USA, Canada, and Hong Kong. The 75-year-old company’s brands include Breville, Kambrook, Ronson, Goldair and Phillips. Breville is the exclusive distributor for the Philips brand (domestic appliances and personal care division) in Australia and New Zealand; it has the licensing rights to make and distribute houseware products under the Laura Ashley brand in North America; and is the exclusive distributor for the Scanpan cookware range in North America.

“We don’t believe Breville is adequately priced for growth,” says Guzowski. “Its US business is kicking goals, and if it can crack that market, there is plenty of upside. While US consumer spending is weak, people are prepared to buy good appliances.”

At 9.6 times projected 2010/11 earnings, Guzowski says Breville has “substantial upside.”

Roger Sharp, managing director of strategic “block” investor Co-Investor Capital Partners – which specialises in providing “patient capital” to smaller listed companies – is impressed by litigation funder IMF Australia (IMF, $186.6 million), although Co-Investor is not an investor in the stock. Sharp says the stockmarket has struggled to understand IMF since it listed in 2000, but says it is a “pretty simple business.”

“IMF funds legal or insolvency cases where the claim size is more than $2 million. It makes a profit if it wins a case. The government has clarified the legislative environment for litigation funders and there is no question that it is a real business. IMF has a good track record, a good forward order book, good management and good growth prospects – because you’d have to say that society is getting more litigious.”

Carey Smith, research analyst at broking firm Alto Capital, likes salary packaging and fleet management specialist McMillan Shakespeare (MMS, $349.9 million).

“McMillan Shakespeare is a very well-run company that really has its space to itself,” says Smith. “Its main clients are government agencies – public servants love their salary packaging – and Top 100 companies, and it has a very good track record of generating strong return on equity and paying good dividends.”

Despite a 60 per cent price rise since January, Smith says McMillan Shakespeare is still good value. “In March MMS bought GMAC’s retail leasing arm, Interleasing, for less than book value, which we think was a really good deal. Even after a pretty strong run, we still have McMillan Shakespeare trading on a price/earnings (P/E) ratio of 10 times expected 2010/11 earnings.”

Elio D’Amato, chief executive of Lincoln Indicators, likes IT systems integrator and consultant ASG Group (ASZ, $217.9 million). He says ASG has won a swag of new contracts, with entities such as Western Power, the Department of Prime Minister & Cabinet, the federal government Department of Broadband Communications and the Digital Economy, the Western Australian Department of Education and the most recent win, with Vodafone Hutchison Australia.

“ASG has picked up $140 million in contracts so far in 2010, and there is now $500 million-plus worth of contracts in the forward order book. Much of this is good long-term work and it gives ASG a very solid base from which to out-perform,” says D’Amato.

He says ASG has grown its earnings per share (EPS) by double-digit percentage amounts in the last four years, its return on equity (ROE) is running at 22 per cent, return on assets (ROA) at 14.2 per cent and based on its latest half-year result, ASG is trading on 15.3 times earnings and a fully franked dividend yield of 4.2 per cent. “It’s definitely a stock that should outperform the market,” says D’Amato.

Independent analyst Roger Montgomery is a big fan of fashion brand retailer Oroton Group (ORL, $273.9 million) – or more accurately, he’s a fan of the company’s chief executive, Sally Macdonald, who has led the company since September 2006.

The shares have almost tripled in price under Macdonald, which is not surprising, says Montgomery, given that the company’s return on equity (ROE) under her has run at an average of more than 50 per cent. “In fact, since she took over, Oroton has raised about $10.5 million in additional equity and retained earnings, and it has earned $22 million after tax on that equity. That’s a return of more than 200 per cent.”

Under its eponymous brand Oroton sells a wide range of products for men and women across bags and leather accessories, jewellery, ties, umbrellas, knitwear, lingerie, men’s underwear and shoes. Oroton is also the licence owner for the Polo Ralph Lauren brand in Australia and New Zealand. The company operates 46 Oroton Stores and 27 Polo Ralph Lauren stores.

Montgomery says Macdonald has streamlined the product offering and launched Oroton Lingerie and mens’ underwear, which has been a success. “Macdonald is a great retailer. The management team spends a lot of time on the shop floor and they really understand retail, but at the same time, they have built the online store to the fifth-biggest store.”

There are two major risks to the company, he says. “First, there is a huge element of key-person risk: if Sally Macdonald were to be poached, it would not be good. Second, the Polo Ralph Lauren licence has two-and-a-half years to run. Oroton has been the licensee for 20 years, it’s a strong relationship, but that licence is a big part of their business, and it would not be good if they were to lose it.”

Against this, Montgomery says the numbers are very attractive. “Operating cash flow is very strong, and I think the company is very under-valued.” While he does not use P/Es or dividend yields, Montgomery reckons Oroton Group is trading at a discount of “somewhere between $1.50-$2” to its intrinsic value, a gap he expects to close over the next two years.

In the resources sector, independent analyst Peter Strachan, of StockAnalysis, is enthused by Cue Energy Resources (CUE, $187.2 million), which has cash in the bank, sustaining cash flow from its 5 per cent interest in the Maari oilfield in New Zealand and its 15 per cent interest in the Oyong oil and gas project in Indonesia, and what Strachan says is “substantial exploration upside” from areas in New Zealand, the Carnarvon Basin, Bass Strait and the Timor Sea.

Cue also has a 14 per cent interest in the South-East Gobe oil field in Papua New Guinea, from which it is negotiating to sell gas to the PNG LNG project, led by Santos, OilSearch and Exxon Mobil. “It’s quite an attractive mix of cash flow and exploration upside,” says Strachan.

Murray McGill, director of Patersons Securities and portfolio manager for the firm’s 80:20 Fund, nominates Lynas Corporation (LYC, $1.1 billion), the owner of the Mt. Weld rare earths deposit in Western Australia. Mt. Weld is a world-class resource of these 17 chemically similar rare metallic elements.

Rare earths contain high concentrations of a number of elements useful in applications such as nanotechnology and emission reduction. The market for these metals is growing rapidly in Japan, Europe and North America because the materials are used in the electronics, automobile, glass and telecommunications industries.

Mt. Weld is considered the richest deposit of rare earths in the world. Lynas’ strategy is to create a reliable, fully integrated source of rare earths supply from mine through to customers. The company is building a concentration plant in Western Australia and a processing plant in Malaysia, and is on track to begin production in the third quarter of 2011.

At that time Lynas will offer the first significant source of rare earths outside China. Based on the resource size, Mt Weld could supply 10 per cent of world demand for rare earths – a market worth $1.25 billion a year – for 20 years, once it enters production. But the GFC has hit the rare earths market: demand fell by 30 per cent in 2009.

But McGill says Lynas Corporation will be entering the market at a time of rising demand and increasing prices. “China restricts exports of rare earths but the demand is rising. When it’s up and running, Lynas will be a major world producer. We think the stock is very cheap on valuation – from here, the risk lies in the execution of the strategy,” he says.

Gavin Wendt, analyst at Minelife.com, likes Northern Territory iron ore miner Territory Resources (TTY, $62.2 million), which has been mining high-grade haematite ore at Frances Creek since June 2007.

Operationally, says Wendt, Territory has performed well, producing to its target rate of two million tonnes a year, but the company has been bestgilled by what he calls “corporate distractions,” involving former chairman Michael Kiernan.

“Territory was part of a diversified resources group that Kiernan was attempting to build, but it went sour in 2008, and Territory was owed million of dollars,” says Wendt. “That unfortunately detracted in the market’s mind from what was going on operationally.”

Territory built up almost $100 million in debt, which at the height of the GFC placed the company’s survival in doubt. But Wendt says the support of the company’s major shareholder, the Hong Kong-based commodities trader Noble Group – with which Territory has a life-of-mine supply agreement – enabled it to re-negotiate its debt.

“Now, Territory is achieving free cashflow of more than $20 million a quarter and this should see the remaining debt paid out by the end of the year, and putting the company back in profit – although it only has an expected mine life of three more years, and will need to deliver some exploration success to extend this,” says Wendt.

Peter Russell, head of research at broking firm Intersuisse, prefers to play the resources sector through a business that supplies services to it: Queensland-based global mining products and services provider Industrea (IDL, $334.8 million).

Industrea’s product and service offering includes longwall mining equipment, gas drainage and collision-avoidance systems, underground and above-ground directional drilling, contractor management, mobile-asset tracking and a driver safety performance index.

The company’s customers include BHP Billiton, the BHP Mitsubishi Alliance, Anglo Coal, Rio Tinto, Xstrata, Boeing, Cockatoo Coal and the major Chinese mining groups such as Jincheng, Shanxi and Shenhua. Industrea is also a distributor for global mining suppliers Sandvik Voist Alpine (Scandinavia) and Tagor (Poland).

Russell says Industrea’s dominance of the mining equipment sector in China in the key areas of safety and productivity has driven its ability to win a steady flow of lucrative contracts. Because of this, he says Industrea is “strongly placed for high double-digit growth,” based mainly on China’s demand for coal. Given the strong performance of Industrea in the second half of 2009-10, Intersuisse has raised its earnings for the stock to 5 cents a share for 2009-10 (the result will be released on August 19) and just over 6 cents a share for 2010-11.

At a share price of 35 cents, that places Industrea on a FY2010 P/E of 7 times earnings, and a FY2011 P/E of 5.8 times earnings.


Other articles in this week’s newsletter

The Best Small Cap Stocks In The Market

18 Share Tips – 2 Aug 2010

Top 5 Tips For Boosting Profits In Forex Trading

Profit In A Rising Interest Rate Environment

Higher platinum prices in store

How to predict exchange rates

Top 10 CFD stocks

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