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The small cap sector offers top prospects for investors willing to take on more risk, according to Scott Marshall, a senior analyst at Shaw Stockbroking. Sharper volatility in the small cap sector appeals to traders willing to crank up risk for potentially bigger and faster percentage gains.  However, the sector’s volatility requires a disciplined buying and selling approach irrespective of market conditions. Shaw Stockbroking has narrowed the small cap sector to a selection of eight stocks for investment consideration. Marshall’s portfolio isn’t a recommendation to buy, but a choice offering for investors seeking to broaden their exposure.

Marshall describes Infomedia as a strong play in a global niche market, offering a “pristine” balance sheet with $8 million in net cash at June 2009. Infomedia, a supplier of electronic parts catalogues to the international automotive industry, has broadened its customer base and product offering, mitigating contract risk of previous years. Infomedia has invested heavily in allocating products to an internet platform to reduce costs. Marshall says Infomedia management is forecasting revenue growth of between 10 and 20 per cent a year for the next three-to-five years, while operating profit margin is likely to increase from 31 per cent in 2009 to 45 per cent over the same period. “There is also scope for a significant step up in prospective revenues if Infomedia wins the upcoming North American GM auto contract due in 2011,” Marshall says.
 
Tox Free Solutions has 14 waste management facilities and 13 industrial service branches across Australia amid the company stgeloping an integrated business model. “Tox has Australia’s only commercial waste incinerator (at Port Headland in WA) and licences for others, which provides a sizeable barrier for entry,” Marshall says.  “Tox has secured contracts with Woodside Petroleum and the Gorgon projects, and has been re-rated after the reporting season despite delivering a disappointing 2009 full-year result. We believe this is a reflection of the market looking through the result and seeing last year as a period of consolidation post expansion in the previous two years.” Marshall says Tox is well placed to secure additional waste contracts under discussion, out to tender, or likely to emerge in future. “Shaw research estimates that these potential wins will add about 30 per cent to the company’s annualised revenue during the next three years at high margin,” he says.

Companies with a market capitalisation of less than $1 billion fit Shaw Stockbroking’s classification of small cap stocks. The stocks are generally outside the S&P/ASX 100 index, but shouldn’t be confused with micro stocks, such as a junior miner with market capitalisation of, say, about $10 million. Marshall suggests small cap buyers set exit targets on the up and down sides from the purchase price. Stick to targets otherwise it defeats investing objectives. “Psychologically, it can be difficult to sell a stock in a rising market, but small caps can fall quite sharply on a sniff of bad news. Because small caps tend to focus on one or two core activities, good or bad news can result in rapid gains or losses.” 

Mining products maker Bradken reported an 11 per cent increase in 2009 net profit after tax to $64 million. But the highlight for Marshall was a strong outlook statement – “a positive surprise”. In 2010, the company’s rail division expects to deliver sales revenue in line with 2009, but with improving margins. “Overall, this is better than we expected,” Marshall says. “Bradken’s 2010 earnings remain below its longer term potential, with only a limited recovery in capital goods demand expected before 2011.”

Marshall describes Swick Mining Services “as a turnaround story” after the collapse in drilling activity during the global financial crisis.  Revenue is forecast to grow in 2010 amid a sustained recovery in commodity prices and an upbeat tendering environment. Marshall says Swick’s success in growing the utilisation rate of its underground diamond fleet in Australia and potentially abroad is appealing.

Marshall says he closely examines and compares a company’s price/earnings ratio with its peers and sector to gauge value. Shaw Stockbroking’s small caps index is trading on an average P/E of 14 times compared with the broader market bouncing around 17 times. A single digit P/E may mean a stock is cheap, or the company’s growth prospects are bleak. Worse, the company could be failing. A high P/E may mean investors are prepared to pay a premium for a bright outlook, or the stock is over valued.

SP Telemedia’s low cost ISP (internet service provider) business model is driving growth. Importantly, Marshall says, high margin growth is via the group’s own infrastructure rather than buying capacity from other carriers. “The outlook for 2010 is robust with management forecasting solid profit growth,” he says. “Growth is likely to be facilitated by new fixed line and VOIP (Voice Over Internet Protocol) telephony products and further gains in market share.”

Marshall says Austin Engineering could surprise on the upside in response to stabilising business conditions and increasing tendering activity. Work at its Queensland’s operations will extend well into 2010, while conditions in Western Australia are improving. “We believe the recovery in demand from Rio Tinto (Austin’s major WA customer) has accelerated, while Austin’s Chilean operation is on track to at least meet the company’s forecast contribution at the time of acquisition.”

Marshall says investors buying small cap stocks should carefully watch performance because they fail to attract the same level of investor and media attention compared to the heavyweights.  Company managers and directors deserve scrutiny because the consequences of a bad decision are magnified in small companies. It’s a good sign when directors buy their own company’s shares, while answers should be sought when they are selling them. Ensure performance is meeting the company’s outlook and keep a close eye on external factors, such as currency movements, that may impact future earnings.  

Transfield Services offers an undemanding valuation after a capital raising reduced net debt. Shaw expects this maintenance services company to generate strong cash flow in 2010 amid a flat-to-modest rise in profits. “The company’s high recurring revenue is an attractive feature,” Marshall says. “We expect Transfield to focus increasingly on internationalising the business, with a heavy emphasis on organic growth.”  The stronger Australian dollar remains a challenge.

McMillan Shakespeare managing director Michael Kay is improving the business by expanding its horizons beyond pre-tax salary packaging to a provider of workplace benefits, enabling it to access a much wider customer base. “It’s now offering car and home insurance, and complementing this organic growth picture is the prospect of a sizeable acquisition,” Marshall says. “The company story is reasonably solid.”

Company

 ASX Code

 Activity

 Share Price Close

23 Oct 2009

Infomedia

IFM

 Electronic parts catalogues

$0.395

Tox Free Solutions

TOX

 Waste management

 $2.48

Bradken    

 BKN

 Mining parts maker

$6.84

Swick Mining Services

 SWK

 Drilling services

$0.59

SP Telemedia

SOT

 Telecommunications

 $1.68

Austin Engineering

 ANG

 Engineering

$2.74

Transfield Services

 TSE

 Maintenance services

$4.22

McMillan Shakespeare

 MMS

 Salary packaging

$4.30

 

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