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looked overvalued for years suddenly
became a lot more interesting.
A sell-off seemed inevitable, such were
the dizzying gains for hot small stocks
in the first three quarters of 2016. At
one stage, small caps, as reflected by
the Small Ords Index’s aggregate price
earnings (PE) multiple, traded at a slight
premium to ASX 100 stocks.
Small-cap stocks usually trade at a
discount to blue chips because they have
less liquidity (share turnover), are not as
established and typically have shallower
management teams. But fund managers
were prepared to pay a premium for
small- and mid-cap stocks, such were the
challenges of a sluggish economy.
By September 2016, small caps had
returned 27 per cent over one year
(including dividends) – about three times
more than the ASX 100 index during the
The question now is whether or not the
sell-off has run its course, and if investors
should buy shares in small- and mid-cap
stocks caps given lower prices. Rarely do
star stocks such as Carsales.com or REA
Group fall so far and so fast from their
I sense that the small-cap sell-off has
further to run in the next few months as
fund managers continue to rebuild their
portfolio weightings in resource and
bank stocks. Many institutional investors,
badly underweight in these sectors, were
caught short when resource stocks rallied
in the fourth quarter of 2016.
Investor surveys suggest that fund
managers are, collectively, still
building positions in mining and
energy stocks, as well as in the
banks, in anticipation of improving
global growth. That suggests that
small caps could underperform blue
chips in 2017, particularly with more
earnings downgrades from this end
of the market in the February interim
It is hard to find a catalyst to re-rate
small-cap stocks in the near term. The
Australian economy remains challenged,
interest rates will probably stay flat or
head lower, and our currency should
ease a little as the US dollar strengthens.
None of that supports sustained
outperformance of small-cap stocks over
A saving grace is the higher proportion
of mining and energy stocks in the Small
Ords index (26 per cent at January 2017)
compared with the ASX 100 index.
A rallying resource sector could give
the Small Ords – at least the mining
component of it – a boost.
In spite of these challenges, value
investors should put quality small-
and mid-cap stocks on their portfolio
watchlists. They will need to be patient,
as the market’s renewed interest in
large-cap cyclical growth stocks lingers.
But the best time to buy small caps
is invariably when irrational market
selling creates opportunities to buy at
sharply lower prices.
Small-cap investing is, of course, about
stock picking rather than following
indices. ‘Index hugging’ – having a
portfolio that broadly replicates a share
market index – is best left to active fund
managers who specialise in large-cap
Australian equities, and is not something
that investors who pay high fees to such
managers should tolerate.
Investors who are prepared to dig for
value will find plenty of opportunity
outside the ASX 100. Remember that
small-cap stocks suit experienced
investors who are comfortable with
higher risk. Small-cap investing is no
place for the risk-averse; they should
stick to ASX 100 stocks or, better still, rely
on well-performing fund managers to
invest their money.
Here are five stocks that
appeal at current prices:
1. REA Group
One of my best
strategies over the
past five years
has been buying
the largest internet
‘portal’ stocks during share-
market pullbacks and corrections – the
likes of REA Group, Carsales.com, Seek,
Webjet and Trade Me Group.
REA, Carsales.com and Seek have
formidable competitive advantages,
and businesses that are hard to replicate.
Being the dominant portal in a segment
usually means a huge gap between you
and the next rival, and little chance for
smaller firms to challenge.
Online property advertising platform
REA Group fell 20 per cent from its 52-
week high to $52.88. There’s no obvious
reason for the extent of the price fall;
REA’s sale of its European businesses
was the main news in December, but
they made just a small contribution to
REA’s overall earnings.
The Australian property market should
remain strong in 2017 as the Reserve
Bank maintains low interest rates. Not
so hot, however, is that properties are
sold within days or weeks of being
listed, meaning that vendors do not
have to advertise as much on REA’s
REA still trades at a significant premium
to the Australian share market, based on
its forward PE of 22 times FY18 (using
consensus analyst estimates). But its
growth rate justifies the PE multiple,
and a consensus price target of $59.50
suggests that REA is undervalued.
Eleven of 13 broking firms that cover the
stock had a ’buy’ recommendation in
February 2017. Two had a ‘hold’.
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