Big returns come from small caps

Big returns come from small caps


John Collett asks the experts for their top investment tips among our smaller companies.

The accounts of our biggest listed companies are pored over endlessly by an army of analysts, which makes it unlikely that investors are going to come across hidden value among these giants.

Smaller medium-sized companies, on the other hand, are usually less visible so they provide potential to uncover hidden value and big capital gains. For investors who are patient and prepared to invest over the long term, smaller companies can add some zing to share portfolios.

Money asked leading small-cap fund managers and analysts for their tips from among those market minnows with well-established track records and a history of paying reliable dividends. Like any sharemarket investments, there are always risks. And smaller companies come with more risks than large companies. Their earnings tend to be the most responsive to economic conditions - both good and bad.

Shares should never be held in isolation but in a diversified portfolio. Many investors may find a better way to get exposure to smaller companies is to invest with a specialist smaller companies fund manager. Professional fund managers run portfolios holding dozens of smaller companies, providing small investors with instant diversification.

The stocks nominated by fund managers and analysts cover the spectrum of the Australian economy - retailers, financial services, technology - but there are no resources stocks. Smaller resources stocks may be terrific investments but are too speculative for novice investors.

TURNAROUND STORY

The managing director of Perennial Value Management, John Murray, nominates OrotonGroup, which designs and makes luxury handbags, leather goods and accessories. Murray is a fan of the managing director, Sally Macdonald, who since her appointment in 2006 has turned the struggling retailer around. The company has expanded product lines and refocused on key brands including Polo Ralph Lauren and Oroton. Murray still has the Oroton briefcase he bought in 1991 and says the brand is "classic value fashion" - quality fashion that is not too expensive.

"We are believers in Oroton and growth will be driven by new stores and product lines like lingerie and menswear," Murray says. Perennial first bought Oroton shares for $3 each in 2007. The shares are now trading at about $7. As a luxury fashion retailer, the company's sales are vulnerable to down-turns in the economy. A little over a year ago, towards the tail-end of the GFC, Oroton shares dipped to $2.80 and in the year since, Oroton's share price has increased 250 per cent.

Before it will invest, Perennial has to be convinced of the strength of a company's balance sheet. And Oroton has good financial strength with low debt, Murray says. On a share price-to-earnings multiple of 11 times, Oroton shares are not cheap but they are still reasonable value, he says.

PIPING HOT

Reece Australia, a plumbing supplier, has many of the attributes the small companies fund manager and chief investment officer of Celeste Funds Management, Frank Villante, likes to see. House prices are rising and spending on renovation is healthy, which means Reece is "fantastically positioned" to take advantage of the trend.

Reece is a conservatively managed company, owned by the same family since the 1930s, and family interests own about 70 per cent of Reece shares. Australian corporate history is littered with examples of majority owners treating minority shareholders shabbily. However Villante says the Reece family has a long history of treating such investors well.

The company has a market capitalisation of about $2.5 billion, which puts it just inside top-100 companies. The company owns about $250 million of land and buildings and Reece's management takes the view that property in the right areas can be an attractive long-term investment. Reece is No.1 in terms of revenue, number of stores and on just about every measure Villante can find. Reece has no debt on its balance sheet; it is carrying about $60 million in cash. Villante is expecting earnings to grow at more than 15 per cent a year between 2011 and 2014.

WEB WONDER

The co-founder of Smallco Investment Manager, Rob Hopkins, is excited about the prospects of the internet sector.

Hopkins particularly likes the well-established internet employment website, Seek, which he says has a "very impressive" management team led by the Bassat brothers who, together with Matthew Rockman, founded Seek in 1997. Rockman left the company in 2006.

Seek expanded into New Zealand and has investments in employment websites in China, Brazil and Malaysia. It owns more than 40 per cent in Zhaopin, one of China's three leading online employment sites.

Seek shares have had a big run. A couple of years ago the stock was $2; it is now $8 and is on a price-to-earnings multiple of 23 times, which is expensive, Hopkins says. With a market capitalisation of $2.8 billion, it is not a market minnow and is just inside the top-100 companies but still has plenty of growth potential. "We expect earnings-per-share growth of more than 40 per cent over the next year," Hopkins says. In internet commerce there is not much room for No.2 and No.3 players. "People looking for a job go to a site where they know all of the jobs are advertised," Hopkins says, adding that the internet sector has plenty of examples where the No.1 player makes very good returns, while the No.2 player is just profitable and the third-placed player loses money.

GRIM REAPER

Fortune favours the grave with InvoCare Limited, which provides funeral homes, burial services, cemeteries and crematoria around Australia and in Singapore. Invocare operates two national brands, White Lady Funerals and Simplicity, and is the only funeral services provider that has a national reach.

InvoCare listed in 2003, having been built up during the 1990s under the ownership of a US funeral services operator and private equity investors that have since sold their shares in the company.

"It's amazing, what we call the death-care industry," says Brian Eley, co-founder of Eley Griffiths Group.

"The number of deaths is rising as the population increases and ages. You have that demographic trend, which is positive for the stock."

InvoCare has been a very good performer, Eley says: The stock is not "super cheap" and it never will be because people know that it's such as good business. The fragmented nature of the market presents plenty of opportunities for the company to grow through acquisitions, he says.

As people become wealthier they tend to spend more on their relatives' funerals, Eley says, and a growing part of the business is pre-paid funerals. He also says the funeral care industry has a lot of pricing power, which means the industry can increase prices by a bit more than inflation with little resistance from customers.

InvoCare has prices that are in the mid-range, which benefits the company as the mid-range is where most of the market is, Eley says.

TICKET CLIPPER

Funds management is a wonderful business because it is so scalable. Taking a percentage of funds under management - clipping the ticket, as it is known - has been the source of riches for banks and insurances.

IOOF, a funds management and investment platform administrator, is a very well-managed company, says Steve Black, a fund manager at Pengana Capital. It has a market capitalisation of about $1.3 billion, which puts it at the larger end of the small-cap companies. It pays out about 80 per cent of its profits as dividends and is yielding about 5.5 per cent, fully franked. "It has done very well but we still see very strong upside in it," Black says. "It is a stock that has not been well understood by analysts, which is why it is starting to perform now as more analysts start to recognise that these guys are delivering really good results."

IOOF, led by managing director Chris Kelaher, is one of the big-five platform providers. These are the administration platforms used by financial planners, which provide their clients with consolidated reports on portfolio performances and taxes and enable easy switching between investments. The platform owner levies a fee that is a percentage based on the assets. IOOF has been acquiring platforms and has its own financial planning network. IOOF is considered a possible takeover target by one of the big banks or insurers.

HEALTHY PERFORMER

Blackmores, the natural health remedies company, has very high returns on equity, which analysts say is a good thing because it shows a company is making good use of shareholder funds.

Whether it's arthritis, joint, bone and muscle pain or "brain health", Blackmores, which was started in 1938 by Maurice Blackmore, has a pill for everything.

Greg Canavan, a sharemarket analyst and editor of Sound Money. Sound Investments, a weekly report on the sharemarket, says Blackmores is a "nice little smaller cap" that is tapping into a growing market for natural remedies. It has a strong business in Australia and has established a presence in Thailand and Malaysia. The company distributes its products mainly through pharmacies and supermarkets.

Canavan says $23 a share is a little expensive and would prefer to buy at $20. "In 10 years' time, I think Blackmores will be a lot bigger company than it is now," he says.

http://www.smh.com.au/news/business/money/investment/big-returns-come-from-small-caps/2010/05/11/1273343328362.html?page=fullpage#contentSwap1

Credit Suisse says HLB's offer price for EON Cap too low

Tuesday May 18, 2010

Credit Suisse says HLB's offer price for EON Cap too low
By RISEN JAYASEELAN


PETALING JAYA: Credit Suisse Securities (M) Sdn Bhd has deemed Hong Leong Bank Bhd's (HLB) offer price for the assets and liabilities of EON Capital Bhd (EON Cap) too low.

This has put the board of directors of EON Cap in a quandary, sources said. EON Cap's board met yesterday to discuss Credit Suisse's opinion on the offer.

The board had requested for its shares to be suspended from trading, pending an announcement related to the offer.

EON Cap said late yesterday evening that its board meeting had been adjourned “pending further clarification from independent financial adviser Credit Suisse.”

But a party familiar with the deal said with Credit Suisse telling the board that the offer was too low, the board has been put in a tough spot as to what to tell shareholders.

“The board had already said it was going to present the offer to shareholders. Does it now also tell shareholders not to accept the offer?” Sources say the situation is tenuous because HLB has no intention of raising its bid.

From its due diligence of EON Cap, HLB may be inclined to ask EON Cap to make some additional provisioning as a condition to the deal, stemming from what it (HLB) deems as unrecoverable loans.

This could mean that the price HLB is willing to pay for EON Cap may be lower than the RM7.20 per share it last made.

EON Cap is said to be disappointed that HLB has not recognised certain deferred tax assets in its valuation of the former, sources say.

HLB's offer is also priced at around 1.4 times the book value of EON Bank, which some analysts deem as low in light of other banking merger and acquisitions done at higher multiples.

The bottom line is that at present, HLB's offer is the only one on the table for EON Cap's shareholders.

Current market conditions are likely to make it difficult for other bidders, such as Affin Bank Bhd, to raise funds to acquire EON Cap.

If this deal falls through, the next bidder for EON Cap may no longer have the luxury of having a lower threshold of shareholder approval for the deal to go through.

http://biz.thestar.com.my/news/story.asp?file=/2010/5/18/business/6282935&sec=business

Related:
Comparative analysis of Malaysian Banking Stocks (16.5.2010)

Comparative Industry and Company Financial Ratios

Just looking at a single ratio does not really tell you much about a company.  You also need a standard of comparison, a benchmark.   There are three principal benchmarks used in ratio analysis.

Financial ratios can be compared to the:

1. ratios of the company in prior years, 
2. ratios of another company, and
3. industry average ratios.

1.  Historical comparison.

The first useful benchmark is history.

• How has the ratio changed over time?
• Are things getting better or worse for the company?
• Is gross margin going down, indicating that costs are rising faster than prices can be increased?
• Are receivable days lengthening, indicating there are payment problems?

2.  Competitor comparison.

The second useful ratio benchmark is comparing a specific company ratio with that of a competitor.

• For example, if a company has a significantly higher return on assets than a competitor, it strongly suggests that the company manages its resources better.

3.  Industry comparison.

The third type of benchmark is an industry-wide comparison.

• Industry-wide average ratios are published and can give an analyst a good starting point in assessing a particular company's financial performance.  Click here for a chart showing various ratios for a variety of companies in different industries:

  Comparative Industry and Company Financial Ratios

Note that there can be large differences in ratio values between industries and companies.

Review the chart.  What do the ratios tell us about companies and industries?

Comparative analysis of Malaysian Banking Stocks (16.5.2010)

Comparative analysis of Malaysian Banking Stocks
A quick look at Malaysian Banking Stocks (16.5.2010)
http://spreadsheets.google.com/pub?key=t3v2VY0rD9DcGSjmVkAV-gQ&output=html

A quick look at BIMB (15.5.2010)

A quick look at BIMB (15.5.2010)
http://spreadsheets.google.com/pub?key=t3svj1f7qc6pJcqKn-FNG6A&output=html

A quick look at Affin Holdings (15.5.2010)

A quick look at Affin Holdings (15.5.2010)
http://spreadsheets.google.com/pub?key=thaNOxyHlsOChhginG8Bq2Q&output=html

A quick look at Alliance Financial Group (15.5.2010)

A quick look at Alliance Financial Group (15.5.2010)
http://spreadsheets.google.com/pub?key=txT0pF1TSK-OQtTDi3QdDdw&output=html

A quick look at Hong Leong Bank (15.5.2010)

A quick look at Hong Leong Bank (15.5.2010)
http://spreadsheets.google.com/pub?key=tycFD1BTkA-RNW-zclpXrIw&output=html

Investor's Checklist: Banks

1.  The business model of banks can be summed up as the management of three types of risk:  

• credit, 
• liquidity and 
• interest rate.

2.  Investors should focus on conservatively run institutions.  They should seek out firms that hold large equity bases relative to competitors and provision conservatively for future loan losses.

3.  Different components of banks' income statements can show volatile swings depending on a number of factors such as the interest rate and credit environment.  However, well-run banks should generally show steady net income growth through varying environments.  Investors are well served to seek out firms with a good track record.

4.  Well-run banks focus heavily on matching the duration of assets with the duration of liabilities.  For instance, banks should fund long-term loans with liabilities such as long-term debt or deposits, not short-term funding.  Avoid lenders that don't.

5.  Banks have numerous competitive advantages.  They can borrow money at rates lower than even the federal government.  There are large economies of scale in this business derived from having an established distribution network.  The capital-intensive nature of banking deters new competitors.  Customer-switching costs are high, and there are limited barriers to exit money-losing endeavors.

6.  Investors should seek out banks with 

• a strong equity base, 
• consistently solid ROEs and ROAs, and 
• an ability to grow revenues at a steady pace.

7.  Comparing similar banks on a price-to-book measure can be a good way to make sure you're not overpaying for a bank stock.


The Five Rules for Successful Stock Investing
by Pat Dorsey

Click here for more discussion on this topic:

https://myinvestingnotes.blogspot.com/2010/05/investors-checklist-banks.html

Market status of countries 'fall' into three categories: Frontier, Emerging and Developed

Received this interesting globe map in my email. TQ

If we let the market status of countries 'fall' into three categories i.e. Frontier, Emerging and Developed, it would look exactly like the one on the left. According to FTSE Group a provider of economic and financial data, this is done on the basis of their economic size, wealth, quality of markets, depth and breadth of markets.

What we are interested in and would like to discover for ourselves are the Frontier Markets. Vietnam, Sri Lanka and Croatia to name a few. Let's discover Vietnam!

A quick look at Eon Capital (15.5.2010)

A quick look at Eon Capital (15.5.2010)
http://spreadsheets.google.com/pub?key=tSgfLNvcIzSMhLmOD_nYDcQ&output=html

Understanding Leverage

Leverage is easily expressed as a ratio:  assets/equity

Most banks equity:asset ratio is around 8% to 9%.  Thus, the average bank has a leverage ratio in the range of 12 to 1 or so, compared to 2 to 1 or 3 to 1 for the average company.

Given the size of the average bank's asset base relative to equity, it's not difficult to imagine a doomsday scenario.

• Earnings serve as the first layer of protection against credit losses.  
• If losses in a given period exceed earnings, a reserve account on the balance sheet serves as a second layer of protection.  Banks must have a pool of reserves to protect shareholders, who hold only a small stake in the company because of the leverage employed.
• If losses in a period exceed reserves, the difference comes directly from shareholders' equity.  When losses at a bank start destroying equity, turn out the lights.

Leverage isn't evil.  It can enhance returns, but there are inherent dangers.

For example, if you buy a $100,000 home with $8,000 down, your equity is 8%.  In other words, you're leveraged 12.5 to 1, which is pretty typical for a bank.  Now, if something atypical happens and the value of your home suddenly drops to $90,000 (just 10%), your equity is gone.  You still owe the lender $92,000 but the house isn't worth that much.  You could walk away from the house $8,000 poorer and still owe $2,000.  Highly leveraged businesses put themselves in a similar situation.

This doesn't mean all leverage is bad.  As a rule, the more liquid a company's balance sheet, the more the company can be leveraged because its assets can be quickly converted to cash at a fair price.

What should investors look for when investing in banks and other financiers?

What should investors look for when investing in banks and other financiers?

Because their entire business - their strengths and their opportunities - is built on risk, it's a good idea to focus on conservatively managed institutions that consistently deliver solid - but not knockout - profits.  Here's a list of some major metrics to consider.

Strong Capital Base

A strong capital base is the number one issue to consider before investing in a lender.  Investors can look at several metrics.

• The simplest is the equity to assets ratio; the higher, the better.  The level of capital should vary with each institution based on a number of factors including the riskiness of its loans.  Most of the bigger banks have capital ratios in the 8% to 9% range.  
• Also look for a high level of loan loss reserve relative to nonperforming assets.

These ratios vary depending on the type of lending an institution does, as well as the point of the business cycle in which they are taken.

Return on Equity and Return on Assets

These metrics are the de facto standards for gauging bank profitability.  

Investors should look for banks that can consistently generate mid- to high- teen returns on equity.  

Ironically, investors should be concerned if a bank earns a level not only too far below this industry benchmark, but also too far above it.  After all, many fast-growing lenders have thrown off 30% or more ROEs, just by provisioning too little for loan losses.  Remember, it can be very easy to boost bank's earnings in the short term by under-provisioning or leveraging up the balance sheet, but this can be unduly risky over the long term.  For this reason, it's good to see a high level of return on assets, as well.

For banks, a top ROA would be in the 1.2 % to 1.4% range.

Efficiency Ratios

The efficiency ratio measures non-interest expense, or operating costs, as a percentage of net revenues.  

Basically, it tells you how efficiently the bank is managed.  Many good banks have efficiency ratios under 55% (lower is better).

Look for banks with strong efficiency ratios as evidence that costs are being kept in check.

Net Interest Margins

Net interest margin looks at net interest income as a percentage of average earning assets.

Virtually all banks report net interest margins because it measures lending profitability.  

You'll see a wide variety of net interest margins depending on the type of lending a bank engages in, but most banks' margins fall into the 3% to 4% range.  

Track margins over time to get a feel for the trend - if margins are rising, check to see what's been happening with interest rates.  (Falling rates generally push up net interest margins.)

In addition, examine the bank's loan categories to see whether the bank has been moving into different lending areas. For example, credit card loans typically carry much higher interest rates than residential mortgages, but credit card lending is also riskier than lending money secured by a house.

Strong Revenues

Historically, many of the best-performing bank investments have been those that have proven capable of above-average revenue growth.  Wide margins have generally been elusive in a commodity industry that competes on service quality.  But, some of the most successful banks have been able to cross-sell new services, which adds to fee income, or pay a slightly lower rate on deposits and charge a slightly higher rate on loans.

Keep an eye on three major metrics:
(1) net interest margin,
(2) fee income as a percent of total revenues, and
(3) fee income growth.

The net interest margin can vary widely depending on economic factors, the interest rate environment, and the type of business the lender focuses on, so it's best to compare the bank you're interested in to other similar institutions.  Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past two decades.  As always, examine the number over a  period of time to get a sense of the trend.

Price to Book 

Because banks' balance sheets consist mostly of financial assets with varying degrees of liquidity, book value is a good proxy for the value of a banking stock.

Typically, big banks have traded in the two or three times book range over the past decade; regionals have often traded for less than that.

A solid bank trading at less than two times book value is often worth a closer look.  Remember, there is almost always a reason the bank is selling at a discount, so be sure you understand the risks.  On the other hand, some banks are worth three times book value or more, but we would exercise caution before paying that much.


The Five Rules for Successful Stock Investing
by Pat Dorsey


Summary:

Equity to assets ratio (capital ratio):  8% to 9% or greater
Loan loss reserve:  High level of loan loss reserve relative to nonperforming assets.
ROE: mid- to high- teen ROE
ROA:  1.2% to 1.4% or higher
Efficiency ratios = (noninterest expense or operating costs)/(net revenues):  < 55% (lower is better)
Net Interest Margins = net interest income / average earning assets:  3% to 4% range
Strong above-average Revenue growth: Look at net interest margin + fee income as percentage of total revenue + fee income growth
Price-to-Book:   Big banks often trade at P/B 2 x  to 3 x range.

Book value is a good proxy for the value of a banking stock.

Because banks' balance sheets consist mostly of financial assets with varying degrees of liquidity, book value is a good proxy for the value of a banking stock.  Assuming the assets and liabilities closely approximate their reported value, the base value for a bank should be book value.  

• For any premium above the book value, investors are paying for future growth and excess earnings.  
• Seldom do banks trade for less than book, but if they do, the bank's assets could be distressed.  
• Typically, big banks have traded in the two or three times book range over the past decades; regionals have often traded for less than that.

A solid bank trading at less than two times book value is often worth a closer look.

• Remember, there is almost always a reason the bank is selling at a discount, so be sure you understand the risks.  
• On the other hand, some banks are worth three times book value or more, but we would exercise caution before paying that much.  

Bank stocks are volatile creatures, and you can find good values if you're patient - especially because even the best banks will generally be hit hard when any high-profile blowup occurs in the financial services sector.  Lining up several banks for a relative P/B valuation isn't as good as putting together a discounted cash flow model, but for this industry, it can be a reasonable approximation of the value of the business.

These metrics should serve as a starting point for seeking out quality bank stocks.  Overall, we think the best defense for investors who want to pick their own financial services stocks is

• patience and 
• a healthy sense of skepticism.  

Build a paper portfolio of core companies that look promising and learn the businesses over time.  Get a feel for

• the kind of lending they do, 
• the way that risk is managed, 
• the quality of management, and 
• the amount of equity capital the bank holds.  

When an opportunity presents itself - and one always does - you'll be in a much better position to act.

A quick look at CIMB (15.5.2010)

A quick look at CIMB (15.5.2010)
http://spreadsheets.google.com/pub?key=tKdR1ezq71j9tVJQn-ldfKw&output=html