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Small caps to own after JobKeeper ends

There have been a number of themes coming through from reporting season, but the most important one is the importance of not playing the FOMO game. There is a great deal of hype in the market evidenced by the US stock  market hitting all-time highs. You don’t have to look far down the track to see that government fiscal stimulus measures such as JobKeeper are being removed or tapered down, before exiting the stage. When confusion reigns, investors will sell non-income producing stocks and revert to value: sustainable earnings, balance sheet strength and dividends. The stocks that don’t look sexy now are the ones to look to buy.

 

What we’re going to see over the next six to 12 months are the real swimmers; those that can produce sustainable profit growth. The momentum stocks that are ticking boxes cannot keep going. You’re playing the greater fool game if you jump on board at escalated prices.

 

What we’re also going to see is a struggling domestic economy. Australia has a small population and tourism has been a growing industry, increasing at annual rates of over 7% a year in the past five years to 2018 and contributing over $50bn to the GDP (3% of the total) while employing over 900,000 people. Until the COVID-19 health and economic crisis. This industry is complete toast, having gone close to zero. The knock-on effects will be considerable, especially to small business and those who depend on them, such as pubs and clubs.

 

As an investor, what do you do? You look for companies earning export dollars and those with secure, or relatively safe income streams.

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The good news coming out of reporting season is that for some companies cash flow is improving. Hard to believe, but it’s happening. Serviced offices provider Servcorp (SRV) impressed once again with its global diversification, enabling problems in some countries to be mitigated in others; as well as how quickly management was able to renegotiate leases, limit expenditure, reduce costs and generate cash.  This is a company that paid a final dividend of 9 cents from EPS of just over 7 cents.

 

Companies are husbanding cash better than ever. Small Caps are not small businesses. These are often companies that have been around for a while and are big enough to cope with distress. What they also have is operating leverage to generate superior profit growth when times improve.

 

Another factor to be wary of is buying stocks for dividends. Many forget during the good times that dividends are a product of profits. Many companies (read big banks) took advantage of domestic investors’ collective addiction to dividends. Investors literally paid for this during March to June this year, shelling out record amounts of $$$ for capital raisings. Dividends without profit growth lead to investors being steamrolled.

 

One stock that always jumps out as a small cap export hero is the ship builder Austal (ASB). The essential service of defending borders has never been so important to politicians, especially those in the Trump Whitehouse.

 

Then there are the telecom services companies, whose infrastructure has never been more important for obvious reasons. In our small cap universe these are MNF (MNF) and Superloop (SLC). The latter has more risk because its revenues are much smaller and it has debt attached, but because it has built its network, revenues come in with a 99% profit margin attached.

 

I own the billing software company Hansen Technologies (HSN) whose shares spiked as much as 30% in the wake of its full year result. They’ve come back a bit but we wouldn’t be chasing. We’re waiting for another buying opportunity because our motto during this crisis has always been: don’t chase!

Richard Hemming, editor, Under The Radar Report

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