Lessons in picking small cap stocks

Investors need a sound knowledge on how to value stocks, do their research and be prepared for higher volatility

 20 Oct 2012 09:08

BY TEH HOOI LING SENIOR CORRESPONDENT


WHETHER it is because investors are tired of being scared, or have finally decided that it is riskier to keep money in the bank earning close to nothing, or that indeed there have been improvements made by governments to solve some of the problems plaguing the world economy, or a combination of all the above, appetites for risk assets have returned to the markets.

Here is the tally for the Singapore market as of yesterday: Between Sept 13, 2011 and this week, the Straits Times Index chalked up a total return of 15.6 per cent.

The FT Straits Times Mid Cap Index fared significantly better - its total return came to 25.4 per cent.

The small cap index is in between, at 19.2 per cent.

In the market, just like in the physical world, dust and straw and feathers - things with neither weight nor value in them - fly easily.

So, based on the numbers above, it would appear that the small- and mid-cap sectors are fertile ground for high returns.

But, not so quick. Further analysis of the numbers tell a different story.

I did my analysis from the time we stopped our small cap column on Sept 12 of last year. At that point in time, 758 stocks were listed on the Singapore Exchange. More than half of those stocks - 57 per cent to be exact - were companies with market capitalisation of $100 million and below.

The average market cap in this category was $37.8 million. Twelve per cent of the market had a market cap of between $100 million and $200 million. The average was $146 million in this group.

Another 18 per cent of the market was made up of stocks with market cap of $200 million to $1 billion. The average there was $446 million. And finally, the remaining 13 per cent had market cap above $1 billion; the average was $6.9 billion.

How have the various groups fared since then?

Well, on average, the smallest stocks in the market chalked up the highest average price appreciation. But this is extremely misleading. The fact is, there are a few outliers which lifted the average figure. For example, the best performer in the group is GSH Corporation. According data from Thomson Financial, the stock's share price shot up from 0.3 cents last year to 9 cents yesterday - a near 30-time jump.

In the market, just like in the physical world, dust and straw and feathers - things with neither weight nor value in them - fly easily.

Here is another fact: Slightly more than half the stocks in this category, that is, those with market cap of $100 million or less, actually have not managed to make any advance in terms of share price in the last year or so.

Only 49 per cent of them did. This explained the zero median price appreciation for this category.

For the next group of stocks, those with market cap of $100 million to $200 million, the average price appreciation was 6 per cent. The median was 2.3 per cent. Only 55 per cent of the stocks have risen in the past year. The top five performers in this category are Asiasons Capital, LMA International, United Fiber, Popular and Nera Telecom.

For stocks with market cap of $200 million to $1 billion, the average return was 12.8 per cent, the median, 5.8 per cent.

Fifty eight per cent saw their share price appreciate between September last year and now. The chart toppers in this group are Yeo Hiap Seng, Ezion, Aspial, Roxy-Pacific and Tat Hong.

Finally, for stocks worth more than $1 billion, the average return was 13.2 per cent and the median, 16.2 per cent. Three in four stocks in this category managed to raise their share price in the past year. Here, the stars are APB, Fragrance Group, F&N, Thai Beverage and First Resources.

So, as you can see, for every point of return per unit of risk that you expose yourself to, the odds are the best in big cap stocks.

Without having a sound knowledge on how to value and pick stocks, the chances of your picking a winner in the small-cap space is significantly reduced.

As mentioned, 51 per cent of stocks below $100 million are still trading at the same levels or lower than in September last year. For the big cap stocks, on the other hand, three in four are already above water - and at quite a comfortable level at that.

As part of this exercise, I relooked at some of the stocks which were in our small-cap portfolio as at Sept 12, 2011.

Some of them have done spectacularly well. Others have bombed. On average, the total return of that portfolio between then and now was 17.5 per cent. The median 10.8 per cent.

Between then and now, the best performer in that portfolio was Roxy-Pacific. Its total return amounted to 112 per cent. Next was Kian Ann, at 105 per cent. Tat Hong came in third at 98 per cent, followed by Adampak at 69 per cent. Fortune Reit was next at 65 per cent, then Pan-United Corporation at 63 per cent.

Those which bombed included China Sky, China Essense, Courage Marine and Ziwo.

I reflected on the reasons I picked those stocks and here are some of the things I realised:

Stocks which did well are those which have established a consistent track record in their respective industry. At that point in time, their stock prices were not hyped up by any upcoming new projects or new trends.

In other words, barring upheavals in the industry that they are in, companies which have created a niche for themselves and continue to plod away at those niches have turned out to be rather good bets.

In fact, for most of these stocks, I did not meet the management of the companies. The metrics on which I based my decisions are return on equity (ROE), return on assets (ROA), price-earnings ratio (PE), price to book ratio (P/B) and dividend yields.

I find that talking to the management of companies can actually cloud one's judgement. Some of the founders and chief executives can be so convincing in painting a picture of abundance in the future, that one is swayed into relaxing one's selection criteria.

For example, the PE of the stock may not be that cheap. But because the management told you about all the wonderful plans that it has for the company, you bought into them.

Another group of stocks in the portfolio which tanked were recommended by friends and contacts who supposedly knew the companies quite well through their business dealings with those companies.

Again, I suspect, the friends and contacts bought into the story of abundance painted by the companies to them.

And then of course, there are the Chinese stocks which have failed big time in the corporate governance department.

Some stocks in the group actually rose more than 40 to 50 per cent in the few months after September last year, but have since given back most of those gains to the market.

In short, here are the few things I observed in small-cap investing: One, understand the industry, and look purely at the track record of the company in terms of its ROA and ROE and its valuation numbers, such as PE and P/B. Buy companies which have shown consistent profitability record and are trading at a cheap level in an established industry.

Two, do your research. Do not listen to tips from friends, or chase after the latest hot stock in the market.

Three, be ready to take profit once you think the market has become too enamoured with one of the stocks you own. The market's enchantment with that stock can go just as quickly.

Four, once the industy outlook turns bad for the small-cap stock you own, sell. If not, the losses can be huge, and chances of the stock staging a comeback are slimmer than, say, a blue chip which has hit a bad patch.

No doubt, the return from small caps can be rewarding. But be prepared to contend with higher volatility. For those with neither time nor skill to do their research, blue chips are as good a place to be. Especially if you buy them at a crisis time.