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Here are 5 top small-cap stocks in an award-winning strategy

Nicholas Grove  |  13 Mar 2017Text size  Decrease  Increase  |  

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Investors Mutual recently took out the top gong in the Domestic Equities Small Caps category at the Morningstar Fund Manager of the Year Awards.

Morningstar cited the shop's "value and quality discipline, skilful application of a sensible process, and savvy people" as the rationale behind its bestowing of the award.

"The strategy has certainly benefitted from the recent rebound in value stocks, but what's much more exceptional is the way (senior portfolio manager) Simon Conn and his colleagues have been able to deliver consistently excellent results in a variety of market conditions," Morningstar says.

"All of this suggests that Investors Mutual Australian Smaller Companies [5340] will continue to reward investors handsomely."

Morningstar senior manager research analyst Alex Prineas says the Bronze-medal-rated strategy is a good way for investors to gain access to companies outside the ASX 100.

He says Investors Mutual's value and quality discipline favours stocks with conservative debt and sustainable earnings--a process Morningstar thinks is well-suited to small caps.

"For small-cap Australian equity exposure, Investors Mutual Australian Smaller Companies is a worthy option," Prineas says.

"Investors Mutual's thorough research means Conn can build high-conviction portfolios that have significant weightings in the 10 largest stock positions.

"Although this adds stock-specific risk, these holdings will come mainly from the industrials sector where earnings visibility is often better."

Below, a handful of the strategy's largest stock positions as at 31 January 2017, along with some of their key attributes and risks, are examined in more detail.

1) Tox Free Solutions

While not in possession of a Morningstar economic moat--and despite operating in an industry often considered far from glamourous--waste management company Tox Free Solutions (ASX: TOX) is a stock that can be considered "recession-proof," Morningstar equities analyst Tim Mann says.

However, the loss of a major project contract always remains a risk in any of the company's three service segments of Waste Services, Industrial Services, and Technical & Environment Services.

Also, Mann points out that the company primarily services customers in cyclically sensitive sectors, such as energy, manufacturing, and industrials.

2) Pact Group Holdings

Mann describes plastic packaging provider Pact Group Holdings (ASX: PGH) as a "well-established business with strong cash flow".

He says the company enjoys strong market positions in its key markets of Australia and New Zealand, and benefits from exposure to the less discretionary end of the consumer spending spectrum.

However, because it operates in a vigorously competitive environment with limited opportunity for excess margin gains, Mann does not consider Pact to have an economic moat.

3) Thorn Group

Operating under the Radio Rentals and Rentlo brands, the no-moat-rated Thorn Group (ASX: TGA) is Australia's foremost electrical and household appliances rental business.

Morningstar senior equities analyst David Ellis explains that a poor economic climate can potentially have a positive impact on Thorn's business--as disposable income decreases, the likelihood of people renting appliances increases.

He also points out that Thorn has an established national network, strong brand, and solid underlying customer base.

But given the household goods rental market is highly competitive and has low barriers to entry, Ellis doesn't believe Thorn possesses an economic moat.

4) Mayne Pharma Group

While also not possessing a moat, Morningstar senior equities analyst Chris Kallos says Mayne Pharma Group (ASX: MYX) has a comparative advantage over some of drug manufacturing peers.

This takes the form of a manufacturing plant in the US that is licensed to produce controlled substances, such as narcotics. This licence limits the threat to the company from low-cost foreign producers outside the US, he says.

However, Kallos points out there are multiple sources of risk behind the high fair value uncertainty rating on the stock, including: delays in regulatory approvals for new drugs; patent and exclusive licence expiries; product recalls; and timely integration of acquisitions.

5) Z Energy

Taking care of close to close to one-third of New Zealand's transport fuel requirements, Z Energy (ASX: ZEL) has a strong market position and many favourable attributes that make it an attractive investment at the right price, Morningstar senior equities analyst Mark Taylor says.

"The business has scale and sells a full range of transport fuels from petrol and diesel, to aviation fuels, fuel oils and bitumen," Taylor explains.

"If, like Shell, other majors outgrow enthusiasm for the small, low-growth New Zealand market, Z Energy could be a major beneficiary via consolidation."

Still, Taylor ascribes a high fair value uncertainty to Z Energy: "New Zealand is a small retail and commercial transport fuel market, regularly subject to intense price competition for market share."

"Z Energy's business requires large irregular shipments of crude oil and refined products, and corresponding requirements for working capital. This exposes investors to commodity and foreign exchange market volatility."

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Nicholas Grove is a senior content editor at Morningstar.

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