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3 small-cap stocks worth a look

Glenn Freeman  |  27 Jun 2017Text size  Decrease  Increase  |  

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These three smaller companies in disparate sectors may present interesting investment opportunities at their recent valuations.

 

While Morningstar's equity research tends to focus on larger companies, this shouldn't infer small-cap stocks--which we define as companies with sub-$2 billion capitalisation--inherently earn low returns.

"On average, we find that both small and large firms in our coverage generate similar returns on invested capital," says Adam Fleck, Morningstar's director of equity research, ANZ.

He explains that while Morningstar doesn't always assign these smaller firms economic moats, "we nonetheless believe small-cap companies can still offer interesting investment prospects".

Each of the following companies are assigned a narrow moat by Morningstar, with approximate market capitalisations of $1.8 billion, $1 billion, and $443 million, respectively.

Blackmores (ASX: BKL) has been in the headlines of late as news broke around the departure of Christine Holgate as chief executive officer. Holgate has accepted a lucrative offer to head up another prominent Australian brand, Australia Post.

With Holgate moving on after nine years at the helm, Marcus Blackmore steps in as interim CEO while the board seeks a permanent replacement. Stephen Chapman, Blackmores chairman, says the board has "a clear strategy in place and a strong executive team, including potential CEO candidates, to take the company forward".

This is a view shared by Chris Kallos, Morningstar's senior equity analyst covering the healthcare sector. He emphasises there is no change to the moat outlook or stewardship rating of Blackmores as a result of Holgate's announced departure: "Management has a good track record of delivering strong shareholder returns, with average earnings per share growth of 12 per cent over the last 10 years."

Given the increasing importance of Blackmores' Asian operations, Kallos refers to the important role played by Peter Osborne, Blackmores' managing director, Asia. "Management continues to cement its position in new regions through the execution of strategically-formed partnerships, which widen the distribution channels and customise the product offerings," he says.

Earlier this month, Osborne and Blackmores were appointed to key leadership advisory roles with the China Association for Quality Inspection, a high-level non-profit national body.

Kallos believes the stock is undervalued, even as product sales volumes normalise in China, having boomed in fiscal 2016: "As such, we see the underlying domestic [Chinese] business reverting [to] previous low-single-digit growth rates".

Cars and trucks

Passenger vehicle and commercial truck retailer Automotive Holdings Group (ASX: AHG) operates more than 180 franchises across some 100 locations across Australia and New Zealand.

"Despite the soft market conditions and the proposed regulatory changes to automotive finance and insurance commissions, the company remains well positioned in the automotive dealership industry, benefiting from holding a diversified portfolio both in terms of brands and geographical spread," says Daniel Ragonese, equity analyst, Morningstar.

AHG is assigned a narrow moat rating, currently leading the Australian automotive retailing industry with around 7 per cent market share.

"We believe the firm's size and scale drives sustainable advantages through lower costs and strong intangible assets ... [and] expect revenue to grow at a mid-single-digit pace for the foreseeable future, outstripping industry growth, underpinned by a combination of targeted acquisitions and greenfield expansions," Ragonese says.

Pubs

Narrow moat-rated Hotel Property Investments (ASX: HPI), which operates in the Australian real estate investment trust (REIT) space, is another of Morningstar's preferred small-cap picks.

The company owns 43 pubs in Australia, 39 of which are in Queensland. All but one is leased to supermarket giant Coles or its subsidiaries.

"Overall, the portfolio should benefit from sustained long-term tenant demand given that the pub properties retain the liquor licence and the vast majority of the gaming licences," says Morningstar equity analyst, Johannes Faul.

HPI's value is largely underpinned by the liquor licences, ownership of which is tightly restricted in Queensland.

"The rental growth outlook is very attractive compared with that of other Australian REITs," says Faul, with more than 80 per cent of the portfolio's rents growing by at least twice the average five-year consumer price index.

"The remainder of the rents grow at fixed rates of between 3 per cent and 5 per cent," he says.

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Glenn Freeman is a Morningstar senior editor.

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