A Small-Cap Speculator’s Delight

Money Morning chief Kris Sayce made a prediction at the beginning of the year that the stock market would be over 5000 points by the end of 2013.

He was early. The stock market is already over 5,000 points. But one catch for Kris is his beloved small caps have mostly been left behind. Not all of them, but it’s the large caps, especially the banks, that have and continue to drive the market rally.

So in the never ending task of looking for value on the cheap, right now it’s probably still more fruitful to be looking into the small caps than anywhere else. Kris has been saying this for a while, too.

It’s the task of today’s Money Weekend to lift the lid on one part of this exciting sector…

A Small-Cap Stock Picker’s Dream

Actually, if you need the point about small caps underperforming large caps driven home, Peter Wells did it on Thursday in The Australian Financial Review.

Remember, the Dow Jones Industrial Average in the USA is hitting a high and dominating the news, but the ASX / 200 is still 25% off its record peak it made in November 2007.

But if you dig a little deeper, it’s interesting to note that the top ASX/20 stocks are only about 10% below their all-time peak.

But the small caps stocks are well off the pace. According to the AFR:

‘The S & P / ASX Small Ordinaries is down 43.5 per cent from its 2007 peak. That’s almost 20 percentage points of underperformance relative to the S&P/ASX 200, and about 30 percentage points relative to the blue chip S&P/ASX 20.’

Now it’s easy to speculate why. Money has shifted into the stock market, but only into the big, stable earners. Maybe investors are still wary of taking on too much risk. Dividends certainly look more attractive against a falling cash rate.

For example, take a look at the performance of the iShares S&P/ASX High Dividend ETF [ASX: IHD] in the last few months:

Dividends Sexy at the Moment

chart of iShares S&P/ASX High Dividend ETF

Source: BigCharts

Dividend investors don’t usually venture too far down to the small end of the stock market. A lot of small caps are miners, which usually have a small payout ratio, if they even have positive cash flow. The second reason is a lot of (non-resource) small cap stocks may not even be making money yet.

But even the profitable small caps are usually volatile and harder to value. Investors generally feel more comfortable in the big stocks with relatively stable earnings, which don’t jump around as much.

And don’t forget the big fund managers and superannuation guys HAVE to hunt mostly at the top end of town. They have too much money that they need to put to work. They need big, liquid stocks that they can move in and out of easily. That drives the values of those stocks higher based on capital flows. Broker research targets those stocks, too.

They’re some of the reasons small caps are a stock pickers dream, really. There’s simply less interest and less competition. But where to look right now?

A Major New Development and Small-Cap Opportunity

Well, if you asked Dan Denning of The Denning Report, right now he’d say the natural gas industry. Specifically, Aussie shale gas stocks. This is one story he’s been following from the beginning.

In fact, right now the shale gas industry is a perfect example of small caps stocks in general. It’s on the edge, unproven, speculative – with the potential to make investors a lot of money.

But it might just as easily be stillborn too, killed by public backlash, legislation or simple economics. The gas resources might be too small, too remote or too expensive to produce. Nobody is certain of anything.

But for now, the shale story is moving – and fast.

Consider the action in the market. You might know Beach Energy (ASX: BPT) made the news last week when it was reported that global energy giant Chevron agreed to a $339 million deal. Chevron has taken a stake in projects where Beach has been drilling and exploring for unconventional gas.

When a big energy company moves in, that’s usually a very bullish sign. Why? Energy majors generally prefer for other companies to shoulder most of the exploration risk. Their most pressing demand is to replace their reserves as their current assets deplete. This means waiting until projects are more certain in their viability.

So Chevron moving into (unproven) Australian unconventional gas may have just ‘de-risked’ some of the idea. And this week BHP indicated it wants in on some of the action.

This from The Australian on Thursday:

‘BHP Billiton is set to join the $1.5 billion rush by international oil companies to gain a foothold in the nation’s burgeoning shale gas industry, flagging it would start taking land positions in Australia in the wake of its $US20bn of US shale acquisitions in 2011.’

BHP made a move into shale in the US. It got caned and cost shareholders a fortune when the company had to write down its assets. But the company must still see potential in shale.

The catalyst might be as simple as demand for natural gas outstripping supply. Shale gas can fill that gap.

There are a lot risks to this idea. But if you’re after big gains in speculative energy shares, you want to get in before the big players really make a move. You can see Dan’s recent report here if you’re interested.

As he says, turning shale into a viable commercial proposition in Australia has been years in the making. But things suddenly seem like they are happening very quickly indeed.

Callum Newman
Editor, Money Weekend

PS. Don’t forget if you want to keep track of the latest things we’re reading and brief commentary on events that happen through the day, check out our Google+ page here or Kris Sayce’s here.

From the Port Phillip Publishing Library

Special Report: Australia’s Energy Stock BLOWOUT

Markets and Money: The Australian Shale Rush Begins

Money Morning: Why the Stock Market Boom is on Pause

Pursuit of Happiness: Here’s Why I’m Positive about the Future and Technology

Australian Small-Cap Investigator: Why Invest in Small-Cap Stocks? And Why Now?

Callum is a feature editor for Money Morning. He covers areas of interest arising from world markets and the global economy that could mean new investment opportunities for Aussie investors.

If you're already a subscriber to these publications, or want to follow Callum's financial world view more closely, then we recommend you join him on Google+. It's where he shares investment insight, commentary and ideas that he can't always fit into his regular Money Morning essays.

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