Small-cap stocks can outperform the STI, if investors know where to look

INVESTORS tend to focus on blue-chip stocks on the benchmark Straits Times Index (STI). But market watchers say small-cap counters should not be overlooked as they could offer portfolio diversification and deliver market-beating opportunities.

However, analysts suggested that investors, before casting their lots with these small-cap stocks with a total market value of less than S$2 billion, should pay close attention to their underlying businesses, and their track record for paying dividends.

According to Azure Capital chief executive Terence Wong, investors should take a closer look at small-cap stocks with good track records, especially those that have delivered dividends despite challenging times.

“You’re talking about a track record that goes back decades, so these are the companies that will be able to ride through really rough times,” he said.

Furthermore, Maybank Securities analyst Jarick Seet said that small-caps may be more attractively valued than large-caps on the market.

“For larger-cap companies, you pay a higher valuation so it’s all priced in, but for a smaller-cap company, there’s always value to be discovered,” he said.

Paul Chew, head of research at Phillip Securities, believes that the most critical factor in investing in small-caps is the strength of a company’s balance sheet.

He also emphasised the importance of dividend performance as it could point towards strong cash flows.

“Of course, the caveat is that they’re not paying the dividends through higher borrowings, but in general they don’t. Most small-caps are quite mindful of the balance sheet,” Chew said.

“Especially if they give attractive dividends… you are sometimes paid to wait for your whole thesis to pan out,” he added.

In addition, Chew noted that since such counters tend to suffer from poor liquidity, much of the returns from such investments would come in the form of dividends.

“That’s the hazard with small-caps; they have to consistently grow. You trip once and (investors) will cut you down all the way, in part because the liquidity is so poor,” he said.

Chew added that investors should be comfortable with the general trajectory of the companies they are investing in, even if they cannot predict precise growth levels.

Maybank’s Seet noted that in the past, small-caps have seen liquidity decline as a result of weak sentiment.

A case in point is consumer staples company Food Empire , whose trading liquidity collapsed as the Russia-Ukraine war began in February 2022.

The company made a combined 58.1 per cent of revenue from Russia, Ukraine, Kazakhstan and Commonwealth of Independent States markets for its financial year ended Dec 31, 2021.

However, Seet noted that after Food Empire posted a 134.4 per cent rise in net profit for the half year ended Jun 30, 2022, liquidity rebounded in August as it released its profit guidance and earnings report.

“Volume may be an issue, but it doesn’t mean that they will (all) have low volumes. When there’s a good story and they continue to deliver results, the volume will pick up accordingly,” he said.

Azure Capital’s Wong said that some small-cap counters may already have seen large run-ups in their prices because of past trends.

For instance, exceptionally high shipping rates bolstered the earnings of companies such as Samudera Shipping Line . Elsewhere, luxury watch players such as The Hour Glass and Cortina saw their earnings soar as more buyers sought out watches with their cryptocurrency earnings. These trends have tapered off somewhat as shipping rates fell and cryptocurrency valuations shrank.

Still, there are other sectors that could be worth watching.

Both Wong and Phillip Securities’ Chew pointed to the property sector as a potential space to watch, with Propnex being a potential small-cap to watch. Chew said: “We think 2023 will be a recovery year for property transactions, so they will be a beneficiary… especially when heading into 2023, the external environment is turning softer,” he said.

Another area to watch will be the tech manufacturing sector, said Maybank’s Seet.

“If you look at the last three years, tech stocks did very well except for the second half of last year, when they took a huge correction.

“But if you look at their revenues and profits, I would say that companies such as Frencken , UMS , AEM , they have all done very well and more than doubled or tripled their net profits in the last three to five years,” Seet said.

This level of growth, he added, has not necessarily been captured by the STI counters.

Another factor that investors should consider when investing in small-caps is the corporate governance of the companies they would like to invest in.

Seet said that although retail investors may not have a chance to meet companies’ management, they could observe if management’s commentaries come true, whether they go through with expensive related-party transactions, and if they are paid too highly.

Investors may also be concerned over family-run small-caps, where families sometimes own 60 per cent to 70 per cent of their businesses.

Wong noted that such businesses would be incentivised to declare good dividends, which would also be in all shareholders’ best interests.