Mid caps: John Addis Five to buy

Smaller stocks show greater promise but they can also be riskier

Had you set out in 2006 and invested solely in the S&P/ASX 50, a collection of Australia’s largest listed businesses, the capital value of those stocks would be almost unchanged 10 years later. Investors have recovered from the financial crisis, but not by much.

Dividends might have lessened the pain but, again, probably not by much. No wonder attention has turned to smaller listed companies.

Small and mid caps do offer the potential for higher returns: they have greater growth possibilities; are more likely to be acquired; have greater levels of insider ownership; and aren’t covered much by brokers and fund managers, a fact we can turn to our advantage.

But let’s not get carried away. Over the past decade to the end of last year, the ASX Small Cap Index underperformed even the top 50 index. Despite all the conceptual benefits of investing in smaller stocks, the reality has been even more painful than merely standing still.

Which brings us to the risks. Unlike large caps, small and mid caps tend not to have a long history and haven’t therefore refined their business models. That can introduce a level of risk that established businesses don’t face. With smaller companies, their brands tend to be relatively new and market positions less entrenched. Earnings are also less diversified and, with fewer layers of management, there’s a greater reliance on key people. And, finally, with less available research and public scrutiny, more opportunities exist for misdeeds and poor decisions.

Lately, investors have been setting aside these risks, although overpricing has yet to reach extreme levels. Opportunities still exist. The question is how best to approach them.

Above all, we look for cheap stocks and deploy a measured amount of diversification. These picks feature in our investible Intelligent Investor income and growth portfolios, both of which contain at least 20 stocks. That gives you an idea of the kind of diversification we aim to achieve. Small stocks are riskier, so don’t get carried away. AMAYSIM BUY BELOW $2.20 Telstra accounts for half the mobile phone market and Optus and Vodafone combined account for another 40%. The remaining 10% consists of virtual network operators that resell access from major networks. The largest, with a 4% share, is Amaysim.

The company’s biggest costs are the network charges it pays to Optus. The remaining 30%-40% of costs, from billing, marketing, service and activation, are fixed, which means the bigger Amaysim gets, the more it earns in profit per user.

Two years ago, Amaysim had just over 600,000 subscribers and operating margins (before depreciation and amortisation) of 7%. When subscriber numbers hit 966,000 last June, the operating margin was twice that. Even if margins remained at 10% – unlikely in our view, but possible – the business should generate net profit of $20 million, giving a price-earnings ratio (PER) of 16 and a yield of 4%.

Amaysim relies on Optus but, as the dominant source of Optus’s customer growth, the reverse is also true. Indeed, Optus may well like to see Amaysim grow even more quickly, which is why it offers an attractive risk-reward payoff.

TRADE ME BUY BELOW $5.25

Trade Me has risen over 30% since its inclusion on our buy list three years ago but still offers access to a portfolio of high-quality businesses with network effects at a

reasonable price. Think of it as New Zealand’s answer to eBay, REA Group, Seek and Carsales rolled into one. These Australian online classifieds businesses trade at far higher PERs than Trade Me’s equivalent figure of just 22. With an EBITDA (earnings before interest, taxes, depreciation and amortisation) forecast of close to $NZ160 million ($150 million) in 2017 and the longterm potential to push premium pricing higher, we’re comfortable paying up to 12 times 2017 prospective EBITDA.

This is a high multiple – a prospective price-earnings ratio of 21, in fact – but we expect profit growth to accelerate. Plus the Australian dollar buy price of $5.25 equates to a historical free cash flow yield of around 4.5%. Trade Me isn’t the bargain it once was but still offers good long-term value.

VIRTUS HEALTH BUY BELOW $5.50

Good businesses going through bad times often offer opportunities for enterprising investors. IVF provider Virtus Health is one such business. After revealing that the number of fresh IVF cycles undertaken had fallen 7.2% in the six months to December 2016, the share price fell over 15%.

This is bad news, but there’s a lot to like about this business in the long term. IVF is a huge untapped market with increasing rates of infertility. We think 3%-4% market growth is a reasonable long-term assumption, with the 7% growth achieved last year and 6% decline this past half being blips on a long-term upward trend.

Virtus is still the market leader with economies of scale, a clean balance sheet and excellent returns on capital. The stock now trades on a price-earnings ratio of around 13 and free cash flow yield of about 9%. The road has proved bumpier than we expected but investors are being well compensated for those risks.

NAVITAS BUY BELOW $5

This university college operator reported record interim earnings of $53 million for the half year to December 31. And yet the share price fell 6% on the day, taking the decline since the July 2016 high to more than 25%. This was our long-awaited opportunity.

Despite the disappointments of the past two years, Navitas remains a good business. A high return on capital employed (37%), a negative working capital model (whereby Navitas receives fees upfront and pays its teachers later) and long-term industry tailwinds mean the stock should trade at a premium.

And it does – a 2017 forecast PER of 19, in fact. But current earnings do not reflect the company’s long-term potential. Changes to immigration and student visa policies remain a risk but international students will continue to want quality education in English-speaking countries. Navitas has shown itself to be a leader in facilitating relationships with universities. The current price represents reasonable value for a very good business.

NEWS CORP BUY BELOW $20

It’s difficult to find a company less loved than this one. But whichever way we dice it, News Corp looks cheap. Buying in requires a leap of faith, though – one that assumes Rupert Murdoch is right and the market is wrong.

So far the market is winning. The stock has fallen a fair way since it joined our buy list a year ago, a recognition that many of the company’s businesses are structurally challenged. But here’s the kicker: the company’s wonderful digital real estate business, together with its cash, effectively justifies more than 80% of the company’s market capitalisation. You get the remaining businesses – with revenues of around $US7 billion ($9 billion) – for not much more than $US1 billion.

John Addis is founder of Intelligent Investor. All stocks feature in either Intelligent Investor’s investible growth or income portfolios. For a free trial of Intelligent Investor, visit investsmart.com.au/promo/money.