What to look for in stand-out mid-cap stocks

While they typically receive insufficient analysis due to their size, mid-caps can often be a furtive hunting ground for value-plays and growth stocks for those willing to drill down into this part of the market.

The trick when looking at mid-caps is to try and unearth those stocks with the potential to become the next Blackmores (ASX: BLK) or the next TPG Telecom (ASX: TPM) – which have both experienced rapid and dramatic rises from relative obscurity – especially before the rest of the market wakes up to their underlying opportunities.

Ask 10 institutional investors what represents a mid-cap stock within an Australian context, and you’re likely to get 10 different answers. But when Rivkin went in search of promising mid-caps, we looked exclusively those stocks with market caps of between $400 million and $1 billion.

Given that there are only around 170 (10%) stocks on the ASX with market caps over $1billion, there’s plenty of scope for stocks at the top-end of this $400 million to $1 billion market cap range to still make it onto the ASX 200 index; and there are a few interesting stocks who could be knocking on the door of the ‘ASX 200 club’ within short order (see table).

In addition to the extra market coverage, stocks that find themselves on the ASX200 also stand to receive extra market support with some institutional investors being mandated to hold the stock.

For purposes of this exercise, we have excluded the 1,500-plus small-cap and micro-cap stocks listed on the ASX – which incidentally represent a whopping 85% – that currently have market caps less than $400 million.

While we’re not saying that these stocks aren’t worth looking at, they will be the subject of future analysis.

Seven key criteria

We started with a potential pool of 95 mid-cap caps stocks with market caps of between $400 million and $1 billion, and through a series of filters came up with seven stocks, which based on key fundamentals, have the potential to be future standout performers.

Market cap:>$400 million <$1 billion:

Forecast return on equity: >15%

Historical return on equity: >10%

Funding surplus: Yes

Cash flow ratio: >.80

Forecast earnings per share growth: >10%

Net debt to equity: <70%

Having factored in the above seven screens, we’ve effectively built a profile of seven stocks that are more likely to outperform the market.

For starters, all these stocks have a funding surplus, which makes them more capable of paying dividends, expanding the business and successfully weathering downturns, without having to take on debt or perform value decretive capital raisings.

Secondly, by filtering on stocks with an historical ROE great than 10% and forecast ROE greater than 15% – plus forecast EPS growth of 10% over one year – we’ve created a universe of proven outperformers that are expected to go on doing so.

Thirdly, with a net-debt to equity under 70%, and cash flow ratio greater than 0.80, we’re only at looking stocks with fairly respectable balance sheets or better.

Seven mid-caps with the potential to outperform

Stock

Market cap

Historical ROE

Forecast ROE

Cash flow ratio

Forecast EPS growth 1 Yr

Net-debt to equity

Idp Education (ASX:IEL)

$1.1bn

33.46%

35.72%

1.58

17.68%

-17.26%

SG Fleet (ASX: SGF)

$846M

29.11%

29.93%

1.56

25.97%

49.14%

Altium (ASX: ALU)

$813M

25.06%

19.71%

0.82

51.69%

-36.77%

GWA Group (ASX: GWA)

$599M

11.27%

15.22%

1.41

15.07%

27.06%

Webjet (ASX: WEB)

$490M

24.82%

25.64%

1.37

15.67%

-52.43%

Vita Group (ASX: VTG)

$473M

65.87%

57.05%

3.17

16.05%

-18.94%

Sealink Travel Group (ASX: SLK)

$437M

16.27%

18.68%

1.09

74.72%

51.21%

Source: Skaffold 7 April 2016

While all seven stocks warrant closer evaluation, based on what the numbers are telling us, five of them are trading at premiums to their intrinsic value (IV), with software company Altium (ASX:ALU), and online travel booking company Webjet (ASX: WEB) trading on premiums to IV of 62.05% and 40.26% respectively.

However, the two standouts, given that they’re trading on significant discounts to their IV are IT stock Vita Group (ASX: VTG), and fleet management and salary packaging company SG Fleet Group (ASX: SGF).

SG Fleet Group saw its share price jump around 7% after the group reported impressive results for the six months to December 31. However, the stock is still trading on a 17.25% discount to IV, and is forecast to deliver 29.93% ROE and EPS growth of 25.97%.

Meantime, shares in Vita Group Limited also recently rallied 11% after the group reported strong growth numbers in its interim profit result for the six months ending December 31.

However, Vita Group is still trading on a 21.59% discount to its IV, and is forecast to deliver a 57.05% ROE and grow its EPS by 16.05%.

Based on these numbers both stocks look to be in value-play territory.

While SG Fleet is trading at a 15% discount to its recent high of $3.93 last December, and Vita Group is still trading at a 36% discount to its all-time high of $7.81 mid-2014, the gap between price and value does seem to be closing.