In spite of economic and market uncertainty, small companies are trading at a premium to large companies, and valuations for small industrial stocks are based on high earnings-per-share (EPS) forecasts.
SmallCo Investment managing director Rob Hopkins believes consensus analyst forecasts of 18 per cent EPS growth for small industrials in 2011/12, up from 4 per cernt a year earlier, are unsustainable.
"There are a lot of downside earnings risks for small industrials and industrial stocks generally," Hopkins warns.
"We expect more profit downgrades and earnings forecasts revisions in the next few months. Companies exposed to consumer discretionary spending could produce some horrible numbers."
He notes the average valuation for small industrial stocks - a forecast price/earnings (P/E) multiple of 11.7 times 2011/12 earnings - is not expensive.
But the consensus P/E depends on earnings growth forecasts being met.
"If small industrials produced an average 4 per cent EPS growth in FY2011 (the financial year just ended), I can't see them achieving anywhere near 18 per cent earnings growth this financial year," Hopkins says.
"I would suggest earnings growth will be below the FY2011 result given all the micro and macro fears at present."
He is especially concerned by waning consumer confidence.
"Statements from big retailers suggest May was mediocre, June was poor and July was horrible," he says.
"Now we have consumer confidence back at GFC (global financial crisis) levels. Trading conditions will deteriorate even further for companies exposed to consumer discretionary spending, such as retailers and media groups. The GFC has really changed the consumer psyche and it could take years for more normal spending patterns to return."
The divergence between small industrial and resource stocks is stark. Small resource stocks (in the Small Ordinaries Index) are trading on a forward P/E of 10.4 times, based on 150 per cent forecast EPS growth for 2011/12. Such forecasts leave little room for error if commodity prices weaken or bad weather in summer affects production.
The high weighting of small resource stocks in the Small Ordinaries Index explains why it trades on a 5 per cent premium to the ASX 200 Index (based on forward P/E multiples for each index).
In theory, small-cap stocks should trade at a discount to large-cap stocks, and a persistent high premium for small caps is often seen as a sign to sell, although the resource sector's strong performance complicates matters.
A booming resource sector makes it even more challenging for small-cap fund managers that focus on industrial or mining service stocks to outperform their benchmark Small Ordinaries Index. Material and energy stocks comprised 46 per cent of the Small Ords in July, compared to 17 per cent in 2001.
More than 70 per cent of Australian equity small-cap funds beat the Small Ords in the five years to 31 December 2010, according to Standard & Poor's.
But sustained outperformance for small-cap funds, especially those less exposed to the resource sector, is becoming harder as the gap between small resource and industrial stocks widens.
