This article first appeared in Capital, The Edge Malaysia Weekly, on November 30 - December 6, 2015.

After the worldwide rout in the equity markets in the third quarter, mid and small-cap stocks have bounced back rather strongly compared with heavyweight blue chips. The FBM Small Cap Index has been rallying since August, jumping nearly 18%, in tandem with the recovery in the global markets. It outperformed the benchmark FBM KLCI, which only managed to muster a 10% increase during the same period as foreign selling continued.

In the near term, fund managers and analysts generally believe that the rally in the Small Cap Index will continue amid the anticipated year-end window-dressing activities.

However, some are less optimistic about the period after that, saying the rally might hit a speed bump because the share price increase is being driven by impressive earnings growth partly boosted by foreign exchange gains, thanks to the export-oriented nature of their businesses. Once the high-base effect sets in, the companies’ earnings growth will not be as strong.

Inter-Pacific Research head of research Pong Teng Siew opines that the excitement in the small-cap space has been caused by the better profits reported by the counters recently.

“You don’t get that kind of profit (growth) with the blue-chip stocks. The small caps have outstripped the blue chips in terms of profit growth. In fact, the overview I have gotten so far is that the top 300 stocks showed a 12.7% contraction in profit compared with the bottom 300 stocks, which recorded a 64% increase in profit,” says Pong.

However, he believes that the share price of many small-cap counters might have run excessively ahead of their underlying fundamentals. Hence, the upward momentum might not be sustainable in the long run.

A fund manager points out that many of the small-cap stocks, especially those that are export-oriented, have benefitted from foreign exchange gains from the depreciation of the ringgit. In addition, the current low commodity prices help to bring down production costs, resulting in fatter profit margins and firmer earnings growth. “This foreign exchange gain is an extraordinary gain and may not be sustainable in the long run as it is dependent on the ringgit’s movement,” he says.

Since the start of the year, the ringgit has weakened 19.7% against the greenback. The normalisation of the US interest rate is expected to strengthen the currency.

But how much lower can the ringgit go? Last week, it climbed to its highest in five weeks to reach RM4.209 on Wednesday. And that provided an impetus for investors to offload shares in companies such as rubber glove makers, whose earnings have been lifted by lower rubber prices and a firmer US dollar. Among the small outfits, Careplus Group Bhd fell about 7% at the close of Wednesday, while industry heavyweight Top Glove Corp Bhd dropped 3.7% in a day.

An analyst opines that the outlook for most export-oriented sectors in the small-cap space does not look that exciting anymore. He says exporters will feel the heat when the ringgit starts regaining strength.

“The expectations for these stocks that are benefitting from the foreign exchange gains are high. Look at the price-earnings ratios … they have increased significantly. The companies will be working from a higher base in the next financial year, which means that they will have to increase sales to meet that expectation,” he says.

Simply put, moving forward, the small caps need to work harder to churn up their sales volume rather than rely on the favourable foreign exchange factor.

Manulife Asset Management Services Sdn Bhd head of equities Tock Chin Hui notes that the valuation of the small caps have increased to nearly 10 times, slightly above the mean, compared with the average of seven to eight times previously.

“While valuation is not entirely excessive, the ‘easy money’ has been made. Going forward, outperformance [of these small-cap stocks] will have to come from earnings momentum. That will require a bottom-up stock-picking strategy on a broad market re-rating,” she says.

Another fund manager contacted by The Edge says she is not ruling out all small-cap stocks, although generally, she has a “neutral” view of them. She says most of the stocks are at their fair values, with growth already priced in for the next two years.

The fund manager is looking at small-cap stocks that have Asean growth potential. “Some technology stocks and consumer product-related companies have diversified to countries like Cambodia, Vietnam and Myanmar, which have huge business growth potential.”

Besides, she says, the construction industry could fare better as it is poised to benefit from the multiplier effect of the infrastructure projects that have been announced this year.

Meanwhile, the plantation sector, which investors have been shying away from, could be a hunting ground for undervalued gems.

An analyst notes that over the next six months, small-cap plantation counters could see some upside if El Niño strikes the region, reducing output and supply and moving commodity prices higher.

But he cautions that now is not the time for investors to jump into the market. Instead, they should take profit.

“There are many uncertainties in the equity market moving into next year. We have the US interest rate hike, the retirement of Bank Negara Malaysia governor Tan Sri Zeti Akhtar Aziz and the continued weakness in consumer sentiment, just to name a few (that could influence the direction of the market),” he says.

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