Lots of homework can be rewarding - but understand the Small Ords index first.
By Boyd Peters, Contango
The S&P/ASX Small Ordinaries Index covers the small-cap listings of the S&P/ASX 300 Index but excludes those in the S&P/ASX 100 Index.
As such the Small Ords typically comprises companies between stock number 101 and 300 on ASX at the time of their inclusion, by market capitalisation. The index covers approximately 7 per cent of Australian equity market capitalisation and can be rebalanced once a quarter to adjust for stocks that have risen or fallen in value.
The following tables give a further insight into the composition of the Small Ords index at June 28, 2013
|Number of constituents||200|
|Constituent total market cap ($A millions]|
|Maximum market cap||$3,570m|
|Minimum market cap||$6.8m|
|Mean market cap||$550m|
|Median market cap||$348m|
The 10 largest constituents shown in Table 2 below have a combined index weighting of 17 per cent
|Navitas Limited||NVT||Consumer Discretionary|
|REA Group Ltd||REA||Consumer Discretionary|
|Platinum Asset Mgmt Ltd||PTM||Financials|
|Cromwell Property Group||CMW||Financials|
|Goodman Fielder||GFF||Consumer Staples|
|Super Retail Group Ltd||SUL||Consumer Discretionary|
|JB Hi-Fi||JBH||Consumer Discretionary|
|IOOF Hldgs Ltd||IFL||Financials|
|Dulux Group Ltd||DLX||Materials|
The chart below shows the sector weighting in the Small Ords Index is relatively evenly shared across financials, materials, industrials and consumer discretionary. This may dispel perceptions that the index always has a heavy exposure to resource companies.
S&P/ASX SMALL ORDINARIES INDEX
Investing in small companies
Investors can build a portfolio of 10 to 15 small-cap stocks or invest in a pre-built portfolio through either a managed fund, Listed Investment Company (LIC) or Exchange Traded Fund (ETF). They all have advantages and disadvantages.
Unlike, say, the ASX 200, investors building a portfolio from the Small Ordinaries index cannot simply select the 10 largest stocks to provide sector exposure - they are too small.
The table below shows that ASX stocks ranked 101 to 110 represent only 11.7 per cent of the total market value of the 200 companies ranked 101 to 300. Self-managed super funds (SMSFs) and other do-it-yourself investors must therefore do considerable work to first research and then build a diversified portfolio of small-cap stocks.
|as at 30.06.2013||Number of companies||Market Cap ($b)||Top 10 companies as total %|
|Largest 500/All Ords||
For investors who have the time, skill and inclination it can be very rewarding. However, for many it is cheaper and more effective to buy an LIC or ETF through ASX and have dedicated professionals manage their portfolio for them.
Who invests in small caps?
Investing in small caps brings higher potential upside, but typically also brings more price volatility and risk. Those suited to the sector include long-term investors (usually at least seven years), investors seeking long-term capital growth, and SMSFs.
Benefits of investing in these stocks
Those who choose to invest in small caps do so for various reasons, including to reduce exposure to too many large caps in portfolios, and gain exposure to lesser-known ones that are less researched. Often these stocks can be mispriced and at some point in their future have the potential to rise substantially.
Of course, with the potential for higher return comes increased risk and small caps are not immune. Risks of investing in smaller-cap stocks include they trade less often and in smaller volume, meaning impatient buyers and sellers are at a price disadvantage getting into and out of them.
Short-sellers (who look to profit from share price falls) can also have a bigger impact on price volatility, and the company itself might be a single product or service provider that is heavily reliant on good market conditions to preserve revenue streams.
These risks can be reduced by investors not allocating too much of their portfolio to small caps and holding a diversified portfolio of them rather than just a few. Also, investing in established companies with reliable cash flow and income streams is always wise.
The composition of the Small Ords index is very different from the ASX 200, which is less volatile and has more stability and market liquidity. As seen in the chart below, the ASX 200 has greater exposure to financials at the expense of consumer discretionary and industrial stocks.
Comparing the performance between the Small Ords and the ASX 200 highlights extreme disparity, which some may believe suggests little reason to invest in small caps.
|As at 30.06.13||1 Year||3 Year||5 Year|
|S&P/ASX SMALL ORDINARIES||-4.7%||-1.3%||-4.9%|
However, investing is a decision about pricing the future. If people only invested by looking at past returns they could miss months such as July 2013, when pent-up value and compelling value was realised in over-sold sectors and particularly small resource stocks.
|Period||ASX200||ASX Small Ordinaries||ASX Emerging Companies||Small Industrials||Small Resources|
Specific events that contributed to a strong resurgence in the market in July include:
Combined, these formed a compelling argument to investors that the global fundamentals were sufficiently positive for previously ignored stocks to be considered.
In addition, aggressive short-sellers were forced to cover and close short positions (which can drive prices higher). It was not surprising to see strong price rises of between 20 per cent and 50 per cent in many small and micro stocks, particularly those with resources exposure.
Although July was an exceptional month for small, particularly resource, companies, there is still far to go to reverse the breakdown within the Small Ords between industrial and resource stocks since the GFC. As is apparent in the chart below, for investors and fund managers the battle over this five-year period has been to make the correct sector allocation decision between small industrials and small resources.
Industrials versus Resources index bar chart - 1 month to 5 years per annum
Small industrials performed well
What the chart above and the table below show is how well small industrials have performed over the past five years, particularly compared to the ASX 200. Those who simply looked at the headline returns of the Small Ordinaries Index are likely to have missed the performance within.
|As at 31.07.13||ASX200||ASX Small Ordinaries Accum||Small Industrials||Small Resources||ASX Emerging Companies|
|2 years pa||12.0%||-6.4%||10.9%||-35.7%||-18.1%|
|3 years pa||8.8%||-0.6%||10.0%||-21.3%||-6.0%|
|4 years pa||9.1%||1.3%||9.4%||-15.0%||-1.9%|
|5 years pa||5.0%||-2.8%||3.3%||-14.8%||-4.6%|
Since 2007 the decline in resource company valuations has necessitated sector rotation in the asset allocation of the Contango MicroCap Limited investment portfolio, which is a diversified portfolio of 60 to 90 ASX-listed micro-cap companies.
This rotation reflects the general change that occurred in sector weightings of the small and micro indices through the period. The table below follows the change in the 20 largest holdings within that portfolio over the past two years.
Rank in Top 20 as at
|IAU||Intrepid Mines Ltd||1|
|DCG||Decmil Group Ltd||8|
|MIN||Mineral Resources Ltd||11|
|SGH||Slater & Gordon Ltd||12||2|
|AZT||Aston Resources Ltd||13|
|EHL||Emeco Holdings Ltd||15|
|SAR||Saracen Mineral Hldgs Ltd||17|
|HZN||Horizon Oil Ltd||18|
|NXS||Nexus Energy Ltd||19|
|WPG||WPG Resources Ltd||20|
|AUT||Aurora Oil & Gas Ltd||2|
|ANG||Austin Engineering Ltd||3||6|
|NWH||NRW Holdings Ltd||4||20|
|FGE||Forge Group Ltd||5||15|
|MMS||MacMillan Shakespeare Ltd||6||1||5|
|IDM||Industrial Minerals Ltd||7|
What of the outlook for the future of small caps, and also small industrials and small resources?
Although we cannot provide investment advice, consensus data from brokers shows that small-cap stocks, collectively have attractive Price Earnings multiples and a favorable earnings per share growth outlook. Based on latest reporting season results, it would not be unexpected to see smaller companies, including resource stocks, continue to return to more normalised historical valuation ranges over the coming year should global markets show signs of continued confidence.
The nature of small companies is their potential to generate strong returns in periods of recovery and economic growth. Provided proper research is undertaken and a responsible allocation is made to the sector, investors with realistic investment time horizons should have confidence in the small caps sector to deliver positive returns in the future
Looking forward: Consensus FY14 valuations
|Sector fundamentals at 16/8||S&P/ASX100||S&P/ASX Small Ordinaries||ASX Small Resources||ASX Small Industrials|
|Return on equity||14.1%||11.8%||8.1%||12.7%|
|Price-earnings||14.2 x||13.2 x||6.9 x||14.9 x|
About the author
Boyd Peters is National Distribution Manager at Contango MicroCap (ASX code: CTN), an investment company investing in a diversified portfolio of 60 to 100 Australian micro-cap companies listed on ASX with a market capitalisation generally between $10 million and $350 million. CTN produces a free Quarterly MicroCap Investment Commentary.
Listed Investment Companies provides a wealth of information on LICs. Use ASX Market Update information to review LIC premiums and discounts to NTA since 2004. View the monthly sector update to see overall LIC performance. Examine quarterly performance returns to gauge a LIC's investment performance against others.
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