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The role of small-caps in portfolios

This article appeared in the September 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Long tail of ASX listings can hide big hitters with potential.

Photo of Richard Hemming By Richard Hemming, Under The Radar Report

There are risks in any investment but when you are paying very low prices for assets that have relatively big potential, there is less that can go wrong if there are hiccups. You can have many of these types of stocks in your portfolio that won't do anything, but for the ones that do, it will be worth the ride.

The sharemarket historically tends to rise more than it falls, in seven out of 10 years. If you average out the returns, you are looking at about 10.5 per cent a year, and your timing has to be good to generate that, even over a number of years.  You can potentially do better than the average if you include a few well-chosen small-cap stocks in a portfolio.

The term small caps is bandied about a lot because many fund managers want to be associated with a part of the market that signifies above-average growth. The reality is, however, that the definition many use stretches the concept of a small listed company.

Almost 2000 ASX-listed small caps

Fund managers often say a small cap is a listed company outside the S&P/ASX 100 index, which means many companies they invest in have market capitalisations above $1 billion. There are 2185 listed companies on ASX and the median market cap of the 200 biggest at 30 June 2013 was $1.8 billion.

But it is the long tail where most action can be found by shareholders looking for better-than-average returns. Almost 90 per cent of ASX companies, or just under 2000 of them, have market caps below $300 million. These are the ones this article classifies as small caps, and it is normal for them to make few announcements other than profit numbers.

In the 12 months to the end of June, the S&P/ASX 100 Index of the biggest companies by market capitalisation outperformed the S&P/ASX Small Cap Index by nearly 30 per cent. It was up about 15 per cent compared with the Small Cap Index's negative 11 per cent. This was mainly because of investors hunting for earnings certainty and dividend yields.

More than half of the S&P/ASX 100 Index's return last year came from three of the four big banks, Telstra and the pharmaceutical company CSL.

More recently it has been a different story. Since July 1 the Small Cap Index has climbed 17 per cent, compared with the top 100 Index, which was up 9 per cent.

I believe the big reason is bargain hunting. There is genuine value at the smaller end of the index, particularly in mining and mining services. Remember that even after a recent bounce, the Small Resources Index is still down 65 per cent over the past year.

Growth is the key

Another factor is that right now people are in love with dividends, but earnings growth is the key to making money. Small caps do not have the luxury of paying out all their earnings in dividends as some big companies do, but can work to an investor's advantage because earnings are being reinvested to help the company grow faster.

It is important to remember that the movement of share prices, not the dividends paid, dictates the returns investors make over any period of time.
From 2000 to 2012, the return from Telstra's dividends was 73 per cent, but its price return was minus 47 per cent. It delivered a measly total return of 26 per cent over this whole period.

Ultimately, companies only grow when enough profits are reinvested. When a company's sole objective is to maintain a high dividend yield, it does not augur well for long-term value.

A lack of information

For all the benefits, there is risk in buying small caps - there is risk in buying any investment, especially in the sharemarket.

Stocks such as the banks, Telstra and some internet companies are trading at record high levels because investors perceive a relatively high certainty that their earnings will appreciate, delivering growing dividend income. These companies have high "price risk". If there is any softening of their earnings growth, their share prices are vulnerable to falls.

In contrast, what you see with small caps is "information risk". Their historical earnings performance can often bear little resemblance to future earnings. This is what presents opportunities for investors prepared to do their homework in small caps.

About the author

Richard Hemming edits Under the Radar Report: Small Caps, a newsletter that helps investors achieve real growth and consistent returns from their portfolios. ASX subscribers are being offered a 30-day free trial. Visit the Under the Radar Report website or call 02 9331 1999.

From ASX

Company snapshot provides basic information on ASX-listed companies with a market capitalisation below $50 million. This initiative is part of the ASX Equity Research Scheme.

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