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This article appeared in the March 2015 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.

The next phase of the recovery will be small- and mid-cap companies that benefit from the improving domestic economy.

Photo of George Boubouras By George Boubouras, Contango Asset Management

Asset allocation decisions will be the core driver of your total investment returns over time. Most investors should be diversified across all asset classes, and within each class, to help lower the volatility of portfolio returns while targeting appropriate expected returns that reflect your risk tolerance.

The goal is to have exposure to asset classes that are negatively correlated through a market cycle; that is, do not move in the same direction.

The market's performance during the last Australian recession in 1991-92, the Asian financial crisis (1997-98), the technology bubble pop (2000), the unforgiving GFC (2008) and the various European credit shocks, is clear evidence that diversified portfolios significantly lower the volatility of portfolio returns.

The real benefit of portfolio diversification is that it significantly reduces risks in a portfolio while still allowing for solid returns that build wealth systematically over time.

A strategic asset allocation plan is the fundamental building block for constructing a successful portfolio.

Filling the portfolio

The first question has to be what assets to include. The answer is that most people will have a mix of cash, fixed income, equities, Australian Real Estate Investment Trusts (A-REITs) and alternatives such as, private equity, infrastructure and absolute return strategies.

The next question is what weighting to assign each asset class. The average balanced fund will have up to 60 per cent exposure to equities, domestic and global. The remaining 40 per cent will consist of cash, fixed income and alternatives.

The expected return of a typical default balanced fund would be around 6.8 to 7 per cent with an annualised volatility of around 7 per cent. This implies a negative annual return every six or seven years.

If a portfolio was 100 per cent invested in equities it would imply a negative annual return every three and a half to four years. Equities alone are clearly more volatile, which is why they generally offer a higher average expected return.

Building a diversified equity portfolio

Understandably, many domestic equity investors focus on large-cap stocks, particularly the top 20 or 50 in the index. This is because most investors know about large-cap companies that get a lot of media attention and are household names, such as BHP Billiton, Telstra Corporation and Commonwealth Bank.

However, investing only in large-caps can add risk to a portfolio that you may not be fully aware of. For example, the ASX 100 index composition is heavily weighted to Financials ex-REITs (40 per cent by market capitalisation) and has a relatively low weighting to Consumer Discretionary stocks (only 3 per cent).

Therefore, if you invest only in ASX 100 stocks you may have systematic sector biases in your portfolio that may not be optimal over the longer term.

Small and micro stocks help further diversification

Exposure to small-cap and micro-cap stocks can provide extra diversification for a portfolio without significantly reducing longer-term expected returns. They can also provide exposure to faster-growing companies and industries of the future, including technology, biotech or new-age service sectors.

Often, trying to find exposure to these types of industries or high-growth companies among large-caps is difficult as many of them operate in relatively mature industries.

Some good examples of successful small and micro companies that have returned significant value to shareholders are REA Group (REA), Slater and Gordon (SGH), Magellan Financial Group (MFG) and Domino's Pizza Enterprises (DMP).

An important question is: what is an appropriate level of exposure to small and micro-cap stocks. It clearly depends on your risk appetite and targeted expected returns, but a basic rule of thumb is up to 25 per cent of a domestic equity portfolio.

The remainder of your domestic equity should consist of mid-cap and large-cap companies. Combining these exposures will ensure additional earnings and return diversification while maintaining an appropriate expected return.

In addition to sector and industry diversification, exposure to small and micro companies can add some economic diversification as well.

Generally, large-caps are the first to outperform in the early stage of an economic recovery. They are generally more responsive to lower interest rates and are able to take costs out quicker than small companies, which usually have relatively lean business models.

However, as the economic recovery matures, benefits start to flow to the broader economy, and the small-cap and micro-cap sectors are more dependent on the domestic economy.

Broader recovery expected in 2016

Looking forward, most economists expect an economic recovery in 2016 and beyond, which would be supportive for small companies. However, some areas could continue to struggle, including resources and mining services. These sectors face structural headwinds and bank lenders are not keen to increase their exposure.

This does not mean you should have zero exposure to these companies, but rather be very careful about which ones you select for your portfolio. At this stage of the cycle, there may be some opportunities for companies with low gearing, solid high-quality contracts and those that can benefit from lower energy prices.

Systematically identifying these small and micro-cap companies that offer strong returns can be difficult and time consuming. The risks of investing in this segment of the equity market are higher compared to the top 100. These smaller companies tend to be at the early stage of their lifecycle, often with exposure to only a single product or single mine.

It requires significantly more work to uncover the quality of a small company's balance sheet, the core drivers of the business model, the key-person risk and structure of the management team and the board (governance).

In addition, from time to time small and micro companies undertake equity raisings or IPOs that require careful analysis and scrutiny. A prudent investor would need to take an even deeper dive into the risks and opportunities presented in a business model.

This is why fund managers in this segment tend to have very experienced portfolio managers who have managed through a number of market corrections, and relatively large investment teams that are required to systematically exploit value.

Finding value in the small and micro-cap sectors also requires a more diversified portfolio than a typical large-cap portfolio. For example, a typical large-cap portfolio may hold around 30 to 35 securities, whereas a typical small-cap portfolio may hold around 40 to 60.

In a diversified micro-cap portfolio it is not uncommon to hold up to 90 securities.

Being across that many companies and sectors at one time can be a daunting prospect for some investors, who instead opt to use a professional fund manager with the resources to review and analyse stocks.

The micro-cap sector tends to be across many more sectors compared to the top 50 stocks and generally consists of companies with a market capitalisation of $250 million to $350 million. The definition tends to be broad because once a stock enters the top 200 it is no longer considered a micro-cap.

The small-cap index is the ASX 300 excluding the top 100, but the portfolio manager typically tends to go outside the top 300 in search of additional returns. There is some crossover regarding a micro-cap portfolio and a blend of both (small and micro-cap stocks) is recommended for optimal portfolio diversification.

Outlook looks promising

The recovery profile of micro and smaller companies tends to lag compared to large companies, which are well into their cost reductions and capital-management phases. They are repairing their balance sheets and beginning to benefit from the lower Australian dollar (those with offshore earnings) and lower interest rates. This is why the large-cap sector has outperformed recently.

The next phase of the recovery will be the many hundreds of securities that will benefit from the improving domestic economy in the years ahead. 

Current prices reflect future earnings and the 2015 calendar year is set to be promising for the small and micro-cap sectors.

In summary, investors should aim to blend their domestic equity portfolio across the micro, small, mid and large-cap sectors. This blend will vary between each investor but will help to achieve a more optimal risk-adjusted return over time.

About the author

George Boubouras is Chief Investment Officer at Contango Asset Management, a boutique equity fund manager formed in 1999. It manages active portfolios across all sectors.

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