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Opportunities in outperforming small-cap stocks

Photo of Michael Glennon By Michael Glennon

min read

Growth rate makes them a worthwhile addition for portfolios - at the right price.

Small-cap stocks have outperformed large-caps this year as investors pay higher valuations for companies with faster earnings growth.

The S&P/ASX Small Ordinaries Index had a total return (including dividends) of 28.4 per cent over one year to September 27, S&P data shows. The S&P/ASX 100 returned 10.9 per cent in the same period.

ASX Investor Update asked Michael Glennon, founder of Glennon Capital, about the recent outperformance of small-cap stocks and whether it will continue in 2016. Glennon Capital launched Glennon Small Companies, a Listed Investment Company that specialises in stocks with small market capitalisations (small-caps), on ASX last year.

ASX Investor Update: What are small-cap stocks and how do you measure them?

Michael Glennon: A small-cap is any company outside the ASX 100 and measured against the S&P/ASX Small Ordinaries Index, consisting of 200 companies that meet several criteria. They are, loosely, the next 200 largest companies after the top 100 by size. They range in size from $8 billion to about $150 million in market capitalisation. Overall, there are about 1900 small companies listed on ASX.

ASX Investor Update: What role do small-cap stocks play in portfolios?

MG: Small-caps give investors exposure to exciting companies, some of which may be trading at a bargain price or are growing rapidly to become the leading companies of tomorrow.  Quite often these companies start with one entrepreneur who has a vision to build a company. 

Investors need exposure to fast-growing businesses to ensure their investments are growing faster than the rate of inflation.  Many small companies are able to grow faster than the rate of growth in the economy in general. If your portfolio is only growing at the rate of inflation, you are actually treading water and not moving forward in terms of growing your wealth.

This year has shown that owning a portfolio of the top 50 companies does not protect your portfolio from downside risk. Many top-50 companies are trading at lower levels than 12 months ago.

ASX Investor Update: Why are small-caps outperforming large-cap stocks?

MG: Small-caps were cheap last year relative to large caps. Over the past few years small-caps have underperformed large-caps as the resources sector declined. There was a significant impact as investors moved away from small resource companies and the industries that surround the sector, such as mining services. This created a situation where many small companies were oversold. 

From mid-2012 to the beginning of 2016, smalls-caps underperformed large caps, creating the situation where they became cheaper on a relative basis. This happens often in small-caps where there are periods of disconnect between prices and value. 

At the same time, there were some very well-run small companies that, despite general economic conditions being benign, were continuing to perform well and beat market consensus earnings estimates.

Over the past 12 months, managers in large-cap stocks have invested in many small companies with positive earnings momentum because the larger companies failed to deliver the same levels of growth. This weight of money has contributed to small-caps outperforming large-caps over the past year.

ASX Investor Update: Can small-cap outperformance continue this financial year and if so, why?

MG: While there is more money in small-caps and valuations are getting stretched relative to large-caps, we believe that trend will continue. It is only the larger, well-researched companies that are overvalued; there are still many opportunities in those less well-researched companies where we tend to invest.

However, caution is needed because this shift has created some bubbles in the small-cap sector. We have taken this opportunity to sell some of our investments that are trading on high valuations, as the risk profile of these has increased. We are moving to value investments as the risk-reward trade-off is looking better for value investments rather than growth investments at the moment.

In an overall economic environment that is directionless and showing limited signs of growth, we believe small-caps offer a better way to get some growth into your portfolio and expect them to continue to do well in this environment. We are cautious on the outlook for high price-earnings (PE) multiple companies as well as companies that are trading as “bond proxies”; that is, being bought for their dividend yield.

ASX Investor Update: Which small-cap themes do you prefer?

MG: We try to look for quality companies that are under-researched and not well understood. Often there is little research on these companies because while they number 1900 they are only 8 per cent of the aggregate value of the market. This year we have done well from investments from a diverse range of companies operating in different industries.

While we are generally stock-specific rather than thematic in our approach to investing, themes do emerge as a result of our bottom-up approach. Quite often an entire sector will fall out of favour with the market and our portfolio will reflect those themes.

This year we have benefited from small gold companies and mining services companies. We continue to like mining services companies that were oversold and some resource companies. We believe the healthcare sector is starting to look attractive after the recent sell-off. 

We believe there will also be a theme of corporate activity in the small-cap sector as large companies look to make acquisitions to supplement growth that cannot be found organically.

ASX Investor Update: What are some top small-cap holdings in your portfolios?

MG: We release the top five positions in our portfolio monthly. The top five last month were Mayne Pharma (MYX), RCR Tomlinson, (RCR), Retail Food Group (RFG), Altium (ALU) and Ausdrill (ASL).

ASX Investor Update: Why would investors choose a Listed Investment Company (LIC) for small-cap exposure?

MG: With so many small-cap companies to choose from, it is virtually impossible for an investor to effectively cover the entire small-cap market, especially if it is being done on a part-time basis. I think anyone with an interest in the sharemarket and investing should hold some small-caps directly. However, for a lower volatility and lower risk approach, buying an LIC that has exposure to small-caps is a good way to get exposure to the smaller end of the market. 

Professional managers spend a considerable amount of time speaking to management, looking at the operations of a company, talking with competitors and ensuring that everything is on track and that the company will not disappoint the market. If you get in wrong in small-caps the market can be unforgiving. Also, portfolio management is a unique skill in addition to picking stocks.

About the author

Michael Glennon is the founder of Glennon Capital, a specialist small companies investment manager. It launched a new small-cap Listed Investment Company (LIC), Glennon Small Companies Limited (ASX Code: GC1), in August 2015.

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