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Julian Beaumont
Bennelong Australian Equity Partners
Look to smaller companies for higher returns and genuine diversification – but beware the risks.
It is commonly assumed that if you want a higher return you need to take on more risk. But consider the following table.
1-year return | 10-year return p.a. | 10-year volatility* | Forward PE multiple | Dividend yield | |
S&P/ASX 20 | 23.4% | 7.8% | 12.1% | 17.1x | 4.6% |
S&P/ASX 50 | 27.4% | 8.6% | 11.4% | 17.2x | 4.3% |
S&P/ASX 100 | 26.9% | 8.7% | 11.4% | 17.0x | 4.1% |
S&P/ASX 200 | 26.1% | 8.5% | 11.4% | 17.0x | 4.0% |
S&P/ASX Small Ordinaries | 21.7% | 4.6% | 14.5% | 17.5x | 3.1% |
S&P/ASX Emerging Companies | 33.6% | 1.9% | 17.8% | 8.7x | 1.5% |
Source: S&P Indices at 29 November 2019. *Volatility is based on the standard deviation of monthly returns.
Over the past 10 years, returns have actually been inversely correlated with risk, as measured here by volatility .
The table shows:
(Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this story).
What gives?
In our view, these results can be explained by the overall quality of the underlying stocks.
Quality can be thought of as the strength of a company’s competitive position, management, corporate governance and balance sheet. Fundamentally, these are the attributes that govern both the risks and rewards of owning stocks. On both counts investors are better off with higher quality.
The ‘sweet spot’
Most investors assume they need to compromise on quality if they choose to invest beyond the large-caps. However, mid-caps are a sweet spot on ASX where there is still the quality but also more potential upside from generally better growth prospects.
There are other benefits as you move further down the market:
What about small-caps?
It is really only when you move down deeper into smaller-cap stocks that quality starts to become an issue.
Small-caps, including micro-caps, represent a very diverse range of stocks: the good, the bad and the ugly, in roughly equal measures.
In aggregate they underperform over time; but it is also where you will find some of the best opportunities.
Taking a selective approach means you can do wonderfully well, as seen in the Bennelong Emerging Companies Fund (mFund: BAE05).
The opportunity
Small-caps can offer spectacular growth – particularly given their less mature businesses – and this can supercharge returns.
This was on show in 2019 in a remarkable willingness on the part of investors to pay up for growth, most clearly seen among fintechs, biotechs and other tech names offering disruptive growth.
Stock | FY19 growth | 1-year return |
Audinate | 44% | 147% |
EML Payments | 37% | 205% |
Jumbo Interactive | 64% | 138% |
Nearmap | 45% | 75% |
Polynovo | 128% | 200% |
Pro Medicus | 48% | 148% |
Zip Co | 108% | 250% |
Source: Company reports, IRESS at 29 November 2019.
The risk
In large part because of stocks like these, the Emerging Companies index returned approximately 34 per cent over the past year.
However, we know this group of emerging companies underperforms over time and their volatility means higher highs and lower lows. To this end, smaller-cap stocks are particularly sensitive to investor sentiment and investment flows.
This is most pronounced in whatever is “hot”’ at the time – shale oil, 3D printers, lithium or tech. Hype builds, valuations stretch and stock prices can overshoot. We saw signs of this in late 2019, with Nearmap, Jumbo and Pro Medicus all falling a third from their highs, albeit with still stellar returns for the year.
It is a lesson for investors to be wary of the hype.
How to sort the wheat from the chaff?
Again, it all comes down to quality – in our experience the least risky and most reliable guide to accessing the outsized returns available.
small-cap investing is as much about what to avoid as what to own. After all, more than 60 per cent of all small caps delivered a negative return over the past 10 years, leaving less than 40 per cent from which to make money.
Genuine diversification
An important benefit of small and mid-caps is the diversification they offer.
Many large caps represent much the same thing. For example, 11 of the top 20 stocks are mature, domestic-only oligopolies, with limited growth in Bennelong’s view but large dividend payout ratios . Think Commonwealth Bank, Woolworths and Telstra.
In contrast, smaller caps offer far greater diversity of investment propositions and this allows more genuine opportunity to diversify. This includes:
At present, Bennelong sees more interesting opportunities in global companies than the largely domestically focused top 20. Particularly interesting are those profitably leveraging an “exportable” competitive advantage such as a brand or intellectual property into far greater growth potential offshore.
Examples include Treasury Wine (which owns the Penfolds brand), Aristocrat (video and slot games), Breville (new appliance designs) and IDP (with its dominant IELTS English-testing business).
Attractive valuations
Smaller stocks have historically traded at a premium to large caps because of their stronger growth prospects. Today this premium is as small as it has been for decades, even though these stocks continue to offer far superior growth.
From the earlier table, mid-caps are trading on a PE multiple of 17 times, on a par with large-caps, while small-caps are just half a PE point higher.
Given relative valuations between the two historically mean revert, the implication is that small and mid-caps should outperform large caps from here.
That said, it is wise to consider the key message of this article: it pays to be particularly selective, especially with small caps.
To that end we would recommend a focus on quality and to watch out for any hype.
About the author
Julian Beaumont, Bennelong Australian Equity Partners
Julian Beaumont is Investment Director at Bennelong Australian Equity Partners.
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