Small-cap stocks – time to revisit?

Photo of Michael Glennon By Michael Glennon

min read

Small-cap stocks appear to be out of favour. There is a groundswell behind diversifying portfolios into international share funds and other asset classes, beyond small-caps.

But it’s probably time to revisit the small-cap sector. Following the herd never makes money and sometimes keeping it simple and being rational is the best policy to produce good investment returns.

(Editors’ note: Definitions of small-cap stocks vary. Many fund managers use the S&P/ASX Small Ordinaries index, which measures stocks ranked 101-300 by market capitalisation, as the proxy for small-cap performance.)

Asset consultants from some of the largest industry superannuation funds have a permanent allocation to small cap funds. The reason is they know that good investment managers have the ability to consistently generate strong returns and they also understand the characteristics of the small cap market.

On the surface, if you look at the returns from the Small Ordinaries index relative to the ASX 100 index, the returns look poor over five or even 10 years. However, if you delve deeper into what has happened by looking at the composition of the index, a different story emerges.

Making blanket statements about small caps underperforming large caps does not show why that has happened or what has been happening in the small-cap space. Too many investors have decided that small caps are “broken” and thrown the baby out with the bathwater.

The chart below compares the performance of small industrial and resource stocks to the ASX 100.

Figure 1, Source: CapIQ

At Glennon Capital, the returns from the past three years have been the best since setting up in 2008 in a market where the small-cap index has underperformed the ASX 100 index. Returns have outperformed both the small and large company indices over that time.

To understand why, you need to know a bit about the small-cap market. There is more to it than just the 200 companies in the small cap index. There are more than 2000 companies listed on ASX and nearly all the companies outside the top 300 listed companies are under-researched.

The market is also dynamic: there are new companies listing on ASX, others being taken over, and others making acquisitions and management changes. This creates a situation where the market is constantly evolving and new opportunities arise every day.

What happened in small caps

At its peak towards the end of 2010, small resource companies made up about 48 per cent of the Small Ords index after strong performances since 2003. Their subsequent underperformance has resulted in their weighting falling to 16 per cent of the Small Ords index. If you remove the impact of the small resources stocks and just look at small industrials and the top 100 since 2010, both indices have performed in line with each other on a price basis, as can be seen below.

Figure 2, Source: CapIQ

Therefore, by avoiding the small resources companies there has been no difference between small and large companies over the past five years. One thing the chart above demonstrates is that there is a case for active management in small caps. If you had a fund that just tracked the small cap index you would have underperformed as a result of the resources exposure.

There is risk involved in investing in small caps. It is an important sector to generate strong returns but you need to understand how to control the risk and manage a portfolio of risky assets. Small-cap stocks lend themselves to having a specialist manager who has the time to go and see a lot of companies every year and pick the best and risk-weight their investment size in a portfolio.

My personal view is there is less risk in investing in Australian small caps with a professional manager than there is in investing in international shares. The simplest reason is that domestic shares do not have the volatility of being subjected to foreign exchange gains or losses.

The China factor

There is a perception that the Australian economy is going to be weak because of the slowdown in China, which is being used by promoters of international share funds at present. The argument just reinforces that investors should have some small cap exposure.

If Australia’s economy is going to be adversely effected by the reduction in the commodity sector, those very large Australian companies that already represent a significant share of consumer wallets will struggle to grow at rates faster than the rate of growth of the Australian economy, which is currently around 2.5 per cent.

Two things will occur. First, low interest rates stimulate growth in an economy; second, a low dollar makes our exports more attractive to foreign buyers (we don’t just export commodities). It also makes Australian assets cheaper to buy, so foreign companies will be making takeover offers in Australia.

With this in mind, there are companies we believe will benefit from both a low dollar and low interest rates. As a final note on that point, exports of non-resource-related goods and services, which are significantly larger than resource-related exports, are still growing and now there are government policies aimed at helping the economy grow.

Optimal timing

Now is an optimal time to be deploying cash into Australian small caps, based on the following factors:

  • Expansionary monetary policy stimulating the economy.
  • Not buying at the top of the market: the small cap index was flat over the past five years.
  • There is an asset price bubble in housing and infrastructure.
  • Small companies are not as perfectly priced as big companies and there is a lot of value that can be uncovered.
  • Smaller companies can react quickly to developments in the economy.
  • Recent changes in the Significant Investor Visa (SIV) will see an estimated $1 billion inflow into small cap funds each year.

About the author

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

From ASX

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