Over the last five years, small publicly listed companies – including so-called microcap companies – have outperformed their Top 100 colleagues, according to the ASX’s own indices. While that’s some evidence that “from little things big things grow”, how did Australian microcaps go in 2007? What’s the outlook for them in 2008?

There’s something a bit exotic and exciting about investing in Australian microcap companies – the sense that you’re discovering an untapped ore of smaller companies that the mammoth institutional investors have somehow missed and/or undervalued.

But to truly gauge Aussie microcaps – approximately 600 ASX listed companies with market capitalisation of between under $100m and under $250m – Compareshares put its ear to the ground with Jonathan Rosham, CEO of Cygnet Capital, an investment firm specialising in microcaps.

Looking Back

With some 13 years of investment market experience in microcaps, and having produced returns of over 70% for his managed account private clients in the past 2 years, Rosham has this to say about the last one:

“2007 was a very good year – one of the three or four best years in my experience, for microcaps (which I define as companies with a market capitalisation below $200m). It was particularly strong for microcap resource companies and industrials leveraging the resource sectors. There were also some creditable outcomes in some parts of the bio-tech sector but in the main that sector remained unloved.”

In October, Rosham truly put his money where his mouth is. Cygnet launched its own microcap managed fund – the Cygnet Microcap Opportunity Fund – which is open to sophisticated investors with a minimum initial investment of $50k. While its early days, the fund generated returns of about 7% for investors since beginning investing in November 2007.

The 2007 results of other managed funds in the general small cap / microcap space mirror the good results:

1. Macquarie’s Small Companies Growth Trust came in at 47.61% for the year. Operating since 1998, this fund requires a minimum initial investment of $5K. The fund currently manages approximately $88.97m and it backs “a diversified portfolio of 30 to 60 small company shares”. Some of this Mac fund’s larger microcap holdings are health services provider Ramsay Health Care and engineers Downer EDI and Worley Group.

2. The Challenger Wholesale Microcap Fund reported an increased return of 32% to end September. Among the biggest contributors to the fund’s success were manganese miner OM Holdings, gold miner Dominion Mining, and driller Swick Mining Services.

3. The AMP FLI – AMP Small Companies fund finished off 2007 with a 32.8% return. A long-term player open since 1989, the fund has no minimum investment requirements. It has some $157.7m on its books which it puts to companies “outside the top 50” listed on the ASX. Wool trader AWB Ltd and plumbing manufacturer Reece Australia Ltd are marginally of this AMP fund’s two heaviest microcap holdings.

4. The Australian Unity Acorn Microcap Trust brought the year in at 28.73%. With doors open since 2002, this fund requires a minimum initial investment of $1K and minimum additional investments of $500. Acorn has some $15.63m going into a “diversified portfolio of listed Australian shares from outside the top 250 by market cap”.

Lest you think that microcap funds are solely aimed at individual investors, think again. Indeed, it’s interesting to watch the experience of the big kids in the playground in 2007.

As one example, Contango Microcap is a listed investment company specialising in the microcap sector – which in their case is companies outside the ASX 300 Index. Among Contango’s major shareholders are giants like UBS Warburg, National Australia Bank, and Citigroup. First listed at $1 per share in 2004, Contango Microcap’s share value has traveled from $1.91 to $2.33 to $1.77 over the last six months – which says something about the sector’s volatility and exposure to general trends.

Looking Ahead

When microcaps are put under the microscope for 2008, they continue to continue to look good, according to Cygnet’s Rosham. He says: “I remain optimistic. There are some specific challenges around – such as increasing costs in the resources sectors due to capacity constraints including infrastructure, port access and skills shortages – – but if you are selective you can still make money in microcaps.”

How? According to Rosham, it’s about being “more nimble and more aggressive. Working in microcaps is unique and not like investing in larger capitalised companies. To invest wisely, you need to know companies’ management; you really need to know who’s who in the zoo so you can even get access to quality deal flow from an investment perspective.

“It’s all about our internal research with specific industry experts. There is no science or computer based model to investing in microcaps – it’s an art. Anticipating and evaluating investment opportunities and then translating it into positive results for clients is the key,” Rosham said.

What kind of positive results? For his own fund, Rosham sets a broad horizon of potential returns above the All Ordinaries index. “We need to achieve results above the All Ordinaries index to justify the higher levels of risks our clients are taking,” he said.

Cygnet’s website transparently states the pro’s and con’s as it sees them of microcaps. On the positive side, it lists:

1. High returns: microcaps often move early in a cycle and can grow rapidly.

2. Value-add opportunities: through dedicated research, portfolio managers can add value to microcap portfolios by locating undervalued stocks.

3. Under-researched: the microcap investment universe is vast and under-researched, allowing specialists to take opportunities before the larger institutions do.

Cygnet also puts up a few warning signals, including volatility, advising that “micro-caps are volatile by nature and while strong on the way up, they can suffer more in a downturn (with) sector expertise required to navigate this risk.”

Rosham explains that “the volatility leads to lack of liquidity at times in our space”, but adds that genuine microcap players should be longer-term investors.

Bottom Line

Depending on how you count, the top 100 companies might account for nearly 80% of the value of the ASX. While this leaves hundreds of microcaps and other smaller companies somewhat out of sight, it may pay to have a fund manager hold a good spotlight for you if you’re going after them.

Some “Micro-Tips”

1. Be clear about the definitions. In Australia, investment professionals tend to define companies with a market cap of under $100m to under $250m as microcaps, whereas the US approach can even include companies under $1b. Different managed funds have different approaches to categorizing small and/or microcaps.

2. Compare apples with apples. When you are looking to benchmark or compare the performance of microcaps, be aware that the widely used measure of the performance of small Australian companies – the S&P/ASX Small Ordinaries Index – includes both microcaps and non-microcaps. See Tip 1 above!

3. Manage the risk. One option for taking some of the “specky” out of playing the “speckies” is to direct your microcap investment through specialist funds of which there are now several.