As a whole, small caps have generally performed well over the last several years, although performance has been down of late due to market volatility. However, a clearer picture of the capitalisation-defined sector emerges when we look at the resources and industrials subsectors.
Paul Biddle of small-cap boutique specialist Celeste Funds Management describes the performance of the small-cap market in recent years as “a binary tale in nature, with a euphoric resource sector and a catatonic industrial sector.”
Likewise, Lin Ngin, Senior Investment Analyst with Lonsec Ltd., noted that “the S&P/ASX Small Industrials Accumulation Index returned just 2.2%, while the S&P/ASX Small Resources Accumulation Index returned a strong 30.7% return for the year.”
The Lonsec review found that the “average” small cap manager in its universe is underweight the resources sector, largely due to a “quality” bias in their investment process. “This can be incompatible with small cap resources stocks where the company may not be generating cashflow or earnings, or may be a higher risk, single mine business,” said Ngin.
Small-Cap Funds Slipping on Volatility, but Still Likely to Outperform Index
Looking at small-cap performance in recent years, Chris Becker, co-founder of Empire Investing, said that “the only area of decent outperformance are the small-cap funds, which are more likely to outperform their benchmark index, the S&P/ASX Small Ordinaries. Over the last 5 years, 70% of small-cap funds have managed to do better than the index, with the outperformance averaging 2.4% p.a.” However, Becker noted, “this is a relative outperformance for an index that has given overall negative returns so even the small-caps have lost money over the last few years.”
More recently, said Michael Hevern of TraderDealer.com, “We saw the market volatility spike in March due to the Japanese disaster, but the market has undergone a stellar recovery from the lows of the severe sell-off. March performance has been flat across the board, which is surprising given the huge sell-off triggered by the Japanese disaster. However,” Hevern said, “the small caps and mid caps underperformed and finished in the negative, indicating that investors are becoming more risk-averse due to the market volatility.”
Continuing his “binary tale,” Celeste’s Biddle noted that valuations in the small-cap industrial sector were at decade lows in many instances. “As the markets focus moves into financial year 2012,” Biddle said, “small-cap industrial valuation multiples and fully franked yields of more than 5 per cent are compelling. Earnings per share growth expectations amongst the small-cap industrials appear achievable at 7 per cent in financial year 2012.” However, Biddle warned of overly optimistic predictions for performance by small-cap resources. “Earnings per share growth expectations for the small resource sector of more than 90 per cent for financial year 2012 appear excessive and prone to negative revision.
Despite the outstanding performance of small-cap resource stocks, Paul Taylor, Portfolio Manager of the Fidelity Australian Equities Fund, suggested that the best investment opportunities in the mining sector are in the big miners, saying he preferred them over the small-cap miners. Taylor explained, “Right now all the miners – big and small – are trading on similar multiples, which is unusual. History tells us that the big miners such as Rio Tinto and BHP Billiton should trade at significant premiums to the small-cap miners because they have diversified earnings streams and quality management, are proven operators and own the tier-one assets – the low-cost, long-life mines. They should trade at a premium to the small-cap miners.” Yet that doesn’t describe market behaviour, said Taylor. “When commodity prices are rising, the market generally gets excited about small-cap miners.”
Limited IPO Activity
The market for small-cap IPOs has echoed the division in performance between resources and industrials. 2009 was a relatively quiet year, seeing just $7.5 billion in IPOs across large and small caps. While 2010 saw $25 billion in IPOs, most was in large caps – or small resources.
“The lack of new industrial stocks is of some concern,” commented Ngin. “This is compounded by the departure of some industrials, such as JBHiFi, which became a midcap stock and therefore out of the investment universe for most small cap managers.”
NovaPort Premier Smaller Companies Fund portfolio manager Sinclair Currie also observed that there have been fewer floats in the small caps industrial market compared with the resources subsector. “I think that’s been another factor contributing to the rise in the resources weighting of the small caps sector,” Currie says. “Private equity is much more of a competitor to the stock market than it ever was. Private equity will buy companies that probably would have floated, at premium prices, and that has disrupted the flow of companies to the stock exchange.”
More News from the Small-Cap Sector
Morningstar’s Tim Wong announced on 15 April 2011 that the Co-Portfolio Managers of UBS’s Australian Small Companies fund, John Campbell and Jeremy Bendeich, had resigned. “These departures were a blow” said Wong. “We’d considered Campbell and Bendeich to be competent, high-conviction investors, and team depth was a strength.”
UBS moved quickly to replace the departed managers, however, and recently announced the appointment of Victor Gomes as portfolio manager for its Australian Small Companies Fund. Gomes has 17 years investment management experience, and will co-manage the Small Companies Fund alongside Stephen Wood, UBSGAM said. “We are delighted with this high calibre appointment that will strengthen our Small Companies team and broaden its capability,” UBSGAM Australia and New Zealand head Ben Heap said. “Victor’s strong experience and successful track record in absolute return all-cap investing will further enhance our client offering.”
Meanwhile, the Australian Securities Exchange (ASX) is conducting an SME, Mid-Cap and Micro-Cap Equity Market Review with the aim of better meeting the needs of issuers and investors outside the S&P/ASX200. In March, ASX released a Consultation Paper outlining their findings of the first stage of the Review which included a comprehensive analysis of the ASX market from a market capitalisation perspective.
Following the completion of the second stage of the Review, ASX will stgelop a series of recommendations and potentially consider listing and trading rule changes in relation to a wide range of issues, including the establishment of a separate small cap exchange.
Sarah Dulhunty and Elizabeth Hourigan, attorneys with the firm of Blake Dawson, noted that
“Australian market operators have previously responded to the needs of an identified market segment with second boards. Second boards tend to differentiate from the main stock exchange on the basis of listing rules (eg admission requirements), the capital raising regulatory environment and compliance arrangements. However, the Consultation Paper reports that preliminary soundings by ASX suggest that there is currently little demand from listed companies for the reintroduction of a second board in Australia.”
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