(August-2001) Signs point to real growth

Smaller companies have had a rough ride since the start of 2000. According to Darryl Paul, who manages Macquarie’s small cap fund, the Small Ordinaries Index has been dragged down by the flood of hi-tech stocks which listed in the 1990s (growing to make up almost 30 per cent of the index’s weighting by April 2000) and which were battered last year when the dot.com bubble burst.

At that time too, adds Paul, concerns about the economy caused a flight to quality stocks (which tend to be the larger shares), leaving the sector languishing in the doldrums.

Not that this has been much of a problem for the superannuation industry, which has generally steered clear of small caps in recent times.

There are well over 60 Australian equities managers, but only about 17 managers of small cap funds. The majority of these have funds under management of less than $200 million, indicating that wholesale clients aren’t getting much exposure to the small part of the market.

Towers Perrin principal Andrew Kirk says many super fund investors were burnt by small caps in the early to mid 1990s and haven’t really ventured back into the water since.

They were lured into this part of the market by expectations that smaller businesses would show faster growth than others, and would reward them with a higher risk premium for taking a chance on them.

What killed this theory, says Kirk, was the surprise realisation in the late 1990s that smaller companies would not be able to keep up with their larger counterparts when it came to leveraging the benefits of technological advancements across their businesses.

At the same time, some investors have been put off by the volatility of small cap stocks and their sometimes wild performance fluctuations.

As BNP Paribas head of equities Brian Ingham points out, the degree of their downturns are generally more severe than the upswings. During 1999, when the broader industrial index rose by nine per cent, the small industrial index increased by 21 per cent. Conversely, as the growth in the total market moderated during 2000, the industrial index increased by three per cent, but the small industrial index fell by 21 per cent.

Over the longer term, however, US research has repeatedly confirmed that one can add value through small caps.

In addition to its higher risk premium, this part of the market is also less efficient, which means better opportunities to pick up mispriced stocks.

While the large cap stocks are researched by all and sundry, it is much harder to get information on many of the small companies, which opens doors for good stock pickers who are willing to get in there and kick the tyres before anyone else does.

Paul notes that this type of work has certainly paid off for small cap managers and helped them prove their ability to add value. While the Small Ordinaries Index rose four per cent in the year to end May, the 16 specialist managers in the Mercer Small Companies table produced a median return of 17.9 per cent. And, says Paul, these managers usually outperform the index by around 15 per cent.

A number of pundits, including Paul and Ingham, expect the Small Ordinaries to start picking up, along with the economy, next year, although they expect that it could be a bit choppy for the rest of this year.

Ingham says research by BNP Paribas has found that there is strong evidence to suggest that small company stocks perform well when economic activity is robust and liquidity is growing strongly.

“As growth starts to improve, the risk spectrum widens and investors tend to move away from more stable blue-chip companies,” he says.

He adds that stronger liquidity and stronger growth invariably go hand-in-hand, whether or not liquidity drives activity. So, not only is the risk appetite increased during an upswing, there are the funds available to finance greater risk activities - which all bodes well for the small cap sector.

BNP Paribas has found that small cap performance correlates strongly with the A$/US$ cross rate, resource stocks, the yield curve and credit spreads. And, this correlation suggests that investors in small caps need to carefully control their total portfolio risk, says Ingham.

“As for the current situation, the building blocks are in place for an improvement in small cap performance, particularly if the easing in monetary policy is successful in stimulating activity and raising monetary growth,” he says.

David Fleming, head of small cap at Rothschild, also believes that small caps can expect a reasonable time ahead of them in the absence of any economic disasters.

“We are coming into a period when trading conditions last year were particularly poor, so these companies are operating off a low base and are likely to show some profit recovery,” he says.

But not everyone is convinced. Chris Cahill, senior portfolio manager at AMP, believes that the outlook for small caps is presently “uninspiring” and he sees no end to their underperforming streak.

One reason is the current absence of IPO activity, which means a lack of new companies coming in to the sector, while, at the same time, those companies that have been successful are outgrowing this market and moving on to the mid cap sector.

He is a little more bullish, however, about the prospects for some of the basic industrial companies in the sector, such as the engineering stocks, which are likely to benefit from the economic pick up and various lucrative infrastructure projects being launched in some states, and by resource companies in Western Australia. That said, Cahill still expects the sector to continue to underperform the market.

Kirk says Towers Perrin believes that super funds wanting to get into small caps should do so for their diversification benefits, rather than for their growth opportunities (given their bumpy performance of late).

He also questions whether small caps are worth the trouble in Australia because the market is so small, noting that what’s beyond the ASX 200 is such a small part of the market that it doesn’t add more than two per cent to the investment universe.

But, he says, it’s a different situation overseas where the indices aren’t as concentrated with big companies as they are in Australia. That’s why Kirk recommends that investors looking to diversify their portfolios by gaining small cap exposure use a global manager.