(August-2003) Small caps shine

In an increasingly competitive superannuation industry, small caps, typically neglected compared to large caps, may provide the much sought after boost to investment portfolios.

Having outperformed the broader market over the past year, smaller cap stocks are attracting attention. Many small cap fund managers note strong flows of cash coming into their sector over the past few months and research resources into small caps are also being boosted.

The S&P/ASX Small Ordinaries Index returned 3.7 per cent over the financial year to end June. This is compared to a 2 per cent drop in the large cap index, the S&P/ASX 100 Accumulation Index, and the 1.1 per cent fall in the broad market index, the S&P/ASX All Ordinaries Index.

Peter Gunning, chief investment officer at Frank Russell, observes that small cap stocks are not as widely researched by brokers and fund managers as the large cap stocks. “As a result, the small cap sector is less efficient, leaving more mispriced small cap stocks than large caps.”

More resources are being poured into researching small caps.

Morningstar reckons the Australian small cap market comprises some 66 individual funds that have a universe of over 200 securities to invest in.

Gunning recalls that “two years ago we did not research specialist small cap managers as the broad market managers provided adequate small cap exposure. As these managers have grown, they have become less able to invest in small companies”.

Morningstar, which ranks Perpetual Investments the strongest smaller companies fund manager, finds that style does not appear to have a strong correlation with benchmark outperformance in small companies funds management, with only three small cap fund managers having distinct styles — Perpetual (value), JBWere (growth) and Challenger (style neutral). Morningstar analyst Howard Tweedie argues that stockpicking in small companies is paramount “because, with only small teams, reliance is placed on individual portfolio managers. This, in turn, produces ‘key person risks’ that could affect future performance”.

Drawing on the US market, Gunning identifies the key factors benefiting small cap managers as being strong sell disciplines, managing expectational risk, robust idea generation, a high level of objectivity towards holdings, and an understanding of the importance of catalysts for changes to the market view.