(June-2002) Good things in small packages?

Three managers - Ausbil Dexia, BT Funds Management and Perennial Investment Partners - have joined the tight ranks of the Australian small cap manager universe this year, hoping to offer investors a viable alternative as hopes for double digit returns from the broader equities market fade.

Small caps have been an attractive part of the local landscape, enjoying a return of 14.2 per cent in the year to end March 2002. And, specialist small cap managers have done even better, with an average return of 16.5 per cent.

While small cap managers have experienced difficult market conditions recently, industry experts expect them to offer better returns than the broader share market in the medium to long-term.

Darryl Paul, small companies portfolio manager at Macquarie Funds Management, says a large number of profit revisions occurred in April and early May, affecting the short-term performance of small caps. Nonetheless, he still expects some out-performance from the sector over the medium-term.

“Given that moderate economic growth is expected to continue despite interest rates rising, this pull back provides attractive entry to the sector,” he says.

Perennial Investment Partners’ CEO Ian Macoun agrees, noting that now is a good time to include or increase exposure to the sector because it still offers good value.

“The economy appears to continue to do well, including the global economy, and these are conditions in which smaller companies tend to do pretty well, providing the economy does not become over heated,” he says.

“If it does, interest rates can go up a lot and that is damaging for smaller companies, but we don’t see it being a likely situation at this stage,” he adds.

The level of initial public offer (IPO) activity has dried up in recent times, which can limit the opportunities for small cap managers, but this is not expected to inhibit their overall performance.

Head of investment research at van Eyk Research Tom Cottam says although IPOs do help, they don’t have much influence over the results and don’t take managers to double digit growth returns.

Rothschild Australia Asset Management senior manager small companies Paul Hannan adds that the events of September 11 and the technology downturn in 2000 have left many smaller investors weary of IPOs.

What is becoming more common, he says, are capital raisings in secondary markets. Indeed, $2.1 billion of the total $4.4 billion funds raised by small caps over the past 18 months came from secondary markets, while rights issues only accounted for 14 per cent.

BT Small Companies portfolio manager Brian Eley says: “Value stocks have had a terrific performance in the last 12 months, but the market is now questioning the next 12 months, asking whether this sort of performance can be expected to continue.”

“Fundamentally, these companies are reasonably low quality that is why they are on a low PE ratio in the first place. But at the same time, no one is brave enough to jump on the growth band wagon right now.”

Eley adds that the market is currently looking for confirmation of solid earnings growth and he expects some volatile months of performance until the reporting season starts in August.

Small caps have an average market capitalisation of $314 million, compared to the $6.3 billion of ASX 100 companies. They are generally less liquid than bigger stocks and their performance is more volatile, with their downturns generally more severe than their upturns.

“By their nature, smaller stocks get knocked a bit more by economic conditions than their larger counterparts,” says Perpetual smaller companies portfolio manager Matt Williams.

They are also riskier than larger companies because they don’t have the same diversification of earnings streams. The loss of one client, for example, can be devastating to a small company.

On the other hand, smaller shares are less researched by analysts, allowing small cap managers to take advantage of market inefficiencies.

“Although small caps are largely caught with the leader market, the most important point to make is that within small caps there are still a lot more cheaper stocks than in the overall market and you will find far more bargains in small caps than within the large caps,” says Cottam.

Small cap managers have certainly been proving their ability to do better than their index. A recent study by van Eyk Research found that all 13 managers and 15 styles examined outperformed the small cap index in the three years to end-December, 2001.

Van Eyk Research associate director Dragana Timitojevic adds that these managers averaged returns of 23.8 per cent, outperforming their index by 2.8 per cent and the broader equities market by 12 per cent a year over this three year period.

Small cap managers are also able to change their portfolios faster and more easily than larger managers when they need to.

Ausbil Dexia CEO Reub Hayes, however, argues that the “sweet spot” of the Australian market at present is the small to mid cap market. This includes companies from 51 to 200 by market capitalisation, rather than the traditional small cap domain of companies from 101 to 300.

“The niche, mid-small cap sector is characterised by companies which are starting to hit their serious growth phase, giving investors access to expanded opportunities and greater potential,” says Hayes.

He adds: “Below 200 stocks, there is serious liquidity concerns and the benefit in investing is more than negated by the cost of illiquidity the stocks display.”

Nonetheless, a separate small cap allocation isn’t the way to go for every super fund.

Mercer Investment Consulting executive director Tony Cole says most funds want to keep things simple and part of this is not to have too many managers. If funds want a small caps exposure, they will use one of their generalist equities managers.

“But for larger funds that have focussed on performance, having a dedicated small cap manager would be a reasonable way to go,” says Cole.