Our market just wants to go down, page-7

A good read

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SMART MONEY
Smallcaps can they continue to defy gravity?
Apr 20
Craig James

The pundits are in broad agreement: the Australian economy is doing well. Even The Economist, the respected international journal, comments on the down under "wonder" economy.

The beleaguered global economy is also starting to improve, although the likely pace of the upturn remains unclear.

So what does the brighter economic picture mean for investors? According to strategists, it means that investors can widen their horizons, with many recommending they take a look at the small companies segment.

This segment is generally known as small caps companies of relatively small size or market capitalisation compared with the overall sharemarket.

The key benchmark of the smallcap sector is the S&P/ASX Small Ordinaries Index, which includes companies in the S&P/ASX 300 Index, but not the S&P/ASX 100 Index.

While the Small Ordinaries is the preserve of small caps, the S&P/ASX 100 is the key benchmark of their largecap cousins. The size differences are quite substantial. Market capitalisation of the Small Ordinaries Index stands at $60billion, about onetenth the size of the S&P/ASX 100 Index.

But, as you'd expect, size is not the only notable difference between small and large caps; the characteristics of the companies also vary markedly.

A key difference is that small caps are generally focused on growth or narrowing the size gap with their larger competitors.
The best environment in which to achieve this is one in which consumer and business spending is accelerating, fuelling faster growth of the economy effectively, a time like the present.

According to Tim Rocks, an equities strategist at Macquarie Research, the strong domestic economy and improved global prospects mean that the planets have moved into alignment for small caps.

"We believe the outlook is very positive for small caps," Rocks says. "Small caps always do well as growth rebounds because investors are willing to take on more risk, and this inevitably leads them into smaller companies.

"This is particularly true this time because as a generalisation, of course large caps have spent the past few years reducing risk profiles by focusing only on core businesses and removing satellite businesses that might provide growth options at some point in the future."

And investors appear to have heeded strategists' views, with small caps rebounding in the aftermath of the September 11 terrorist attacks.

Initially, share prices fell following September 11, not just in the small-cap sector, but across the board, reaching a trough on September 24.

But investors soon realised that central banks would do everything in their power to support market activity. In the more positive environment of the past few months, the Small Ordinaries Index has risen 8 per cent more than double the 3.7 per cent gain registered by the S&P/ASX 100 Index.


While small caps have outperformed in recent months, the improvement has been from a low base; on September 24, 2001, the Small Ordinaries was at its lowest level in more than six years. This highlights one of the key risks for investors in small caps: volatility.

The Small Ordinaries Accumulation Index (which measures capital and dividend returns) has fallen in two of the past seven years (1997 and 2000), while the big-cap S&P/ASX 100 Accumulation Index has improved each year. There have been feast as well as famine years, with small caps significantly outperforming large caps in 1996 and again in 1999.

Over the past seven years, however, small caps have underperformed. The Small Ordinaries Accumulation Index showed returns of 7.8 per cent each year on average while big caps, as measured by the S&P/ASX 100 Accumulation Index, returned 13.5 per cent each year.


Small caps have not only tossed and turned amid the vagaries of the economic cycle, they also have experienced the highs of the technology boom and the lows of the tech wreck. This highlights yet another consideration for investors in the small-cap sector: the higher risk of business failure, particularly evident during the 1999-2000 technology boom.

According to the CommSec small companies team, enthusiastic investors embraced the 52 tech company floats in 2000. There was somewhat less enthusiasm about the 10 IT floats last year. The lack of revenue certainty or cash burn proved the undoing of many, with only nine of the floats over the two years trading above their issue price today.

The vulnerability to business failure and increased share price volatility are two of four risks highlighted by fund manager Rothschild Asset Management in a recent presentation on the small-cap sector.

The third risk concerns liquidity. The smaller number of active buyers and sellers for a small cap may pose difficulties for individual investors. In particular, this may present a problem when an investor is trying to sell shares in a falling market.

The fourth risk identified by Rothschild is that investors may have difficulty in obtaining information on small companies either from the company itself, or market information produced by brokers.

So has this combination of higher risk and variable returns turned you off investing in smaller companies?

Well, there is an alternative. Rather than wading into the small-cap waters yourself, you may prefer to leave it to a fund manager.

There are about 15 major fund managers active in the small-cap arena, taking on the significant responsibility of researching and selecting stocks on behalf of individual investors. Evidence accumulated by investment research company van Eyk (see table above) shows that small-cap fund managers have had considerable success in the past three years.


"Our survey of small-cap managers has confirmed that the small-cap market offers strong potential for high returns. All 15 styles [13 managers] that we have analysed have produced strong returns, significantly outperforming the broader universe and the small-cap index [Small Ordinaries Index]," van Eyk notes.

It found that the fund managers generated returns of about 23.8 per cent a year in the three years to December 31, 2001, outperforming the Small Ordinaries Index, which returned an average 2.8 per cent a year over the same period.


As well as having the performance runs on the board, fund managers may be better placed to take advantage of new opportunities.

Paul Hannan, a senior manager at Rothschild, has noted that small companies raised $4.1 billion over the past 18 months, either in initial public offerings or floats and secondary market capital raisings such as placements or rights issues.

However, over that period small companies have increasingly focused on placements, which tend to be targeted at the professional, rather than retail, market.

While floats have not dried up, individual investors have had significantly less choice in terms of new opportunities.

Hannan believes that the IPO market will remain subdued over the next six months, but says investors are not being starved.

"What is hot at the moment is the small-cap resources market, with more than 20 IPOs in the past few months. This highlights the cyclical nature of small caps: they raise money when they can, and they are playing on the global cyclical theme," he notes.

The more positive outlook for the global economy certainly has lit a fire under the Small Resources sub-index of the Small Ordinaries. Over 2002, the Small Resources has risen more than 15 per cent, while the Small Industrials has fallen 1 per cent.

Looking ahead, strategists believe that the environment will remain favourable for small caps in both the industrial and resources sectors.

Researchers at Macquarie and Salomon Smith Barney particularly favour small caps exposed to the non-residential construction cycle.

But Lidia Ranieri, the director of research sales at Salomon, voices a view that is widely shared by strategists and fund managers alike: "While macro overlays [such as examining prospects for certain sectors] are useful in identifying baskets of stocks that may include strong performers, stock selection remains the key.

"In the final assessment, the same qualities that make a great mid or large cap will apply to small caps strong cash generation, solid balance sheet, sound management and attractively valued earnings growth."

Salutary advice, not just in the small cap arena but for the stockmarket generally