Lonsec releases its Small Cap Australian Equity Sector Review

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Lonsec’s review of the Large Cap Australian Equity Fund sector encompassed 36 active funds across traditional small cap, mid cap and micro cap funds. Lin Ngin, Senior Investment Analyst responsible for this review explains the difference between these funds.

“A traditional small cap fund invests primarily in the S&P/ASX Small Ordinaries Index, where a mid cap fund invests predominantly in the S&P/ASX51-150 segment.”

“Lonsec reviews five microcap funds, which typically invest in small stocks outside the S&P/ASX Small Ordinaries Index. Microcap stocks are generally a relatively immature business, offer the highest level of risk and are usually quite illiquid – but potentially offer the highest level of growth opportunity.”

Of the 36 funds reviewed, five attained Lonsec’s top rating, Highly Recommended; one midcap fund, the Ausbil Australian Emerging Leaders Fund and four small cap funds – Hyperion Small Growth Companies Fund, Pengana Emerging Companies Fund, Schroders Australian Smaller Companies Fund and the UBS Emerging Companies Fund.

“Six new funds were added to Lonsec’s small cap Australian equity universe in this review, including two microcap funds, the Ausbil Microcap Fund and the Macquarie Australian Microcap Fund,” said Ngin.

Sector observations

Strong gains….if you were in the right place

“The S&P/ASX Small Ordinaries Accumulation Index gained a solid 13.1% in 2010 – a far cry from the 53.2% loss in 2008 and the 57.4% gain in 2009,” observed Ngin.

“However there is a mixed story – 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.

Midcap stocks continued to struggle compared to small cap stocks, with the S&P/ASX Midcap 50 Index returning just 4% in 2010. In contrast, funds that were able to invest in the other end of spectrum in microcap stocks were the strongest performers, with the S&P/ASX Emerging Companies Index returning 25.7% over the same period.

Limited IPO activity in this sector

Historically, IPOs have been a major source of investment ideas for small cap managers; however 2009 was a relatively quiet year with 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.”

Other IPOs – such as Rebel Sport – have been put on the backburner after the lacklustre performance of high profile industrial IPOs such as Myer, Kathmandu and QR National.

Fund flows continue to be flat

While funds under management continued to grow, this was largely due to market movement – actual inflows were relatively flat. This is consistent with the findings of Lonsec’s recent large cap review.

“Unlike the large cap sector, the small cap universe has not been subject to competition from low cost ETFs and index style products,” said Ngin.

“These products are much less likely to impact the small cap universe as the argument for passive index style products is substantially weaker in this sector.”

IMPORTANT NOTICE: The following relate to this document published by Lonsec Limited ABN 56 061 751 102 (“Lonsec”) and should be read before making any investment decision about the product(s). Disclosure at the date of publication: Lonsec receive a fee from the fund manager for rating the product(s) using comprehensive and objective criteria. Lonsec’s fee is not linked to the rating outcome. Lonsec does not hold the product(s) referred to in this document. Lonsec’s representatives and/or their associates may hold the product(s) referred to in this document, but detail of these holdings are not known to the Analyst(s). Warnings: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to “General Advice” and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek further advice on its appropriateness. If our General Advice relates to the acquisition or possible acquisition of particular financial product(s), the reader should obtain and consider the Product Disclosure Statement for each financial product before making any decision about whether to acquire a product. Disclaimer: This document is for the exclusive use of the person to whom it is provided by Lonsec and must not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by Lonsec. Conclusions, ratings and advice are reasonably held at the time of completion but subject to change without notice. Lonsec assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, Lonsec, its directors, employees and agents disclaim all liability for any error or inaccuracy in, or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

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