van Eyk Research has awarded three funds its top rating in a new review of the small cap sector in a strong field of managers, all of which have a consistent record in beating the benchmark index.
van Eyk considered a total of 29 strategies in the review, awarding three strategies its top ‘AA’ rating. There were also eight ‘As’, nine ‘BBs’, and two ‘B’ ratings awarded.
Five strategies were screened and two refused to be rated.
Separating the best managers from the rest were a stricter attention to stock valuation, superior knowledge of the small sector and individual stocks and an intimate understanding of what causes a stock to re-rate, which is central to successful small caps investing.
Lead analyst on the review Varun Venkatraman said it was a strong field. All the strategies reviewed outperformed the S&P/ASX Small Ordinaries index over a 1-5 year time frame.
The AA-rated managers also all outperformed the S&P/ASX200 over the same time frame.
“It’s a highly competitive peer group, much more so than the large cap sector” Mr Venkatraman said. “It reinforces our belief that over the long term there is good potential for these managers to generate excess returns for investors.”
The ability of managers to identify quality companies was key to their rating but in the small caps sector this is particularly important given it is relatively under-researched by the market compared to the large cap sector. Managers that are able to definitively identify strong balance sheets, superior management and defendable earnings streams are more likely to outperform.
“This also means that a manager has to have a very broad knowledge of the sector,” Mr Venkatraman said. “The composition of the small caps index changes relatively quickly and managers have to keep on top of who is in the investable universe.”
Small cap managers often have a closer relationship with the management of a company whose stock they own not only because these companies tend to be more approachable than larger companies but also because it is frequently necessary to get enough information on the company.
A rigorous approach to the valuation of stocks was also critical as well as a thorough knowledge of potential triggers for a company’s stock be re-rated by the market. “Finding companies that are undervalued and knowing what changes will likely lead to a price correction is an important skill in a successful small cap manager,” Mr Venkatraman said.
van Eyk has a bias towards small cap managers that are “benchmark unaware” given the potential for deriving excess returns from the sector. That is, the managers are not subject to strict stock and sector limits and are free to exploit investment opportunities to their fullest.
van Eyk also considers the level of funds under management important when rating a manager because managers must remain small enough to be able to quickly and easily take advantage of new investment opportunities.
Many managers believe that about one per cent of the Small Ords index is a suitable capacity limit. “We believe this may be somewhat on the high side,” Mr Venkatraman said. “We are more comfortable with 0.5%-0.7%.”
