Research house Lonsec said small companies posted modest gains of 6.6% during 2012, a welcome improvement on the negative 21% returns of the 2011 year.
The majority of managers in the Lonsec small cap peer group considerably outperformed the benchmark in 2012.
The Lonsec Small Cap Australian Equity Sector Review observed that while small caps recorded a reasonable return, they again underperformed large caps for the year with the broader S&P/ASX 200 delivering a healthy rise of 20.3% for 2012.
“This trend is not unexpected given the more volatile nature of small companies compared to larger peers,” said Steven Sweeney, Lonsec Senior Investment Analyst.
“Small caps will tend to outperform larger caps in periods of more buoyant market sentiment while experiencing more downside weakness when markets are troubled.
“With risk appetite remaining relatively constrained, investors were more comfortable chasing high yield and defensive large caps during 2012 than venturing too heavily into small caps,” Mr Sweeney said.
Should risk appetite improve as appears the case in the current climate, it presents an opportunity for investors to revisit their small cap allocation.
Investment management team stability has been uncommonly positive in the past few years, a beneficial aspect of the bear market, with personnel more likely to be preoccupied with existing responsibilities versus eyeing greener pastures. The prevalence of boutique investment platforms in the sector with high alignment of interest and investment team buy-in has also improved stability.
One factor identified by the review as impacting small cap investment managers is declining market depth.
“Weak capital market conditions prevailed in 2012 with a lack of IPOs, capital raising and merger and acquisition activity limiting a traditional hunting ground for small cap managers,” Mr Sweeney said.
“The IPO market remains in drought and at cyclical lows for industrials. Indeed, 2012 was Australia’s weakest year on record for share market floats, which only totalled $876 million – down 32% from 2011, which was also a weak year.
“A dwindling of new opportunities suggests managers are increasingly hunting in a shrinking pool and looking for similar qualities in companies, resulting in a crowded trade scenario with the same companies being widely held.”
The Lonsec Review concluded the performance of the average small cap manager in the Lonsec peer groups versus the benchmark gives support to a meaningful allocation to small caps and an active investment approach.