There are 2,077 ASX-listed smaller companies stocks, known colloquially as small caps; that is, companies outside of the ASX-100 index[1]. Of those, just 200 comprise the S&P/ASX Small Ordinaries Index, which represents the small cap members of the S&P/ASX 300 Index. The index covers approximately 7% of Australian equity market capitalisation.
This article explores why small caps can be an attractive investment, and considers the current outlook for the sector. Simon Brown, co-Portfolio Manager of the Grant Samuel Tribeca Australian Smaller Companies Fund, shares his thoughts about some interesting themes and stocks in the small cap sector.
Why invest in small caps?
There are a number of factors that make small caps attractive. These include:
- Smaller companies are often under-researched by stock analysts and therefore potentially mispriced, presenting opportunities for astute investors to cherry pick the best opportunities.
- Investing in a small cap company in its early stages of development, staying invested while it expands and grows, can potentially provide substantial returns. All companies had to start somewhere – even Australia’s top 50 stocks were once ‘small caps’.
- Smaller companies are often the target of merger and acquisition activity, which is generally positive for the company’s share price.
- As illustrated by the following charts, the ASX-200 is dominated by financial and resource companies – small caps provide exposure to a more diverse range of industries. Some growth areas, such as health care or information technology, have greater representation outside of the ASX-200.
With any investment opportunity comes risk. Small caps generally exhibit higher levels of risk. Potential downsides to investing in smaller companies include:
- Small companies are generally less liquid while their business model and balance sheet can be less well established.
- Small companies may be more susceptible to changes in the economic environment. Instances such as a larger company pushing out its payment terms during tough times can starve a small company of vital cash flow and have a devastating impact.
- Smaller companies are generally often reliant on one product or service, particularly in its early days; a change in demand for that product or service can have an adverse impact on the business.
An increase in small cap IPOs
There have been an increased number of Initial Public Offerings (IPOs) in the small cap market over recent months. There are several reasons for this:
- Private Equity (PE) funds generally raise money in five year investment cycles. As can be seen from the chart in Figure 2, there were a large amount of PE investments in FY07-08. Consequently we have seen an increasing number of IPOs in recent years as PE firms realise or partly realise their investments given this five year horizon of funds.
- Smaller companies typically have less access to debt capital markets, so the equity market is often an attractive way to raise capital to fund growth. Given the lacklustre growth being delivered by the larger capitalised companies on the ASX (think banks, supermarkets and large resource companies) there has been plenty of investor capital interested in companies delivering earnings growth in the small cap sector.
- The share market is willing to pay a premium for growth. Companies with high price/earnings multiples are trading at a significant premium to their long term average, with the majority of these companies being growth companies or those providing very certain income streams.
Small companies can often operate in higher growth sectors of the economy, or those sectors that are highly fragmented where there is an opportunity to consolidate. Through an IPO, vendors can take advantage of equity capital to grow faster. - Apart from Government privatisations or large corporate de-mergers, many IPOs come to market with less than AUD$1billion market capitalisation, and are therefore classified as ‘small cap’.
What’s interesting in small caps at the moment?
Tourism
The tourism industry is currently the recipient of a strong tailwinds via the depreciation of the Australian dollar (AUD). The following charts illustrate that since the AUD started its decline in early 2013, short term international arrivals rebounded and have continued to grow strongly.
Meanwhile, the emergence of the Chinese tourist can be seen from the following charts, which show phenomenal growth over the past 15 years. Australia is experiencing very strong inbound Chinese tourist growth.
So much so, China has now overtaken New Zealand to take second place in terms of inbound passengers at Sydney Airport.
Domestic tourism should also benefit from a lower AUD as the increased cost of overseas travel results in more holidays taken at home. Domestic travel expenditure is higher in periods where there has been a lower dollar, and as illustrated in Figure 6, measures of domestic visitor nights have seen a recent pickup.
Small cap tourism stocks of interest include:
Event Hospitality (EVT)
Around 40% of EVT’s earnings are generated from tourist facing hotels, management letting rights (MLR) and ski fields. A structural underbuild in hotel stock over the past decade has resulted in strong utilisation and pricing power for EVT’s owned hotels, while growth in tourism has flowed through their MLRs and Thredbo resort. Tribeca believes the company will continue to benefit from the strong growth in tourism and believes it is not trading at a significant premium to the market.
Sealink Travel Group (SLK)
Over half of SLK’s revenue is exposed to tourism, predominantly through their ferry services at Kangaroo Island in South Australia and around Sydney Harbour. The fixed cost nature of the business means a large portion of additional tourist traffic drops directly through to earnings. At the same time, significant consolidation opportunities exist in the Australian ferry market, with scale benefits coming from becoming a larger business. Tribeca believes that SLK has excellent growth prospects organically and via M&A, and that the current valuation is still attractive.
Food and Agriculture
The Australian food and agriculture sector has emerged as a significant segment of the small cap market in recent years, both through strong growth in existing companies and a number of IPOs. Australia’s proximity to heavily populated Asian nations and their focus on securing future food supply has seen large volumes of foreign capital invested in the sector. The domestic market contains a variety of producers, processors, manufacturers, infrastructure owners and exporters across different subsectors, offering a broad range of investment opportunities.
The food products sub-sector has seen exceptional growth recently, particularly on the back of strong Asian demand; the image of Australia as a clean, green and safe market is a strong selling point. A number of companies have successfully marketed themselves into these neighbouring markets and have developed strong brand names with loyal followings. While there are a number of investment opportunities that offer potentially strong growth in small caps, valuations have often expanded and largely priced in this growth.
Small cap food and agriculture stocks of interest include:
Tassal Group (TGR)
Salmon demand in Australia is growing 7-10% per annum, and the salmon industry has expanded in recent years to make the fish more accessible to mainstream consumers. Three salmon farmers, of which TGR is the largest, supply the majority of domestic consumption. Large invested capital bases, limited growing areas and quarantine import regulations mean it is likely to remain a domestic oligopoly.
Recently, the lower AUD and various fish health issues in the major producing countries of Norway and Chile have resulted in large declines in fish inventories and higher prices on global markets; this has resulted in less competitive processed salmon imports to Australia. Tribeca believes this provides a buffer to local farmers such as TGR as they continue to grow supply to meet the increasing demand, while also opening up the possibility of exports into Asia. TGR has produced 17% earnings per share compound annual growth rate over the last three years, and Tribeca expects continued growth going forward.
Nufarm (NUF)
This global provider of generic agricultural chemicals and seed technologies has embarked upon a material cost out program as it aims to streamline production facilities, supply chains and product portfolios right across the business. After more than a decade of acquisitions, a new management team identified the opportunity for a significantly leaner business going forward, while also improving the geographic diversification of earnings through improved profitability in poor returning regions. There is material upside to group earnings if management delivers on this strategy, on which the market has taken a conservative view. NUF has corporate appeal, with major Japanese shareholder Sumitomo and the Chairman of Chinese supplier Fuhua both holding material stakes in the company.
What is the small cap outlook for the remainder of 2016 into 2017?
The recent small cap reporting season finished, on average, in line to slightly better than market expectations. Domestic cyclical and value stocks benefitted from an aggressive rotation away from growth and defensive companies as their results generally met, or were not far away from, recently downgraded expectations.
It is evident that domestic economic conditions continue to prove resilient and provide support to company earnings and there are signs that a much needed broadening in growth drivers is taking place. However, Tribeca remains cautious and expects economic headwinds to intensify through 2016.
Pockets of weakness in local housing prices need to be watched given that sector has many economic multipliers and the recent rebound in the AUD could certainly stall Australia’s economic progress.
[1] Australian Securities Exchange (ASX) as at 13 April 2016
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